There are at least five possible scenarios:
1° Draghi remains in office with the same majority. But it seems unlikely as it would imply a massive turnaround of Giuseppe Conte’s Five-Star Movement – the largest political party within the coalition (104 deputies at the Chamber of Deputies on a total of 630 and 61 senators on a total of 315). The party triggered the current crisis by refused to support Draghi’s government in a critical vote;
2° Draghi is successful in setting up a new government with a different majority. But it is a tricky task since there is no real alternative to the Five-Star Movement;
3° Draghi requests irrevocable resignations without asking Parliament vote. This is unlikely at that stage;
4° Under pressure from the Italian president Sergio Mattarella and several political parties (such as Matteo Renzi’s Italia Viva), Draghi agrees to limp on for a little while longer in order to avoid a political crisis. He heads a technocratic government until the 2023 general elections (‘caretaker’ government). This could be a consensual approach among Italy’s political class and certainly the best scenario for the eurozone in order to avoid turmoil in the middle of the summer break;
5° Draghi fails to form a new government or refuses to lead a transitional and temporary government until the next elections. The snap election takes place within 70 days (likely in September). The latest polls show the Five-Star Movement would get crushed, with less than 12 % of voters. Giorgia Meloni’s Brothers of Italy would be the main winner. It secured just 4.8 % of the vote in the last general election in 2018 (37 deputies and 21 senators in the current assembly). It is now the country’s most popular political party, favoured by about 22.5 % of voters. If its members stick together, Italy could be ruled by a center-right coalition led by Meloni. This would be very bad news for the eurozone at the worst time ever (lower growth ahead, fragmentation risk in financial markets, low market volumes and risk of energy crisis this winter). Monetary tightening is already adding a lot of pressure on the financial system: liquidity is worsening, volatility and market maker restraint and failed settlements are at a record high. Add to that the usual Italian political crisis and you get the worst cocktail ever for the summer break. Expect a faster rise in Italian yields whether this should happen. However, this does not mean the European Central Bank (ECB) would automatically intervene. There is first a problem of timing regarding some technicalities. It is likely the ECB will say something about anti-fragmentation on Thursday, but the tool is probably not ready yet. The central bank will basically kick the can to September. In addition, the ECB will probably not intervene anyhow because the spread widening results mostly from political uncertainty and not “unwarranted” tightening.
In our view, snap elections are far from certain. It is never easy to predict the outcome of an Italian government crisis. We need to be humble about that. Most of the time, we get it wrong. Earlier this year, President Mattarella did not want a new term. Market analysts were expecting a new political crisis (myself included). Finally, he was persuaded to stay on after failure to find a successor. This could certainly happen the same thing this time again. Draghi could stay a bit longer to avoid chaos (scenario 4°). What is certain is that Draghi’s national unity project has collapsed, however. Political instability remains a norm in Italy.
Italy-Germany government bond spread has significantly increased since the ECB’s pivot in past February when the central bank acknowledged that inflation is not that transitory and it requires a change in policy to fight against it (tightening process). But the current spread is still much lower than at the start of the Covid outbreak. When the ECB president Christine Lagarde indicated the central bank « is not here to close spreads », the Italy-Germany government bond spread reached 266 basis points. It is now hovering around 200 basis points. This is not in risk-zone yet. But it is approaching, for sure.