As European leaders brace themselves for the outcome of this weekend's crucial elections in Greece, markets are increasingly concerned about Italy's fragile financial situation and its impact on the euro.

Government data released on Thursday showed that Italy's public debt had reached a record high of 1.95 trillion euros (about 2.46 trillion U.S. dollars) in April, as borrowing costs jumped to 5.3 percent at a three-year bond auction from 3.9 percent a month ago.

The European Central Bank (ECB) recently also released figures showing Italy and Spain have suffered a major withdrawal in foreign investment of up to 600 billion dollars in the past three years, although Italian banks have also cut their investments abroad.

ECB president Mario Draghi said on Friday while there were "serious downside risks" to the economic outlook, political choices must take precedence over monetary policy. But he said the ECB would continue to supply liquidity to solvent banks where it was needed.

"Italy is suffering from collateral damage," said Armando Carcaterra, director of investments at Anima SGR, a leading asset management firm in Milan.

"The recession affecting our country, concerns about public debt and the difficulties and the slow pace of the Monti government's reforms as well as recent election results, highlight the need for growth and this has increased concern across the eurozone," Carcaterra added.

"Italy remains weak inside the eurozone with its elevated level of public debt making it vulnerable to speculation," he said.

As German Chancellor Angela Merkel declared Europe was "in a race with the markets" to create a political union, Italian Prime Minister Mario Monti met French President Francois Hollande for key talks in Rome on Thursday. Monti called for more action to tackle the eurozone debt crisis.

"What has been done is not insignificant, but it is not sufficient," Monti told the media after two hours of discussions overshadowed by violent protests outside the lower house of Parliament nearby.

Italy's benchmark bond yield hovered above 6 percent on Thursday, but on Friday, the country's 10-year bond was trading at an interest rate of 5.99 percent - and the spread had dropped to 450 points.

But the ECB has warned the overall outlook for financial stability in the eurozone was "very challenging," and was particularly concerned about market turmoil and the renewed pressure seen since April.

In its Financial Stability Review in June, the ECB called for member states to step up their initiatives to maintain a "robust monetary union."

"Remaining vulnerabilities in the financial stability outlook demonstrate that there is no room for complacency in implementing needed adjustment, either on the part of governments or on that of banks," the bank said.

The bank wants to prevent a "potential aggravation of the debt crisis" in Europe and is also concerned about the risk to bank profitability stemming from weaker economic growth.

"There remains a clear need for a continued focus on tackling the root causes of the crisis, and a comprehensive response remains key to decisively ending a spiral of systemic risk augmentation," the bank said.

Spain remains vulnerable despite the bank rescue deal approved last week to support its lenders that were hit hard after the collapse of the country's property boom.

On Wednesday, Moody's slashed Spain's rating to Baa3, and said the rescue plan would increase its debt burden.

Nicola Borri, assistant professor of economics at Luiss University in Rome, said the situation in Italy was very serious but the Spanish bailout package had restored some calm on European markets.

"The big, big danger is what is going to happen in Greece over the weekend," Borri told Xinhua.

"If they vote to leave the eurozone we don't know what's going to happen. If investors start pulling their money out of peripheral countries like Portugal and Spain, this will be very difficult."

"I think Italy's banking sector is in better condition but if Greek voters go out of the eurozone, European countries should set up a joint fund to ensure bank deposits are protected."

"We need insurance at a European level and the ECB is well aware of that. If not we could see a lot of money taken out of Portugal and Spain, but this is less likely in Italy."

According to the ECB, bank deposits in Spain have fallen 4.2 percent in the past year, but risen 0.2 percent in Portugal. In March, Italian bank deposits are 2.0 percent higher than they were a year ago.

"There is evidence that domestic depositors are pulling their money out of the banks (in Spain), "Borri said. "That is scary. The banks need confidence and if depositors are pulling their money out that is very dangerous."

Borri said the Monti government had pledged to make changes in Italy to attract more foreign and domestic investment.

"They haven't done it yet, but they are trying to market the country this way," he said.