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Italian elections: three scenario’s


  • The Italian elections are on March 4 and will likely yield a hung parliament. The centre-right has then the best chance to form the next government, but the less leverage Forza Italia will have over the (Northern) League, the lower the probability of success. If the centre-right fails, a Grand Coalition including the Democratic Party, Forza Italia and other centrist parties will get more likely. If that fails as well, President Mattarella will ultimately have to ask current PM Gentiloni to head a caretaker government and to navigate Italy towards fresh elections.
  • The balance of risks is skewed to the downside. Markets like the low-key management style of current PM Gentiloni. A status quo, in which a Grand Coalition is formed under his command, would be the most stable and predictable situation. Everything else would be considered worse, including the formation of a centre-right government.
  • This is because there are too many uncertainties regarding the (Northern) League’s policies. The market may be too complacent about this, focusing only on Five Star. If the League’s ‘fanatic’ ideas ultimately push Forza Italia towards the Democratic Party, the market will turn out to be right. If not, we may see a repricing of risk assets.
  • Italy will stay in the Eurozone, but proposals to alter the budget rules, for more (fiscal) sovereignty and to increase risk-sharing are likely to be put forward. Eurosceptic rhetoric could also increase. If the Italian government were to adopt a highly confrontational stance, which is certainly a possibility if a centre-right government emerges, Italian politics could weigh on Eurozone reform.

About a year ago markets were rattled by the prospects of a possible Marine Le Pen victory, as one of her key pledges was to hold a referendum on France exiting the currency union. In fact, the preoccupation with political risks was at such a level that the firming economic recovery was almost overlooked. It’s now exactly the opposite. The market frets about prospects of higher inflation and what this means for central bank policy, whereas political risks have moved from the headlines to the side-lines. The Italian elections, risky as they always are, are scheduled in less than two weeks but large parts of the markets hardly bat an eye. Even though we don’t expect the elections to turn into a systemic crisis for the Eurozone, this complacency is risky. In this Special we explain why.

The elections: three main scenarios…

The parliamentary elections will take place on Sunday March 4. Exit polls are expected directly after the voting booths close and the results will come in overnight and on the ensuing Monday morning. It’s difficult to judge whether the exit polls will be indicative of the final results. In recent history, they have been pretty accurate, but last year the Italian parliament adopted a new electoral law (called Rosatellum bis) and this may create some modelling problems.

In a previous Special we already wrote about this law, but what follows is a quick take. After a very protracted and mind-numbing political process, the system that was ultimately put into place is a mixed member proportional system. It borrows some elements of proportional representation (roughly 2/3rd of the seats), other elements of a first-past-the-post system (FPTP, roughly 1/3rd of the seats) and then throws relatively high electoral thresholds in the mix.

All things considered, the Rosatellum implicitly puts a seat premium on coalitions. The candidate put forward by the coalition for the first-past-the-post seat in a constituency will likely get the vote of the supporters of all the parties within that coalition – instead of only from his/her own party. This seat premium can get sizable and has almost forced parties with broadly similar ideologies to form an alliance.

The centre-right has formed such a coalition, although the ties between the parties are rather loose. More often than not, Forza Italia’s Berlusconi finds himself at loggerheads with (Northern) League (LN) leader Salvini (the party is widely known as Northern League, but Salvini has recently scrapped ‘Northern’ to appeal to voters nationwide). They are, after all, fishing in the same pond. Still, the coalition fares better than the centre-left, as a political rift within Renzi’s Democratic Party (PD) has prevented the left to form a unifying coalition. Instead, there are now two groups: the centre-left coalition including the large Democratic Party and the left-wing Free and Equal (LeU). Finally, Five Star (M5S) doesn’t do alliances, at least not prior to the elections, because they are anti-establishment and avoiding backroom politics has been one of their main sources of popularity. The anti-coalition stance of Five Star is seen as the reason why the Rosatellum includes first-past-the-post seats, and why Five Star voted against it. That may not be good for democracy, but it has been good for markets. We see the relatively low probability of a Five Star government as one of the main reasons why markets are now paying (too) little attention to the Italian elections.

