Italian elections: A lost year?
Given the Italian election outcome, resurgence of political and financial market unrest seems likely. No party has obtained a workable majority and a coalition seems, at the very least, extremely difficult to be formed. For that matter, there is a chance that Italians will have to go back to the ballot box sometime this year. Regrettably, Italy’s longer term challenges will remain unaddressed until a reform-oriented political party forms a working majority in the Parliament.
Political stability at risk
In both the Upper and Lower Houses, the difference between the winning coalition and the runner up were extremely close. The race for the Chamber of Deputies (the Lower House) was a close call, ultimately won by the center-left coalition led by Pier Luigi Bersani (IBC). They have obtained 345 out of 630 available seats. The runner up, Sylvio Berlusconi, only received 125,000 votes (0.35%) less, meaning that he is not granted the 55% majority premium (see box 1 for details), and currently holds 125 seats.
The race for the Senate (Upper House), however, has spoiled the party for the IBC. The extremely strong comeback of Berlusconi and the large amount of (protest) votes obtained by the 5-star Movement (headed by the former comedian Beppe Grillo) have prevented Bersani to also obtain a workable majority in the Upper House. Due to Mario Monti’s weak performance, even a coalition between the two would give them less than half of the Senate seats.
The large share of votes for Berlusconi and Grillo may indicate that the Italians are fed up with fiscal austerity measures amid a severe worsening of economic prospects. At the same time, the strong outcome for the protest movement led by Grillo reveals that Italians are equally tired of the current political establishment. It is worth noting that the public continues to believe in the benefits of Europe and the euro, and more coordination is even perceived to be beneficial. This is evident in the latest Eurobarometer survey conducted by the European Commission in October 2012.
Box 1: The Italian political system 101
The Italian Parliament is divided into the Chamber of Deputies, the Lower House, and the Senate, the Upper House. Both Houses can initiate laws which have to be approved by the other House before it can be sent to the President. Therefore, a stable government needs a working majority in both Houses.
The Lower House has 630 seats that are divided based on the national election outcome. The Upper House has 315 seats, which are divided based on regional election outcomes. For parties to obtain seats in one or both Houses, they need to win a minimum percentage of votes. The threshold is lower for parties that have formed a coalition prior to the election. In the Lower House, the party or coalition with the majority of the national votes automatically gets a minimum of 55% of the seats. Senate seats, however, are won at the regional level. The coalition winning in a region obtains at least 55% of that region’s seats. Therefore, the majority coalition in the Chamber of Deputies does not necessarily run a working majority in the Senate.
Given Bersani’s very different political standpoints compared to Grillo or Berlusconi, we deem it highly unlikely that he forms a coalition with them. Thus, a hung parliament is the likely outcome. Not to mention that this will increase the likelihood of new elections in the near future . For this reason, the forthcoming period is likely to be dominated by political uncertainty and instability.
 ^ New elections cannot be called before President Napolitano is replaced in May this year.
Het belang van de verkiezingen
The political outcome following the election is decisive for the calm in the eurozone financial markets. If investors doubt the willingness of the next government to (i) address Italy's deep-seated economic problems and (ii) comply with Europe's (austerity and reform) rules, government bond yields may climb to uncomfortably high levels. This is especially because the European leaders may be less willing to support Italy in such a scenario. Given the size of Italy's economy (third largest in the eurozone), negative spillover effects to the rest of the euro area can be substantial and might even lead to a renewed deepening of the debt crisis.
Needless to say that rising yields would be a highly unwelcome development as it reverses all the gains made by Monti and the ECB president Mario Draghi to partly restore trust in the Italian government bonds (figure 1). The austerity and reform measures carried out by the technocratic government in 2012 made it clear that Italy is serious about improving public finances and bolstering the country's growth prospects. This together with Draghi's pledge to do "whatever it takes" to preserve the euro resulted in a sharp drop in Italian government bond yields.
Figure 1: 10 year government bond yields
Source: Reuters EcoWin
Market’s response has been negative
Financial markets have already reacted by raising the sovereign risk premium demanded on Italy's government bonds (figure 1). Sadly, the yields of some other periphery countries have also risen slightly due to negative contagion.
