Christine Lagarde, managing director of the International Monetary Fund, warned yesterday that the world is facing a "lost decade" of economic growth thanks to a eurozone sovereign-debt crisis that is spiralling out of control.

Ms Lagarde was speaking in Beijing on a day when the perilously fragile state of the Italian economy – the eurozone's third largest – came into sharp focus when the borrowing rates of the Italian government shot above levels which have forced other eurozone states to seek international bailouts.

Amid increased concern that Italy might be heading for a default, reports from EU sources in Brussels said that German and French officials had held "intense consultations" about setting up a more integrated and potentially smaller eurozone. The move raises the possibility that one or more countries might have to leave the eurozone.

Investors and traders desperately sold off Italian debt yesterday morning, pushing the yield – or interest rate – on 10-year Italian bonds to 7.4 per cent.

At such elevated borrowing rates, Italy will be unable to roll over its €1.9trillion (£1.6trn) sovereign debt pile, raising the prospect of an uncontrolled default by the country, an event that would plunge the global financial markets into chaos.

The sell-off of Italian debt was prompted by a decision yesterday morning by the London-based bond trading exchange LCH.Clearnet to increase the collateral, or insurance, that traders in Italian debt must pledge. The panic was compounded by confusion over whether Italy will hold early elections. Traders initially responded positively yesterday to the commitment on Tuesday night from the Italian Prime Minister, Silvio Berlusconi, to resign and make way for an administration committed to economic reform. But fear took hold when news emerged of a disagreement between Mr Berlusconi and the Italian President, Giorgio Napolitano, over whether the country should hold elections early next year.

Investors are worried that elections could cause lengthy political uncertainty in Italy at a time when the country urgently needs to demonstrate to its creditors that it is acting to get down its debt pile, which is equal to 120 per cent of the country's annual output.

Mr Napolitano said last night that Mr Berlusconi's departure would come "within days", adding he wanted to "dispel any doubt or misunderstanding" on the subject. He also insisted that economic reforms would be swiftly passed. A team from the European Union is due to arrive in Rome today to supervise Italian efforts to cut the nation's borrowing pile. And David Lipton, deputy director of the IMF, is due to arrive in the Italian capital next week. Ms Lagarde, at a banking conference yesterday, said that national leaders need to co-ordinate their efforts to prevent a widespread international slump.

"If we do not act boldly and if we do not act together, the economy around the world runs the risk of a downward spiral of uncertainty, financial instability and potential collapse of global demand," she said. "We could run the risk of what some commentators are already calling the lost decade."

Stock markets across Europe fell sharply yesterday. The shares of European banks, which are heavily exposed to Italian sovereign banks, were hit hard. And the value of the euro dropped to $1.36 (85p) on international currency exchanges as investors lost confidence in it.

The news from Athens that political parties in Greece are close to forming a new government did nothing to improve sentiment.

Italy needs to issue €340bn (£290bn) in new debt in 2012, a sum equal to 20 per cent of the nation's GDP. If Rome is unable to raise that amount of money in the global financial markets, it will be forced to apply to the eurozone bailout fund and the IMF. But the eurozone bailout fund only has about €300bn in available funds left after the bailouts of Greece, Ireland and Portugal. And G20 leaders meeting in Cannes last week failed to agree on a plan to extend the IMF's stretched resources.

The European Central Bank could bring down Italian interest rates by buying up Italian bonds in sufficient volumes, but the German Chancellor Angela Merkel, under huge pressure from the partners of her domestic coalition, has ruled this out.

If Italy is not able to raise money to pay its creditors, it could be forced into a default, which would send a shockwave through global financial markets potentially greater than the one that followed the collapse of the US investment bank Lehman Brothers in 2008.

The UK would be seriously damaged by an Italian economic collapse. British banks are estimated by analysts at the Swiss bank Credit Suisse to be holding €5.7bn of Italian sovereign debt. They also have loans to Italian companies worth €9bn, according to the results of the official stress tests of the European banking sector conducted in July.

The European Central Bank (ECB) was believed to be buying up Italian bonds in the secondary markets yesterday as part of its programme of stabilising debt markets.

Bond yields: Why 7 per cent spells danger

Yields on 10-year debt:

Greece 33.1 per cent

Portugal 11.8 per cent

Ireland 8.24 per cent

Italy 7.4 per cent

Spain 5.84 per cent

France 3.17 per cent

UK 2.17 per cent

Source: Reuters

Who's exposed: Italian debt The UK link