Italy: New coalition avoids snap vote, but structural reforms and political stability likely to remain elusive
September 20, 2019
A new government between former enemies the Five Star Movement (M5S) and the Democratic Party (PD) was rapidly formed at the start of September, ending the political crisis that the League’s Matteo Salvini triggered in August in search of early elections. Financial markets reacted by breathing a sigh of relief, with Italy's 10-year bond yield dropping to record lows, on hopes that the new government will be less belligerent towards EU institutions and thanks to reduced political risk. Although uncertainty has abated somewhat and early signs suggest Italy will be able to secure a deal with EU institutions on the 2020 budget, the medium-term outlook remains gloomy.
The new government is more left-leaning than its predecessor and its 26-point program published in early September, albeit vague, suggests it will not pursue bold structural reforms. The platform is centered on an expansionary fiscal policy and interventionist approach to spur growth and includes higher spending on green initiatives, social programs as well as the introduction of a minimum salary. While expansionary policies could give a marginal short-term boost to activity, weak public finances and sustainability fears will continue to haunt Italy’s longer-term outlook. In addition, the fractured nature of Italian politics and institutions makes it hard for the meaningful change needed to boost Italy’s growth potential. Moreover, the alliance is fragile due to the two parties’ different electoral bases and their record of bitter clashes. Former Prime Minister Matteo Renzi’s recent departure from the PD only complicates governability further, raising the risk of a short-lived government, although Renzi has stated he will continue to support the coalition.
The government is still headed by Giuseppe Conte, who filled the role of Prime Minister in the former League-M5S cabinet. Top on the agenda will be a draft budget for 2020, which is due to the Italian parliament by 30 September and to the EU by mid-October. The government will have to find more than EUR 20 billion in savings to meet EU rules on fiscal discipline and avoid the already legislated VAT rise in 2020—which would otherwise depress already muted consumer spending. The appointment of Roberto Gualtieri, a PD-veteran and previous chair of the economic and monetary affairs committee of the European Parliament, together with a commitment to not endanger public finances make a deal with EU institutions on the budget more likely than with the former government. However, the government will have to cut spending or raise taxes, although its insistence on implementing an expansionary fiscal policy means it will take full advantage of any flexibility the EU Commission grants the country.
Assessing the impact on Italy’s fiscal position of the new government, Nicola Nobile, Lead Economist at Oxford Economics, states:
“The best that can be said for now is that Italy will probably have a short period of stability with its new pro-European government. […] But as with the previous government, the new ruling coalition will likely push for more fiscal spending, hoping to obtain some flexibility from Brussels. At the moment, we’ve decided to keep our fiscal deficit forecast for 2020 at 2.7% of GDP, below the EU’s 3% threshold but well above the current target for this year of around 2% of GDP. […] Italy’s weak public finances keep it on the edge of fiscal sustainability. Yet our below-consensus GDP forecast does not suggest an imminent fiscal crisis. That’s mainly because existing Italian debt has a relatively long maturity. But a widening fiscal deficit with subdued nominal growth means the public debt (as a % of GDP) will increase next year, continuing the dynamic that started in 2018.”
Although the political crisis was swiftly resolved for the time being, political uncertainty remains high and economic weakness will likely continue to beset Italy. The government is unlikely to deliver overdue liberalizing reforms and given the elevated likelihood of future clashes on several government policies, the risk of early elections continues to loom.
FocusEconomics Consensus Forecast panelists see GDP growing 0.1% in 2019, which is unchanged from last month’s forecast. In 2020, the panel expects the economy to grow 0.4%, which is down 0.1 percentage points from last month’s estimate.