Deputy Prime Minister Matteo Salvini’s withdrawal of support from the Five Star Movement (M5S)-Lega coalition government and the beginnings of talks over the formation of a new ruling coalition now present Italy with three probable options: 1) a new agreement between M5S and the centre-left Democratic Party (PD), in alliance potentially also with other parliamentary groupings, to postpone if not block an early election; 2) should alternative government combinations under the existing parliament fail, early elections and an eventual Salvini government; or, alternatively, albeit unlikely at this stage, 3) an eventual resumption of the current M5S and Lega government, even if on a temporary basis. In Scope’s view, current political and policy uncertainty could hamper investment in the short-run for an economy that has grown in only one quarter of the previous five.

“Salvini calling time on the Five Star Movement-Lega government has backfired so far, with M5S in talks with PD,” says Dennis Shen, Scope Ratings’ lead sovereign analyst on Italy. “There is a lack of clarity on when or even if early elections will occur.”

“An agreement between M5S and PD, even if in the form of a caretaker government, would probably be the most market-friendly of the likely scenarios, as PD could balance out some of M5S’s expansionary budgetary policy impulses with a higher abidance to EU fiscal rules and de-escalate tensions with Europe,” says Shen.

“The first driver of Scope’s downgrade of Italy last December to BBB+ was the re-alignment in the country’s political landscape in favour of anti-establishment parties – shifts we considered structural. This included the implicit assumption that Lega might head a future populist government after the next elections,” says Shen. “However, even if Italy moves now to elections, the risk that a future Lega government leads Italy out of the euro remains unlikely.”

In an election scenario, Lega stands to capitalise on its advances in opinion polls, with the party leading with 37% of voting intentions. This polling stands at roughly 44.5% when Lega’s support is combined with that for fellow right-wing political party, Fratelli d’Italia (Fdl) – suggesting a governing coalition featuring the two parties could, by itself, be in sight of an outright parliamentary majority. It is also this post-election likelihood of a Lega/Fdl government, maybe in coalition with other political groupings such as centre-right Forza Italia, that has brought negotiations between leftist groups interested in impeding that outcome.

“Italy requires a functioning government, even if a caretaker one, capable of formulating a coherent and sustainable fiscal plan with regards to the 2020 budget and the 2020-22 fiscal programme,” says Giacomo Barisone, managing director of Scope’s sovereign ratings team.

“Sustainable fiscal strategy is urgent after the detours experienced over the past year given Italy’s significant unresolved challenges of high public debt and weak medium-run growth potential,” says Barisone. “Any programme that removes or reduces the VAT tax increases amounting to EUR 23bn scheduled for 2020 should include permanent replacement measures to prevent a significant increase in the budget deficit.”

Italian GDP growth will be just 0.1% in 2019 and 0.6% in 2020 according to Scope estimates, with the country’s medium-term growth potential at only 0.7% – one of the lowest among countries Scope rates. In July, Scope lowered its forecast for the 2019 and 2020 budget deficits to 2.0% and 1.9% of GDP respectively, down from previous estimates of 2.6%, on higher-than-anticipated tax revenues, lower-than-anticipated outlays and lower interest payments. Such budgetary outperformance gives Italy more room for fiscal manoeuvre in upcoming negotiations with the European Commission.

10-year BTP yields have fallen to under 1.4% after they had peaked earlier this month at around 1.8%. From peak spreads to Germany in August of around 240 bps, the spread now stands at about 200 bps, reversing almost the entirety of this month’s sell-off. “Ensuring Italian debt sustainability and maintaining market confidence remain significant challenges, even in today’s low interest-rate environment,” says Shen. “A future Italian government should not lose sight of this fact.”

Scope’s next scheduled sovereign rating review date on Italy’s ratings comes on 29 November.