Italy: Political deadlock Once More

The Italian coalition government collapsed on Saturday as Berlusconi's PDL party withdrew its ministers only five months after its formation.

It is now up to President Napolitano to decide whether to dissolve the parliament and call for new elections or to try and solve the political crisis under the current conditions.

President Napolitano seems willing do whatever he can in order to avoid new elections. It is far from certain that new elections will stabilise anything as long as the electoral law has not been changed. President Napolitano and Prime Minister Letta met on Sunday in a first attempt to find new majority possibilities in order to avoid new elections.

PM Letta has called for a confidence vote, which will probably take place on Wednesday. Berlusconi's decision to withdraw from the government has received criticism from within his own party and it is possible that some dissidents will vote in favour of Letta. It also seems that Berlusconi is already trying to downplay his rhetoric a bit after criticism within the party.

The increased political uncertainty has sent government bond yields higher, which adds to the renewed doubts about Italy's fiscal sustainability. At an auction on Friday government bond yields rose to their highest level in three months. The next government bond auction is scheduled on 11 October.

Even though the government budget deficit is near the 3% of GDP limit and recent soft data point to an improving economic outlook, the current political deadlock combined with expectations of further rating downgrades and a government debt around 130% of GDP is a toxic cocktail. We expect markets to remain nervous until a more sustainable political solution is found. If Berlusconi backs down or PM Letta wins the confidence vote, we expect to see some spread tightening.

In the short run a fragile Letta government seems the most likely option. However, it might only be in place long enough for the parliament to change the election laws. Political uncertainty thus seems to be the name of the game in Italy for some time to come.

We do not expect this to trigger a re-emergence of the euro area debt crisis. Although we are all reminded about how hostile the political climate in most peripheral countries is to belt tightening and structural reforms, it is important to keep in mind that this is Italian politics and it is mainly about Berlusconi's personal interests.

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