Opinion polls

The blackout period for the opinion polls has started and a look at the final data on political voting intentions suggests that support is split in three. The centre-right coalition is leading the pack, followed by the rebels from the Five Star Movement and the main centre-left coalition including the PD. The other coalition on the left (LeU) – cannibalises from the main centre-left coalition and is expected to win around 5% or 6% of the vote, i.e. less than the required threshold.

Figure 1: Centre-right in the lead, trailed by the centre-left and Five Star
Figure 1: Centre-right in the lead, trailed by the centre-left and Five StarSource: Macrobond 

Conventional wisdom holds that the centre-right coalition needs roughly 40% of the popular vote to achieve a governing majority, as it will likely win a good chunk of the FPTP premiums and as some votes are ‘voided’ when smaller parties and/or coalitions don’t make the threshold. Not a single poll has produced a ‘40%’-number for the centre-right, but they are getting close to that. The average of the past few weeks is roughly 37.5%, versus 27% for both Five Star and the centre-left. Given that polls have a certain margin of error and that most of these indicate that one in five voters is still undecided, there is still a reasonable chance that the centre-right coalition will ultimately cross the 40% threshold.

1. Centre-right government: not a given

One would therefore be inclined to see a centre-right government as a given, but there’s a caveat. What may be even more important than the headline result for the centre-right coalition is the balance of power within that coalition. Silvio Berlusconi’s Forza Italia (FI) is the more moderate and mainstream pro-business party which has a history of governing, whereas Salvini has turned the (Northern) League into a confrontational far-right party. Accordingly, we find it difficult to see how Forza Italia could operate in a centre-right coalition as a junior to them. Recent polls suggest that Forza Italia will be the intra-coalition winner, but the gap in the polls is only 3%-points. The less leverage Forza Italia will have over the (Northern) League, the more likely a centre-right coalition government cannot be formed or will fail after some months.

Figure 2: The plot thickens: who will be leading the centre-right?
Figure 2: The plot thickens: who will be leading the centre-right?Source: Macrobond

Another complicating factor is that the (Northern) League is bound to win the FPTP seats in their strongholds Lombardy and Veneto, while it remains to be seen whether members of FI who have been put forward as the coalition’s candidates in the South can beat Five Star. This may be held against them later on. Illustrative of the complications within the coalition is that both FI and LN were a no-show at a rally that had been advertised as a show of centre-right unity.



2. Grand Coalition: possible, but with complications

An outright centre-left majority seems impossible, even when the centre-left and the LeU hash out their problems. However, a Grand Coalition between Forza Italia, the PD and some smaller centrist parties, or perhaps a centre-left minority government with outside support of FI, does fall within the realm of possibilities. The better the performance of the centre-left coalition, the higher we see the probability of such an outcome, especially when the centre-right doesn’t reach a majority and/or FI has limited to no leverage over the (Northern) League.

We would emphasise that a Grand Coalition would have its complications. At least on paper, Forza Italia and the Democratic Party take very different positions regarding immigration, EU integration, fiscal policy and many more. We also see in Germany what a ‘GroKo’ does to poll ratings. That said, the PD-FI combination would be more or less the same arrangement as in the past years. And the moderate stance of the PD suits the pro-business style of Forza Italia much more than the confrontational style of the (Northern) League. The main issue therefore seems whether the Grand Coalition will win sufficient seats to form a workable majority.

The outlook for the PD itself is rather weak. All across Europe, social democracy is in demise and Italy is no exception to this. Voter support has been in a declining trend for quite some time. Moreover, if underperformance by Forza Italia is indeed the reason why a centre-right coalition government proves to be difficult, Berlusconi’s and his team will likely not be of much help either. FI and the PD poll at a combined 38%. With the help of some smaller centrist parties a working majority looks feasible. Caution is warranted, though, as the PD will likely win only few FPTP seats.

3. Populist government: unlikely

Based on the polls we believe the centre-right coalition has the best chance to form the next government, even though the risk of failure along the line would be large. The second most likely scenario in our view is a Grand Coalition with the PD, FI and some other smaller parties close to the centre. If both these options yield nothing, we think that President Mattarella will eventually be forced to ask current PM Gentiloni to form a caretaker government until new elections are held.

