Editor’s note: This publication has occasionally published thoughts of the research house and political risk analysts at Exclusive Analysis. In this item, Pepe Egger, head of Western Europe forecasting at the firm, lays out preliminary thoughts following the Italian elections this week, an event that has reignited fears that Italy, the third-largest eurozone economy, could falter in moves to solve huge fiscal problems.  

The main takeaway from the election is that pro-austerity parties failed to find a majority and a reversal of Monti’s policies is likely.

Large chunks of Berlusconi’s Partito delle Libertà and Beppe Grillo’s Movimento 5 Stelle are critical of EU-led austerity policies and even the euro itself.

President Napolitano and the Partito Democratico want to avoid another election, since that would risk giving Grillo an outright victory. The Pd is left with the option of either finding support from Grillo on certain issues and reforms on a case-by-case basis, or agreeing with Berlusconi’s PdL on a form of government and a programme (for example electoral reform, reform of the political institutions, some fiscal reform to contain the size of the debt). Such an arrangement is unlikely to be formed before the end of March.

A Pd and PdL coalition government would probably reverse some of Monti's policies. A Pd government supported by Grillo would be an option much closer to the hearts of the party basis than another deal with Berlusconi, but likely much more unstable and exposed to Grillo's mercurial temperament.

Italy’s future government is unlikely to be stable or effective on core reform challenges to reduce debt and reform the electoral system. The latter especially is likely to contribute to volatility on debt markets.

Future challenges

One of the most crucial challenges for the next Italian government will be to reduce the €2 trillion ($2.62 trillion) in public debt, which represents a major drag on growth and a dangerous vulnerability to exogenous shocks.

Servicing the debt at present costs 5 per cent of GDP and eats up some 10 per cent of total government spending, constraining room to manoeuvre for any future government despite generating a primary surplus.

Background

Italian elections on 24 and 25 February failed to produce a clear winner, with the left-wing Partito Democratico winning a majority in the Chamber of Deputies, but not in the Senate, and with Berlusconi's right-wing Partito delle Libertà only one percentage point behind the Pd and even ahead of it in the Senate. While the anti-establishment Movimento 5 Stelle of Beppe Grillo gained some 25 per cent of the vote, Prime Minister Mario Monti's coalition only captured some 10 per cent, missing its objective of being a necessary coalition partner for the Pd in the Senate.