Italy`s economy has accelerated over the course of 2017, despite the lingering uncertainty about the 2018 general election. The threat of anti-EU, populist forces coming to power in Italy has receded following the reform of the electoral law. However, rising political fragmentation will create difficult coalition dynamics. In our view, the most probable political outcome is a multi-party coalition government headed by the center-right that stretches across the political divide and includes the PD. Rather than a tectonic shift, the 2018 election looks set to deliver ‘more of the same’ with Italian politics having long been characterized by uncertainty and instability. Such an outcome will hence trigger only a limited spread widening for Italian government bonds and will have little direct impact on the economy. Moreover, even in an adverse scenario characterized by a prolonged period of political uncertainty, the negative impact of elevated financial market stress on public finances should be limited. The duration of Italy`s government debt is rather long, so that refinancing needs are limited in the short term. Also, present borrowing rates for Italy are still significantly lower than the average rate on all outstanding bonds (around 3 %). So the downside is limited. On the other hand, it seems unlikely that the election outcome will herald bolder reform moves for higher growth. So there is limited upside as well.
Munich, Dec 21, 2017
Will Italy turn Eurosceptic in 2018? In Italy’s upcoming parliamentary election in spring 2018 half of the electorate is likely to cast their vote for a Eurosceptic political party. Nevertheless we view the probability of a Eurosceptic government emerging as remote. An outright majority for any single populist party is clearly out of reach. In addition the recently adopted electoral law favors pre-election alliances and hence weakens the relative position of the stand-alone Five Star Movement.
No Italexit, no problems? The threat of anti-EU, populist forces coming to power in Italy is receding. However we continue to worry about the rising political fragmentation. A hung parliament is all but certain allowing only for difficult coalition dynamics. Our baseline scenario envisions the formation of a ‘grand coalition’ government headed by a united centre-right camp and including Matteo Renzi’s Democratic Party as a junior coalition partner. The chances of such heterogeneous, ill-suited coalition partners agreeing on an ambitious reform agenda are slim.
How will markets react to political uncertainty? Rather than a tectonic shift the 2018 election looks set to deliver ‘more of the same’ with Italian politics having long been characterized by uncertainty and instability. Hence we don't expect market confidence towards Italy to decline markedly with the robust macroeconomic backdrop in Europe propping up investor sentiment. Moreover even in an adverse scenario the negative impact of elevated financial market stress on public finances would be mitigated by Italy’s favorable debt structure including a low average interest rate, a long average maturity and a strong domestic investor base.
The long view: Italy remains the eurozone’s Achilles heel. If in the medium term Italy is unable to generate growth to address its many fundamental problems, from high public debt to a fast aging population and an undercapitalized banking sector, this will represent a considerable challenge for the eurozone, economically as well as politically.