The numbers might add up, but we deem a populist coalition government with the (Northern) League, Five Star and the Brothers of Italy, or a coalition between Five Star and the ‘establishment’, very unlikely. While Five Star’s leader Di Maio has recently watered down the party’s anti-coalition stance, the party seems divided between pragmatists and conservatives on this issue. Moreover, for every party within such a coalition the downside of trying could be larger than of refraining.

… and the policy proposals

Just as most market participants, we do not foresee an unexperienced, nationalistic and eurosceptic government coming to power after the elections. But as we’ve mentioned before, this does not mean that one should turn a blind eye. With public debt at 132% of GDP and a potential growth rate of between 0.5% and 1.0% (see here for our take on this), there’s no room for policy errors. Italy simply can’t afford to be complacent about (fiscal) policy. Such moves worsen the long-term economic outlook and will ultimately upset markets. In this section, we’ll set forth our views on the implications for debt sustainability and euro area membership of the three different scenarios. While many of the policy proposals are probably not really indicative of future actual policies, we can still identify the general direction.

Figure 3: Economic growth has improved
Figure 3: Economic growth has improvedSource: Macrobond, Rabobank
Figure 4: Debt to GDP has stabilised
Figure 4: Debt to GDP has stabilisedSource: Macrobond

1. Centre-right government: tough talk, modest action?

The centre-right coalition issued a common programme, but the balance of power between FI and LN will be leading in determining actual policy. While Forza Italia is seen as both pro-business and pro-euro/EU, albeit with a touch of populist rhetoric, the (Northern) League is a radical far-right party that is very sceptical of the euro, budgetary rules and immigration.

They find common ground in more labour market flexibilisation, lower taxation at various fronts or even a flat tax rate, and a more flexible pension system. But whereas FI only suggests minor changes to the existing pension system, LN intents to severely roll back past reforms. This would make the system unsustainable. On top of more flexibility, FI proposes to increase the minimum pension from about €500,- to €1000,- a month. The common programme also entails a support plan for families with children, for the South and for the poor. This plan seems to come out of the sleeve of Berlusconi, as FI has recorded in its programme a ‘dignity income’ (a sort of basic income) of €1000,- per month for all Italian households. To promote job creation, FI advocates tax incentives to hire young workers on permanent contracts and LN proposes an unspecified reduction of the fiscal tax wedge.

Forza Italia wants to fund all this by cutting spending elsewhere and with higher revenues that should result from stronger growth. The (Northern) League sees actually no need for cuts, because they claim that higher growth and less tax evasion would (somehow) lead to sufficiently higher tax revenues. The reality is that both plans would significantly increase the budget deficit.

When push comes to shove, however, we expect that Forza Italia is ultimately inclined to respect the EU budget rules, while the (Northern) League is much less likely to care. It even recorded in its programme that it only wants to stay in the Eurozone if the Stability and Growth Pact is being revised or even scrapped, while FI has no intention at all to leave the currency union.

The upshot of all this is that the reform outlook would be weak in this scenario, but also that some tweaks to the tax burden seem likely. Measures that would raise pensions and that to some extent roll back previous pension reforms could also pass. Some fiscal slippage is therefore likely and this will test markets, but we expect that FI ultimately won’t risk jeopardising debt sustainability and financial market stability. We do however expect more pressure to renegotiate Italy’s contribution to the EU and proposals to increase fiscal and legislative sovereignty. That being said, the downward risk of this scenario is that FI is being overshadowed by the more fanatical (Northern) League. In that case, some structural damage might still be done. It’s not likely that this coalition would survive the full five-year term.

