Rome, Italy.

Italy’s Government Crisis adds Risk to Outlook for Economic Recovery and Public Finances

The collapse of Prime Minister Giuseppe Conte’s coalition after the withdrawal of junior party Italia Viva, led by former prime minister Matteo Renzi, brings three risks to the fore for Italy.

First, prolonged political uncertainty could impede effective decision making if Conte struggles to reconstitute a robust ruling coalition. Secondly, fresh parliamentary elections, even if unlikely at this stage, could result in victory for Italy’s right-wing anti-EU political parties according to the latest polls.

The third risk is potential damage to Italy’s relations with Europe: effective management of the pandemic response and successful deployment of EU budget funds to stabilise and kick start Italian growth are in the interests of Italy’s regional neighbours – interests undermined by internal policy disagreements among Italian political groupings.

Political impasse might sour relations with other EU members

European institutions may be concerned that Italy’s political parties are embroiled in domestic power disputes rather than focusing on tackling the pandemic and putting to good use the large amount of resources that European partners have entrusted the country with. Italy had a credibility gap at the onset of the pandemic, with an uneven record in fully and efficiently absorbing EU funds. The country is one of the primary beneficiaries of the Next Generation EU recovery fund with allocated loans and grants of about EUR 209bn.

So far, political tensions have had no significant impact on investor confidence, however, unlike in earlier Italian political crises, due to the ECB’s supportive monetary policies. The spread between 10-year Italian government bond yields and that of German bunds rose to around 120bps before declining to around 113bps at the moment, leaving Italy able to borrow at near record low rates.

Italy’s large budget deficit is a concern without a robust economic rebound

The pandemic is still spreading fast. The government has extended a state of emergency to end-April as vaccination scales up.

Pandemic-related government spending – including an additional EUR 32bn (1.8% of GDP) support package announced last week – and a wider fiscal deficit continue to adversely affect the outlook for Italy’s public finances. We forecast a budget deficit of around 9% of GDP this year, after an estimated 11.5% in 2020, with public debt increasing to nearly 160% of GDP and continuing to rise thereafter, underlining the urgency of addressing the public-health crisis promptly.

Conte’s government has agreed on measures to solve structural economic bottlenecks within its national recovery and resilience plan (PNRR). The integration of NGEU and national fiscal stimulus would result in EUR 311bn allocated to six strategic missions over 2021-26, including accelerating digitalisation and the green transition, encouraging innovation and addressing social inclusion. The government has identified accompanying judicial, civil service and tax reform, without, for the moment, providing details.

Rome is counting on fiscal stimulus, ambitious reforms to generate faster growth

The government is counting on the PNRR to boost the economy by 0.5% of GDP in 2021, with the cumulative impact on output equivalent to more than 3pp by 2026, which, together with high forecasted primary surpluses, could return Italy’s public-debt ratio to pre-crisis levels by 2031.

This upbeat scenario from the Italian authorities relies on accelerating reforms to ensure the Italian economy sustainably grows faster – hence the danger of any prolonged political impasse in Rome that stymies decisive economic and fiscal policy making.

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Giacomo Barisone is Managing Director of Sovereign and Public Sector ratings at Scope Ratings GmbH. Dennis Shen, Director, and Giulia Branz, Associate Analyst, contributed to writing this commentary.