01.06 Weekly Viewpoint : The acceleration in the process of reforming the Italian electoral law could result in elections being called in the country a few months ahead of time.

The most important implication is that the budget law for 2018 would have to be approved by the new Parliament, at a great delay compared to the usual schedule, and a solution would have to be found to avert the VAT hike planned for January 2018……

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In the past few days, the debate over the reform of the Italian electoral reform has undergone a sudden acceleration. An agreement is taking shape among the leading three political parties to adopt what is essentially a proportional system, integrated by a 5% election threshold, and by the election of part of the representatives based on single-candidate constituencies. The reform could be approved swiftly (there is talk of 7 July as the approval date), so as to immediately call early elections, which could be held between the end of September and October. The news generated some unease on the markets, with some tensions emerging on the risk premium required on Italian borrowing. However, to date the widening has been modest, by around 18bps, and has only reabsorbed in part the narrowing which followed the French presidential elections. But what are the implications of recent developments? Should we worry? In essence, there are two main changes compared to the previous baseline scenario: first of all, the date of the elections could be brought forward by a few months, from March-May 2018 to September-October 2017; secondly, the electoral system which is taking shape should result in a stronger concentration of the vote to the advantage of the major parties, but forsakes any majority bonus.

The calling of early elections would not affect the reform process, which was already being held back by the end-of-legislature climate, but would have implications for the budget process. Implicitly, the drafting and approval of the 2018 budget would be left to the new government and to the new parliament: any proposal made by the outgoing government before 15 October, the deadline set by the European calendar, would be seriously undermined if the vote yields a different majority from the one supporting the current government. The only alternative, hard to imagine, would be to find an agreement with the opposition on the contents of the budget. This means that the budget for 2018 will also be passed at a much later date than usual (20 days would lapse before Parliament convenes, and it could take many weeks to form a government). One corollary is that, in order to avoid a hike in VAT rates, which should come into force at the beginning of 2018 and could prove potentially disastrous for consumer spending in Q1, alternative funding would have to be found and approved (with some difficulty, given its huge size, as a budget measure), even only in part, so as to postpone the problem by a few months, until the new government takes office.

The changes to the electoral mechanism would not radically change its proportional nature. Therefore, in a system split into four main blocks (PD and Five Star Movement with 30% each, Northern League and Forza Italia with 15%), the options available to form a majority government could be very limited. The risk is therefore of a situation similar to the ones already seen in Holland and Spain in the past few months: great difficulty in forming government coalitions, with the risk of it becoming necessary to fall back on minority governments, or to hold new elections after only a short period. Would this be enough to generate the risk of higher rates “due to deteriorating confidence on the markets” as the governor of the Bank of Italy warned in his final considerations on Wednesday, 31 May? The Spanish experience has not proven so negative, to date, although it should be said that GDP growth is stronger in Spain, debt levels are much lower. However, risks are mitigated by other factors: first, foreign investors currently hold an even smaller share of Italian debt than during the 2011-12 crisis, and mostly seem to be rather light on Italian assets; second, the structure of foreign liabilities is much more robust than it was in 2011 (the exposure of banks has decreased drastically, as opposed to greater exposure of the Bank of Italy to the rest of the Eurosystem), whereas foreign assets held by residents are on a consistent uptrend; third, safeguard mechanisms are in place today, such as the ECB’s ESM and OMT programmes, which can be activated in case of need. Lastly, the umbrella provided by the ECB’s asset purchase programme will remain open at least until December 2017, and possibly even beyond that date.

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