As the former ECB president steps in to form a new Italian government, opportunities for structural improvement are substantial.

Context

Former premier Giuseppe Conte restored relationships in Europe, and, under his leadership, Italy managed to secure its €200 billion recovery package.

He dealt with the pandemic emergency relatively well and, despite the emergency, gained popularity domestically. Nevertheless, Conte failed to make progress with reforms, lacking sufficient support from a fragmented political class. His leadership was questioned when Matteo Renzi, a key coalition party leader, criticized the government’s reform plans—crucial for receiving EU funds. After weeks of political friction, Renzi pulled out and all subsequent attempts to find a new stable majority failed.

Draghi: The Emergency Call

President Sergio Mattarella could have opted for early elections but this scenario would have left the country with no functional government during the pandemic and a major risk of missing the end of April deadlines for presenting a credible plan for EU recovery funds.

The decision to ask political parties to support a national unity government was not unexpected. Mario Draghi’s name has been whispered for months but the ex-ECB president wisely avoided the political scene until recently. When Mattarella called him, markets and the public welcomed the news. At this point, it remains to be seen what the government composition will be. Parties are unlikely to step back easily and Draghi will have to find a compromise between a technocratic and a political government.

The Opportunity

Italy has its biggest opportunity in decades, a unique chance that should not be wasted after years of austerity—but good use of resources is needed to generate growth and trigger a “virtuous circle.” Debt-to-GDP will most likely reach 160% in 2021.

In order to restore confidence, key priorities will have to be fast-tracked. Public spending plans must be sent to the European commission by the end of April. Agreeing on a reform agenda is crucial and implementation requires commitment and continuous support in Parliament. Key items could include further labor law reforms and addressing excessive bureaucracy and inefficiencies in both public administration and the legal process. Hot topics, like the difficult pension debate, will also inevitably resurface.

Recent polls suggest that Draghi already enjoys broad-based support from Italians, as high as 70%, a number that political forces cannot ignore. The probability of a government with broad support has increased. Will it last?

Markets Implications

The Italian bond market reacted very positively: The 10-year BTP-Bund spread tightened by almost 20 bps and the Italian bank senior bonds by 10 bps. Draghi’s vision of Europe is well known among investors. His praise for structural reforms aimed at achieving growth and debt sustainability was a reoccurring theme of many ECB conferences when he was at the helm. Eurozone break-up risk should moderate further, leading to more convergence among sovereign debt. We expect the 10-year BTP spread to fall below 90 bps, back to its 2010 pre-debt crisis level. A rating upgrade could also follow down the road if the government can last long enough to implement reforms. According to this outlook, we also anticipate outperformance of peripheral banks and the sector to tighten up to 25 bps. The EUR could appreciate further against the CHF as the save haven status of the franc will become less relevant in a context of stronger integration.