The rise in interest rates will have negative implications for Italy's debt sustainability. To appreciate this, we can take a look at the drivers of public debt-to-GDP ratio, which is dependent on the government's primary budget deficit (i.e. budget deficit excluding net interest payments), the stock-flow adjustment and the gap between nominal GDP growth and the effective interest rate paid on government bonds . The latter is referred to as interest-growth differential or snowball effect and is particularly relevant in debt sustainability analyses. The bigger the snowball effect, the more difficult it is for the government to reduce the debt-to-GDP ratio to more prudent levels.
Figure 2: Drivers of changes in public debt
Source: Reuters EcoWin
Figure 2 shows that the interest-growth differential has been a constant push-up factor for Italy's debt-to-GDP ratio. Given the election outcome, debt dynamics are likely to become even less favourable. The figure also makes it clear that Italy has actually run primary surpluses for more than a decade, with the exception of small deficits in the crisis years 2009/10. The primary budget surplus had a downward effect on the debt-to-GDP ratio for many years but they have not been sufficient to reduce the debt-to-GDP ratio substantially.
d is the debt ratio, pd is the primary deficit, r is the government bond yield, g is nominal GDP growth rate, SF is the stock-flow adjustment and t is the period.
Longer term challenges
Due to the current election outcome, longer term economic challenges of Italy are not likely to be dealt with any time soon.
Italy's main economic challenge is its weak growth potential. It will, therefore, be very difficult for the country to grow its way out of debt. The main reason for the sluggish growth is that Italy has been losing competitiveness over the past decade. This is a combination of extremely weak productivity growth  and relatively high nominal wage growth. Figure 3 illustrates that the trade-weighted exchange rate of Italy (adjusted for unit labour costs) has grown strongly since the country joined the euro. In fact, Italy ranks only 42nd on the Global Competitiveness Index and 73rd on the World Bank's Ease of Doing Business scale.
Figure 3: Real effective exchange rate
Source: Reuters EcoWin
Unfortunately, much of the reforms proposed by Monti were watered-down or completely vetoed. Admittedly, a liberalisation package for professional services, simplification of administrative rules, and measures to reduce red tape have been adopted, and these are expected to improve competitiveness in the medium term. The OECD estimated that approved reforms, if fully implemented, could boost GDP growth with 4%-points within a decade.
The technocratic government also succeeded in facilitating entry into the labour market for young workers on apprenticeships, standardising job contracts, encouraging labour mobility and differentiating tax provisions to discourage employers from offering short-term contracts.
Meanwhile, Monti's pension reform made the country better cope with the ageing population. The reform included, amongst other things, an extension of the contribution-based regime to all workers, the increase of the retirement age, which will also be linked to changes in life expectancy, and tightened eligibility requirements for early retirement. Against this backdrop, ageing will no longer automatically worsen the public finances over time.
That said, the upward potential is still enormous. Examples to boost competitiveness are (i) lowering entry barriers to increase productivity in both product and services markets, (ii) improving the judicial system, and (iii) reforming the labour market. As regards the latter, it is of importance to further increase labour market flexibility, bridge the gap between those on permanent and temporary contracts, boost (female) labour participation, and ensure that wage growth moves in line with productivity.
Fiscal policy measures
Also fiscal reforms are necessary. In specific, austerity should be tilted more towards public spending cuts and efficiency savings instead of tax hikes. This would ease the downward pressure on consumer spending and business investment. The tax policy should be simplified and become less distortive, while tax evasion should be fought more effectively. At the same time, privatisation of state-owned enterprises must become a top priority. On the one hand, this would bring in money to reduce the debt stock, and on the other hand, it improves efficiency and productivity, which enhances the country's growth potential.
According to the IMF, a full reform package including product and labour market, as well as fiscal reforms could boost GDP growth by more than 21%-points in the long run. Accordingly, the debt ratio could be lowered from 125% to about 100% by implementing the necessary reforms and maintaining a balanced budget. We must stress that structural reforms will probably weaken economic activity in the short-term and the benefits will only accrue over the longer run.
 ^ Labour productivity declined outright in the first 10 years of 2000, something not seen in any other eurozone country.
The election outcome likely results in a hung parliament, which leads to a period of political uncertainty and instability. The chance of new elections being called this year is non-negligible. In any case, the appetite for further fiscal austerity and reform will be lower than desired. Financial markets have already raised the risk premium on Italian bond yields as they are concerned about the country's fiscal sus-tainability. Meanwhile, Italy's longer term chal-lenges are unlikely to be addressed, thereby hampering the country's long term growth potential.
Figure 4: Economic data and forecast
Source: Reuters EcoWin, Rabobank