Italian Elections: Uncertainty to Linger

Italy goes to the polls Sunday and Monday for national and regional elections. There is great uncertainty about the outcome and this seems to be a major factor behind the under-performance of Italian assets (short and long term debt and the equities) in recent weeks. However, as an event risk, uncertainty is likely to persist for a few weeks after the election. 

Consider that the arcane rules of Italian politics means that the formal announcement of a new government after an election takes several weeks. Even after a landslide victory in 2008, it took Berlusconi four weeks to have his government in place. And that was under the best of conditions.

Now the polls, which were banned after Feb 9, generally agree on three things:: the center-left is ahead by 4-9 percentage points; that Berlusconi has tightened the race in recently; and there remains a  high number of undecided.  In 2006, Berlusconi was running 3-6 percentage points behind in the polls and eventually won.  In an earlier election, the polls suggest Prodi would win handily and just barely managed to claim victory.  If there is a pattern, it would seem that the polls picked up greater support for center-left than how people actually vote.  

Given the difficult economic conditions, Italy needs strong leadership.  One could be forgiven for thinking that the best thing might be for the center-left PD to win a majority in both houses.  The problem is that while that might produce the most stable government, the scope for structural reforms would be limited by the main constituencies.  This is especially true for reforms in the labor market, where Italy's productivity is weak and unit labor costs high.  

The best chances of balancing a strong government with a reform agenda also looks the most likely.  It is the center-left winning the Chamber of Deputies and then forming a coalition with Monti's centrists to secure a majority in the Senate.  The cost of such an alliance would be that the PD might have to estrange some of its far-left partners (such as the SEL).  

This scenario crucially depends on how well Monti's centrists do.   In such a coalition it is also not clear the position Monti can hold.  The PD leader Bersani is unlikely to  move aside to allow Monti to be premier and finance minister would be a step down for Monti.  Some kind of super-minister, or minister without a portfolio might not give him the power base needed to secure his agenda. 

Italian voters did not elect Monti.  Nor do they support him.  The economy contracted each quarter he was premier.  The EC will issue updated forecasts for 2013 tomorrow and is likely to project a deeper contraction this year.  Last summer, before the ECB's Outright Market Transaction scheme was announced, the EC project the Italian economy would decline by 0.6% this year.  It may  now project a contraction closer to 1%.

The unemployment rate is at a 13-year high, and among 15-24 year holds the unemployment rate is near 37%, the highest since 1992.    The Italian banking association (ABI) recently reported that loans to household and business fell 2.5% in January.  The weakness of the economy is souring loans.  Non-performing loans rose to 3.3% of the outstanding from 2.7% at the end of 2011.

Many foreign observer do not understand why there is even a remote chance that Berlusconi, who is currently appealing a tax fraud conviction, can win.   These observers do not give his charisma sufficient due, nor his populist and anti-austerity forces.  Moreover, it is easy to forget that he was squeezed out of office and was not defeated at the polls.  He is an astute politician in his own right and his opponents often do not appear to be stiff, bland and not comfortable with their fellow citizens and in the media.

Five of the seven main parties are critical of the extent of Monti's austerity and reforms.  Two of the parties, the rightist Northern League and Grillo's protest party, 5-Star Movement, favor a referendum on EMU membership.  The 5-Star Movement is likely to receive the third most votes, behind the center-left Bersani and center-right Berlusconi, and several percentage points ahead of Monti.    Grillo, a comedian, has ruled out a coalition with the other established parties. This coupled with the high level of undecided voters makes the electoral outcome particularly difficult to forecast.

Although Berlusconi is in the same European political party as Merkel, he has campaigned against her.  It seems clear that Merkel and German Finance Minister Schaeuble prefer Monti, but are hesitant to push the issue publicly.  Recall they unabashedly supported Sarkozy over Hollande in France and, well, that has not worked out so well.  In addition, with Germany's own election in 7 months, surely they would prefer foreign officials not get involved.

The markets will likely react the most violently to a victory for Berlusoni's center right.  We imagine under such a scenario, Italian yields would spike higher and Italian shares, especially the financials would sell-off.  Insurance via sovereign credit default swaps would be marked higher.

Unlike most of the periphery and many core euro area countries, Italy's economic challenge is not the budget deficit.  Its substantial debt burden, for which is pays about 4.5% of GDP to service currently is a product of past deficits.  Its chief economic challenges is the lack of growth, which reflects struggling competitiveness.  Regardless of the particular electoral outcome, these issues will continue to vex Italy's political elite.