Italy risk: Alert - Progress on political and economic reforms has been mixed

June 30th 2014

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The outcome of the European Parliament elections in May has substantially strengthened the personal authority of the Italian prime minister, Matteo Renzi, within both his coalition government and his party, the centre-left Partito Democratico (PD). However, his political and economic reform plans are ambitious and will have to overcome resistance from vested interests inside and outside the coalition. Since the European elections greater progress has been made towards the introduction of political/institutional reforms, but because these require changes to the constitution, which take much longer to approve, implementation still remains some way off. Progress on economic reforms, which is needed more urgently to maintain investor confidence and boost Italy's dismal economic growth performance, has been incremental. In the European Parliament elections, the PD gained almost 45% of the popular vote, about 10 percentage points higher than most opinion polls had predicted. The surprisingly wide margin of victory—the Eurosceptic, anti-establishment Movimento 5 Stelle (M5S) was second on 22%—has significantly enhanced the dominance of the centre-left within the power-sharing coalition also containing the centre-right Nuovo Centro Destra (NCD) and smaller centrist political parties. This rise in support for the PD was mainly attributable to Mr Renzi's ability to position himself as a political outsider and non-ideological leader, which has extended his popularity to disgruntled centre-right voters. However, this message appears to have been lost on some PD members, who are still resisting his reformist agenda. On June 12th, for example, 14 PD senators suspended themselves from the party, to highlight their opposition to Mr Renzi's plan to reform the Senate (the upper house of parliament). Recent progress on economic reforms has been unspectacular Mr Renzi's European election victory signalled strong popular backing for the economic reforms implemented during the first three months of his premiership. They have been considerably more ambitious than those undertaken during the preceding eight-month administration of Enrico Letta, also of the PD. The measures included a tax cut for low-wage earners and a 10% reduction in regional business levies. The government also began to speed up the release of outstanding debt payments owed by the state to private-sector companies, which the Bank of Italy (the central bank) has estimated could amount to €68bn. New labour market legislation was also successfully passed into law, allowing employers to retain workers on fixed-term contracts for up to three years, and firms to retain up to 20% of staff on these temporary contracts. Equipped with a strong electoral mandate and enhanced personal authority, Mr Renzi has made further, albeit unspectacular, progress on economic reforms in the month since the PD's European election victory. New measures introduced by government decree, and therefore awaiting final parliamentary approval, include a 10% cut in energy costs for small and medium-sized enterprises and households, to be financed by reduced subsidies for renewable energy investment, which are currently paid for by Italian consumers and amongst the highest in Europe. In addition, the government has introduced new self-assessment tax forms to reduce Italy's notoriously excessive bureaucracy and streamline tax collection. Constitutional reform progress has been more impressive Whereas the pace of further economic reforms has not been startling, Mr Renzi's reform plans aimed at reducing future political instability have made greater progress since the European elections. Back in January 2014, before he became prime minister, Mr Renzi reached a controversial agreement with Silvio Berlusconi, the leader of the main centre-right opposition party, Forza Italia (FI), to abolish the existing bicameral parliamentary system—under which both chambers enjoy equal legislative powers—by dramatically reducing the powers of the Senate. In addition, they agreed to introduce a new electoral system for the Chamber of Deputies (the lower house of parliament) to try to ensure the election of more stable parliamentary majorities. On June 20th, the initial reform outline was significantly advanced, with the FI and PD agreeing on a range of new details for this constitutional amendment. Under the new draft legislative proposals, the Senate would be changed from a directly elected body to a chamber in which membership would be allocated according to elections by regional officials, with the number of parliamentary representatives reduced from the current 320 (315 elected plus five life senators appointed by the president) to 100. Crucially, the legislative powers of the Senate would be dramatically curtailed, with it no longer having the capacity to bring down a government during frequently held confidence votes. In addition to reducing the risk of government crises, it would also speed up Italy's notoriously slow legislative process. But the legislative process for constitutional amendments requires that the reforms be approved twice in both houses of parliament at an interval of not less than three months between votes and by a two-thirds majority at the end of the second reading to avoid the reforms having to be put to a referendum. With the smaller coalition parties having no incentive to support reforms that would reduce their future political leverage, Mr Renzi needs the support of Mr Berlusconi and his party. Their support is also needed to implement the proposed reform of the voting system for the lower house, which aims to reduce future government instability by increasing minimum vote share thresholds required for parties to enter parliament. The lower house has already approved the government's draft electoral law, which is contained in an ordinary bill and therefore does not require a special majority, and is expected to be voted on in the upper house before the summer recess in August. However, some further amendments are likely in the Senate, so the bill will then get passed back to the Chamber of Deputies. With the smaller coalition parties and FI incentivised to drag the process out as long as they can, final approval is unlikely until after the summer recess. Increased leeway from Italy's EU partners is likely to be limited As one of the few EU leaders to emerge from the European Parliament elections with his reputation enhanced, Mr Renzi has sought to leverage his increased political authority in negotiations to select the next president of the European Commission. Mr Renzi's hand has also been strengthened by the fact that Italy will take over the rotating six-month presidency of the Council of the European Union in July. In particular, the prime minister has sought agreement amongst European leaders, most importantly the German chancellor, Angela Merkel, for greater flexibility in interpreting current EU fiscal rules. In particular, the Italian government is concerned that the EU's fiscal compact treaty, which requires Italy to reduce its public debt to 60% of GDP from over 120% by an average of 5 percentage points each year, could undermine the future growth prospects of an economy still struggling to emerge from a prolonged recession. Mr Renzi is seeking to persuade his EU partners that like Germany in the early 2000s fiscal flexibility will enhance Italy's prospects for successful structural economic reform. Although a major reorientation of EU policy is unlikely, there are at least some tentative signs that Mr Renzi could win some fiscal leeway from the next European Commission. Assuming that his administration can remain in power until either late 2015 or 2016—this is possible given that the Italian president would be unwilling to call elections until the constitutional and electoral reforms have been put in place—additional fiscal flexibility would improve Mr Renzi's chances of building on recent reforms. However, the high risk of renewed political instability and the severe weakness of economic conditions suggest that reforms are likely to fall short of the prime minister's high ambitions.

Economist Intelligence Unit

Source: The Economist Intelligence Unit