2. Grand Coalition: status quo

The Democratic Party and Forza Italia differ widely on topics like immigration and institutional arrangements, but they could be able to find common ground on tax- and labour market policies. Practically speaking, such a combination would be more or less the same arrangement as in the past few years and would imply a continuation of current policies. The PD advocates lower social security contributions to reduce the fiscal tax wedge, disincentives for temporary contracts, a higher minimum wage, continuation of tax deductions for low income earners, 3-year family allowances per child, a lower corporate tax rate, and an increase in minimum pensions from about €500,- to €750,-. It wants to fund this by reduction in tax breaks for businesses and stronger efforts against tax evasion (always a popular one...). This is unlikely to be sufficient, but the PD has already proclaimed that it will keep policy in line with the latest government’s debt and deficit projections. It’s therefore not likely that all proposals will be implemented.

What is probably most important for markets is that the Democratic Party is very much pro-EU and broadly acknowledges its budget rules, even though it proposes to alter some of these rules regarding the structural deficit. In any case, we don’t expect the PD to implement policies that would seriously endanger public debt sustainability.

The upshot is that also in this scenario the reform outlook would not improve, but there would be no fear of reform rollbacks. While tax incentives to improve the functioning of the labour market and lower tax burden for businesses might be implemented, fiscal slippage is unlikely to become an issue. At the same time, the coalition would be fragile and the government that will be sworn in is unlikely to survive the five-year term.

3. Populist government: weak governance and fiscal slippage

The Five Star Movement, the (Northern) League and the Brothers of Italy could well get the number of seats necessary to obtain a workable majority. Yet we do think the risk of such a government actually materialising is rather small due to the large ideological differences.

Still, if we assume this coalition comes into force, the most important implications are that they would want to increase spending (higher investments and more flexible pensions), significantly lower taxes, and say no to austerity. The government would have no intention to adhere to European budget rules. As mentioned, the (Northern) League wants to get rid of the EU budget rules or otherwise leave the currency bloc. Five Star wants to temporary deviate from the 3% budget rule to fund public investment and get rid of the fiscal compact, i.e. the requirement of a balanced budget. On the positive side, Five Star has removed the pledge for a referendum on the euro out of its programme. Moreover, if actually in government, a populist coalition might tune down its defiant stance against everything.

Still, the inexperience and apparent limited interest to keep public accounts in check would fuel uncertainty. If markets get upset and financial turmoil would increase it is very unlikely that such a coalition would be able to navigate the country out of a crisis.

Conclusion: downside risks

Both the centre-left and the centre-right have attempted to create an alliance on their own flank with the intention to broaden their appeal. The centre-right succeeded best. With 37% of the popular vote, they stand the highest chance of winning an absolute majority. It remains, however, an alliance of convenience. Silvio Berlusconi (FI) and Matteo Salvini (LN) are often at loggerheads and even failed to show up at a joint rally where they’d been invited to sign a pledge to remain faithful to their coalition.

We’ve seen a great show with very ‘eclectic’ party manifestos. We discussed these in the previous section, but with the understanding that it may well turn out that these manifestos aren’t worth the paper they're written on. When the votes are counted and the seats allotted, the second phase of the elections commences: the negotiations behind closed doors. Anything can happen and markets should be prepared for a period of heightened uncertainty.

The balance of risks is skewed to downside. Markets like the low-key management style of current PM Gentiloni. A status quo, in which a Grand Coalition is formed under his command, would be the most stable and predictable situation. Everything else would be considered worse, including the formation of a centre-right government. There are too many uncertainties regarding the (Northern) League’s policies and the market may be too complacent, focusing only on Five Star. If the LN’s ‘fanatic’ ideas ultimately push Forza Italia towards the Democratic Party, the market will turn out to be right. If not, we may see a repricing of risk assets.

Finally, given the large support for M5S in the opinion polls, it would be premature to entirely rule out a Five Star government or an anti-establishment government including Five Star, the (Northern) League and the Brothers of Italy. This would definitely set the stage for some serious turbulence in financial markets.

Figure 5: Risk reversals have turned south, but not as much as last year
Figure 5: Risk reversals have turned south, but not as much as last yearSource: Macrobond
Figure 6: Quite a sanguine view on rates markets
Figure 6: Quite a sanguine view on rates marketsSource: Macrobond
Maartje Wijffelaars
RaboResearch Global Economics & Markets Rabobank KEO
+31 6 2257 0569
Stefan Koopman
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 71 21328

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