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Formation of Italy’s new government raises questions on sovereign outlook, euro area reform

The final steps towards an anti-establishment, new Italian government present challenges for the country’s economic and sovereign outlook, and may impede progress on the European reform agenda, according to Scope Ratings.

The Five Star Movement (M5S) and Lega displaced mainstream parties in the March general election, and the two populist groups have joined forces in negotiating the final steps to form a new government. The coalition pact was voted through in membership ballots this weekend. In Scope’s post-election comment published on 5 March, we touched on the probability of this outcome.

Italy’s 10-year yield spread to Bunds stood at 175 bps as of Tuesday, up sharply on lows of 114 bps as recent as late April.

“The Italian economy holds structural weaknesses tied to low growth, high public debt of 132% of GDP, alongside institutional bottlenecks. The composition and inexperience of this probable new government cast doubt on the country’s future commitment and ability to resolve such challenges,” say Scope analysts Dennis Shen and Dr Giacomo Barisone.

“Many of the negotiated policies would still, in their present form, impose multibillion-euro extra yearly costs on the state without corresponding cuts in government spending or increases in fiscal receipts. However, we believe that many of the proposals are unlikely to be enacted in their current forms, and will probably continue to be watered down, if not blocked.”

Scope notes that earlier controversial proposals, like the request to write-off EUR 250bn of Italian government debt and language referencing EU treaty change to facilitate exits from the Economic and Monetary Union have been excluded from the final two-party agreement.

Nevertheless, the policy pact includes Lega’s proposed tax reduction to a flat rate of as low as 15% for companies and individuals, the rolling back of 2011’s flagship pension reform, as well as M5S’s citizenship income. Estimates have placed these actions at a cost of more than EUR 100bn.

President Sergio Mattarella has indicated his opposition to unfunded spending plans. There are additional constraints on the government’s actions including the Constitution, European treaties, as well as the global financial system. The two parties’ small parliamentary majority, especially in the Senate, Lega’s polling gains, and the probability of forced moderation of campaign promises will test the unity and longevity of this government. Nonetheless, the implementation of even some of the suggested measures, probable inaction on other areas of needed reform, and extended political uncertainty cloud the path ahead for Italy’s “A-/Stable” sovereign ratings.

This new government will also have implications for the European reform agenda. Scope has stated its belief that chances of an ‘Ital-exit’ from the euro are low even in the scenario of this exact government formation. Nonetheless, the parties’ desire to reverse fiscal consolidation and renegotiate EU economic and fiscal governance institutions may result in tension between Italy and European institutions and slow the pace of regional institutional reform.

Please click here for Scope’s post-election comment.