After lengthy negotiations centered on the Italian Recovery Plan for almost one month, the parties within Italy's ruling coalition (5Star, Democratic Party and Italia Viva) failed to strike a compromise. Surprising most observers, Italy's hardcore establishmentarian President Mattarella has moved down the route of attempting to form a Government of National Unity/Technocratic Government until such a time as elections can be held; due to the fact that a caretaker Government - i.e. Conte continuing as PM until elections – would not be able to generate plans for the recovery fund. As a reminder, to access the EU recovery fund nations must submit plans to the EU outlining how they intend to spend the funding.
Then late on Tuesday, Matarella - always working on behalf of Europe and not Italy - shocked markets when he decided to invite (at noon today, CET) former head of the ECB and Bank of Italy (and former Goldman partner) Mario Draghi to form a new government, skipping the common convention of an additional round of meetings with the parties in Parliament.
Draghi has “provisionally” accepted the invitation, i.e., pending confirmation that a sufficiently large share of the parties in Parliament will grant their support.Once this support has been secured, Draghi will face a confidence vote in both the Lower Chamber and Senate (Camera dei Deputati and Senato), possibly early next week. Although the boundaries of the new coalition are still unclear, it will likely have a larger majority in support of Draghi encompassing most of the previous ruling coalition (5Star, Democratic Party and Italia Viva) and Forza Italia led by Silvio Berlusconi.
On the policy front, Goldman expects the new government to improve the fiscal response to the Covid crisis, upgrade the implementation of the Italian Recovery Fund with some structural reforms at the margin and, finally, produce a more effective strategy on vaccination and the Italian health care system. Two main political risks weigh on the new government beyond the confidence vote: first, the fragmented composition of the 5Star movement in its attitude towards Europe – and towards Draghi; and second, the addition of Forza Italia to the coalition will increase the degree of fragmentation in the policy platform.
Meanwhile, Goldman notes that early elections remain very unlikely, especially after Mattarella made clear that their timing (at least 4 months for a new government) would be extremely challenging for the economy and risky for the containment of the pandemic (but apparently the pandemic wasn't a problem for the US presidential elections).
As such, Goldman expects its former employee, Draghi, to form a new government with broad support (at least initially). Of course, a downside tail risk exists if Draghi does not succeed in forming a new government. He is the “lender of last resort”in terms of institutional and political capital and, if he fails, we would expect an increase in sovereign risk, as new elections in Italy would be inevitable, and the chaos associated with Europe's largest creditor would be back front and center.
And while Draghi is preparing to become PM, Salvini, the head of Italy’s League and still the most popular in Italy, has pushed back on this potential mandate for the simple reason that he wants to be PM himself, and continues to push for elections to take place even amid the COVID-19 pandemic. As such, his support – and perhaps by proxy the support of his allies – is unlikely to be forthcoming.
Just as ominously for Draghi's chances, within the current coalition the response has been somewhat muted aside from a senior politician within the 5-Star party announcing they will not support a Draghi-led Government.
In other words, as Newsquawk calculates, Given the League accounts for 130 House and 63 Senate seats and the 5-Star Movement holding 190 House and 91 Senate seats the lack of support from these two parties would make it very difficult for Draghi to achieve a majority. However, given Mattarella’s continuing drive to avoid an election, it is plausible that the parties may give their support to Draghi, solely for the purpose of passing recovery fund legislation and then holding elections in full as soon as is practicable.
Economic Strength, Policy Upside and Political Risks
Notwithstanding the fragmented political landscape and the challenges of the pandemic, Draghi’s job as Prime Minister comes at a unique juncture. The high profile, and fundamentally technocratic, government he is likely to head will not have the hard task of implementing fiscal consolidation but rather the opposite. His government will need to make sure that the available fiscal support provided through the Recovery and Resilience Facility (RRF) is employed promptly and effectively. This puts Draghi’s task on a more solid footing than any technocratic government before him in the recent past.On the policy front, the new government will have an impact on least three relevant dimensions.
- First, it should improve the promptness of the fiscal response to the Covid crisis through a closer monitoring of its implementation.
- Second, it will likely upgrade the structure and management of the Italian Recovery Fund by leveraging the institutional experience of the Prime Minister with the Ministry of Economics and Finance. Most importantly, Goldman expects the new Prime Minister to throw his weight behind the structural reforms of the Italian administration needed to facilitate the allocation and implementation of the European funds.
- Finally, Goldman also sees scope for a somewhat more effective strategy on vaccination beyond the next few weeks and upgrades to the Italian health care system thanks to the ties that Draghi retains with European institutions.
As noted above, two main political risks weigh on the new government beyond the confidence vote. The first hinges on the fragmented composition of the 5Star movement. As party members and MPs are split between a pro-Europe majority and slightly Eurosceptic large minority, 5Star would see internal divisions if it grants its support to Draghi. Although the party cannot afford early elections, this support could break apart its parliamentary groups. This is important since 5Star is the largest party group in parliament (191Deputati and 92 Senators). The second risk hinges on Forza Italia, widely expected to grant its support to Draghi. This addition would nonetheless increase the degree of fragmentation in the policy platform.
Looking Beyond 2021
In past Italian technocratic governments (e.g., the government led by Senator Monti) even the strongest political support in Parliament can fade away in a very short time and bolster support for Eurosceptic parties. While the size of this risk depends on how effective the government is in addressing the country’s needs, political parties in Parliament will focus on the reform of the electoral system towards proportional representation. This change, if successful and timely, should reduce the degree of political volatility even if the country were to go to early elections.
Beyond 2021, the election of the President of the Republic in February 2022 will provide a structural break. There is no limitation to the possibility that the Prime Minister is elected President, although this is something that has never happened in the past. Nonetheless, if Draghi were to be elected as President, his resignation from his role as Prime Minister could trigger a political crisis similar to the current one and, possibly, early elections. Alternatively, also depending on Draghi’s intentions, the Parliament might take some time to identify an alternative candidate, further increasing the degree of political conflict.
Draghi as the (Political) “Lender of Last Resort” or "Whatever it takes to be a Prime Minister"
In Goldman's view, early elections remain very unlikely, especially after President Mattarella made clear that their timing would be extremely challenging for the economy and risky for the containment of the pandemic.Still, a downside tail risk exists if Draghi does not succeed in forming a new government. Because of his personal standing, Draghi is seen as the “lender of last resort” of institutional and political capital to the country. It is therefore hard to envision who could succeed to form an effective government if he fails, and Goldman expects a notable increase in sovereign risk in this scenario.
The euor was relatively muted given the USD’s continued hold of the 91.00 figure in DXY terms. Mar’21 BTPs saw a considerable gap-up this morning to eclipse the 152.00 mark, with Italian yields sliding.
In the equity space, the FTSE MIB is the outperformer with gains of around 3.0% (Euro Stoxx 50 +0.7%) as domestic markets cheer the potential return of Draghi.
The BTP-Bund yield spread has narrowed somewhat from recent levels, currently around the 105bp mark when compared with yesterday’s ~115bp print. On this reaction, SGH Macro highlight that the relatively contained reaction in the yield spread is due to both the ECB purchase program and perhaps, as indicated by sources, to the expectation that the European Commission will fully utilize the enforcement mechanisms with the recovery fund. Therefore, Italy will have no choice but to stick to a prudent and responsible fiscal plan, irrespective of who is the PM, in order to access this funding.