Italy – Reform Plan Faces Daunting Obstacles

The success or failure of Prime Minister Mario Draghi’s post-pandemic recovery plan will have a significant impact on political and economic stability over the medium term. Backed by EU loans and grants from the bloc’s recovery fund, the $315 billion blueprint for restarting the economy targets substantial investment in clean energy projects, digitization, and infrastructure improvements for the depressed southern region.

However, obtaining the funds for investment in railways, ultra-broadband and 5G, and various green industries will require the government to implement reforms intended to improve the functioning of the legal system, reduce the bureaucratic inefficiencies that have long been a prominent characteristic of the operating environment in Italy, and patch the leaks in the tax system.
The new prime minister, who took office in February as head of an ideologically broad coalition government, is a former head of the ECB, and his presence will allay concerns about any consideration of a default. However, his lack of partisan affiliation means that he has no reliable support within the Parliament, and it is an open question whether Draghi can achieve consensus on reforms required to ensure the uninterrupted delivery of EU funds.

The state of the market for Italian bonds suggests that investors have much more confidence in Draghi than was the case with his predecessors. When the government announced in early April that it would spend some $48 billion, equivalent to about 2.4% of GDP, on stimulus measures, yields barely moved. However, confidence could crumble if the reform agenda becomes stalled.
The challenges are compounded by instability within some of the governing parties. M5S is undergoing a transformation from a big-tent, anti-establishment entity to a respectable center-left party under the guidance of former Prime Minister Giuseppe Conte, a process that could result instead in its disintegration. The far-right League is jeopardizing its credibility with euroskeptic voters by supporting Draghi’s government, and would likely part ways with the coalition if polling data points to weakening popular support for the party.

More immediately, the latest pandemic-related data is encouraging. The hope is that the current decreasing trend in COVID-19 cases, which has permitted the easing of health restrictions. The opening of the economy comes at an opportune time, as the tourist season is about to begin.

The appetite for Italian bonds remains robust, reflecting a projected narrowing of the budget deficit from somewhat more than 12% of GDP this year to about 4% of GDP by 2024. Benign financing conditions under the ECB’s Pandemic Emergency Purchase Program, instituted in March of last year, will allow Italy to take advantage of low lending rates. Any meaningful reduction in public debt levels going forward will depend largely on a sustained economic recovery.

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