By Philip Pullella
ROME (Reuters) - Prime Minister-designate Enrico Letta saw "improving" chances of success as he began negotiations on Thursday to form a new government and end a nearly two-month-old stalemate in the euro zone's third-largest economy.
The 46-year-old deputy head of the badly fractured center-left Democratic Party (PD), was the President Giorgio Napolitano's surprise choice to head a broad-based coalition.
"He told us that as the hours pass, he feels things are improving, whereas at the start he felt desperate," said Massimo Bitonci, an opposition lawmaker who held talks with him.
Markets have reacted favorably to the prospect of an end to the political deadlock, with bond yields and the spread with comparable 10-year German bonds falling.
Letta is viewed as a politician capable of governing by consensus. An opinion poll for Italian state television said he would enter office with a 43 percent approval rating.
The government will include the PD's traditional rivals, Silvio Berlusconi's People of Freedom party (PDL), as well as caretaker Prime Minister Mario Monti's centrist group, both of which have said they will support the government.
Letta is a moderate who speaks fluent English and at 46 would be one of Italy's youngest prime ministers, representing a generational change from the era of Berlusconi and Monti.
Berlusconi told an Italian television station it did not matter who headed the government as long as it enacted reforms.
"The important thing is that there is a government and that there is a parliament that can approve measures that we absolutely need to emerge from the crisis of recession and get back on the path of growth," he said.
5-STAR MOVEMENT, LEAGUE, CONFIRM OPPOSITION
Letta began the consultations at parliament early on Thursday morning with smaller groupings, including the Left Ecology and Freedom party, which reiterated that it would remain in opposition.
The anti-establishment 5-Star Movement, the largest group in the lower house Chamber of Deputies, has also said it would sit in the opposition, but would support specific reforms.
The Northern League, a former ally of Berlusconi's PDL, also reiterated that it would not join the government but said it would cooperate on some reforms.
Thursday was expected to be dedicated to horse-trading over about 18 ministerial posts in the new government, expected to be made up of technocrats and politicians.
The economy ministry could go either to Fabrizio Saccomanni, the Bank of Italy's director general, or Carlo Padoan, chief economist at the Organization for Economic Cooperation and Development (OECD), according to Italian media.
Angelino Alfano, the secretary of the PDL, has been tipped by some to become deputy prime minister, a choice that would placate Berlusconi but upset some on the left of the PD .
The industry and labor ministries could go to politicians and the foreign affairs portfolio to Monti or former Prime Minister Massimo D'Alema of the PD, local media speculated.
The PDL is pushing hard for a much-hated tax on primary residences to be abolished, which was a key plank in their campaign ahead of the inconclusive February elections, which gave the PD a majority in the lower house but not in the Senate.
Letta hopes to form the government before markets open on Monday and seek confidence votes from both houses of parliament early next week.
The PDL and PD had previously failed to reach a deal but Napolitano twisted their arms on Saturday when he was re-elected to an unprecedented second term and threatened to resign unless parties tried to find common ground to pull Italy out of its political rut and work on institutional reforms.
Rivalries between the parties as well as rifts within the PD, which fell short of a viable parliamentary majority in February's vote, could still block an accord. But formation of a government after such a long impasse would signal that Italy is finally ready to make a start on much-needed reforms.
Accepting his mandate on Wednesday, Letta said Italy faced an untenable situation and the government must provide answers on jobs, poverty and the crisis facing small businesses in a recession that now matches the longest since World War II.
He also said European Union economic policies had been too focused on austerity, rather than growth.
(Additional reporting by Stephen Jewkes, Stefano Bernabei and Francesca Piscioneri; Editing by Alistair Lyon, Janet McBride)