A RIGHT-WING COALITION TAKES OFFICE, AND POLITICAL INSTABILITY REMAINS THE RULE

As was expected after Draghi’s resignation in July, a far-right coalition secured a comfortable victory (43% of the vote) in the September 2022 snap elections. The new government is led by Giorgia Meloni, whose Fratelli d’Italia (FdI) secured 26% of the vote. She is joined by Silvio Berlusconi’s Forza Italia (8% of the vote) and Matteo Salvini’s Lega (9%). Despite this definitive electoral victory, Meloni will face significant challenges to remain in office. For one, the need to seek compromises with the European Commission and reassure investors may rapidly put her out of favor with anti-establishment voters. Second, due to policy and personal disagreements, Salvini will likely defect if Meloni loses enough popular support. Meloni has signaled a significant willingness to cooperate with the EU, but this will be tested as her popularity erodes. Italy must keep good relationships with the EU to be eligible for bond purchases under the ECB’s Transmission Protection Instrument (anti-fragmentation tool). While the tone set by the Meloni government has surprised on the upside, the main political risk in Italy remains the continued instability of the executive. The Meloni government has a high chance of collapsing before the end of its mandate. Italian populist parties tend to rise comfortably while in opposition only to quickly hemorrhage voters once they take office. Otherwise, tensions with other European governments will likely emerge on topics like migration and the negotiation of new EU fiscal rules.

A RELIANCE ON ENERGY-INTENSIVE INDUSTRY AND NATURAL GAS LEADS TO A RECESSION

After negotiating key partnerships with Algeria and Azerbaijan, Italy has strongly reduced its dependence on Russian gas to 10% of total gas imports (from a pre-war level of 40%). However, these diversified supply sources have been secured at very high prices. Hence, inflationary pressures have intensified and should only moderate gradually in 2023. Italian companies are therefore facing increased cost pressures, lower margins, and increased uncertainty, all of which will take a toll on capital investment. With businesses’ working capital needs becoming increasingly acute, corporate investment will slow down markedly. This is especially true for vital energy-intensive industries (paper, glass, construction, chemistry, ceramics, metal, and machine-tool manufacturing). Similarly, the erosion of purchasing power is expected to have noticeable adverse effects on consumption, which should contract in the first half of the year, then recover its pace as we head into 2024. Public investment, on the other hand, will remain resilient. Italy will still receive unprecedented financial support from the EU. Out of the EUR 750 billion of the NGEU fund, EUR 209 billion will be allotted to Italy (10.4% of 2019 GDP over 2021-2027), making it the single largest beneficiary in absolute terms. These funds are set to renovate the productive apparatus by funding the green transition, strengthening fiscal and digital infrastructures, human capital, and the social safety net. Tourism (13% of 2019 GDP) will continue to recover (albeit slower than in 2022). Still, the unfavorable price effect in commodity imports will dominate and negatively contribute to net exports. Owing to tight labor markets, the increase in unemployment should be limited compared with previous recessions.

MONETARY NORMALISATION WILL BE A TEST FOR SOVEREIGN RISK

• Like other European nations strongly exposed to the energy crisis, Italy has deployed substantial deficit spending to shield consumers and businesses, whose cost (net of energy windfall taxes) is estimated at 3.1% of GDP. Most of the government’s intervention has come in tax credits, gas VAT reduction (22% to 5%), and specific subsidies to the most vulnerable sectors and households. Meloni’s 2023 budget is based on a continuation of the Draghi government’s approach in that it seeks a resolute response to the energy crisis while making efforts for fiscal consolidation. Out of the EUR 35 billion in new spending, EUR 21 billion is destined to support the energy bills of vulnerable households and firms. Conversely, the expensive citizen’s income scheme, the flagship measure of the weakened 5SM party, is set to be phased out gradually. The positive nominal GDP performance of 2022 and the inflationary boost to tax receipts will result in a continued fiscal deficit reduction. Nonetheless, the primary source of budgetary risk could result from the ECB’s reaction to rising inflation. Indeed, rising policy rates, the inflation premium, and growing concern among investors over government bonds increased debt servicing costs from 3.5% of GDP in 2021 to 4% in 2022. Italy’s remarkably high public debt ratio makes it highly sensitive to increases in sovereign yields. Any excessive rise in sovereign spreads should be contained by ECB bond buying, provided that the ruling government remains on good terms with the European Commission. Contingent liabilities of the state to the banking sector, estimated at around 15% of GDP, also represent a risk. Deterioration in the energy balance and the export contraction will shift the current account into a deficit. However, external vulnerabilities are low, with external liabilities mainly in Central Bank ratios.