Enrico Letta, the Deputy Secretary of centre-left Democratic Party (PD), has been mandated to form a government. Enrico Letta was the ‘number two’ before Pier Luigi Bersani resigned as head of the PD. Enrico Letta will now try to put together a cabinet, probably encompassing politicians across the political spectrum as well as technocrats. The President of the Republic has decided to stay for a second term only if the politicians find a common ground, some believe. So many suspect that the chances of successfully forming a government under Enrico Letta with broad political support are quite decent.

Enrico Letta

This arrangement, with the choice of Enrico Letta pre-cleared by the political parties, and policy experts working alongside elected politicians in various key ministerial posts, should pass a confidence vote that will be held in a few days to make the government operational.

…same parliament:

In a note with ‘the shortest shelf life we have ever published’, Morgan Stanley says all the risks surrounding the outcome of the Italian election have materialised as it unfolded – i.e., the centre-left did worse than expected, the centre-right slightly better than the polls suggested, the Five Star Movement much better, Monti’s group much worse, etc.

So whether the parliament, after an initial phase, will continue to support government action remains to be seen. While this is possible, the fortunes of Monti’s technocratic government, which lasted a little over a year, remind us that the possibility of a ‘change of heart’ in parliament, given its deep fragmentation, remains a key factor to watch.

What’s the process:

In Italy, several steps have to happen for a government to become fully operational. They are:

1. Prime minister nomination: Enrico Letta is nominated by the President of the Republic, after a negotiation with the political parties. This is what has just happened.

2. Cabinet formation: The ministers are proposed by Enrico Letta, but they too are formally nominated by the President. This is likely to happen very soon (no set date).

3. Confidence vote: After the nomination, the cabinet is sworn in and, within ten days, has to seek the confidence of the parliament (again, no set date).

What happens if this attempt fails:

In this hypothetical scenario, the earliest date for a new election is late-June/early-July with the current electoral law, which might again generate a fragmented parliament, or this autumn probably with a new electoral law, even though the political parties have not been able to agree on new rules so far.

Will it last the full parliamentary term?

With bouts of political instability and government changes having been quite frequent in Italy, one might wonder whether the new government is likely to stay the course for five years. While speculating on this is of little use, the purpose seems more to execute on a narrow programme over a short timeframe.

Will the reforms reach ‘critical mass’ this time?

With a difficult political situation, Italy has so far struggled to deliver on key reforms. Monti’s attempt, after a good start, couldn’t gain traction. This time, the new government will base its policies on the template of the ten wise men that President Napolitano employed a while ago. The plan, which is widely supported in Italy’s policy circles, revolves around a number of reforms to reduce the costs of the political system, cut red tape, liberalise the economy, streamline the justice system, etc. Over time, it might boost growth. But whether there’s political consensus to execute remains to be seen.

No imminent inversion of negative cyclical phase

That Italy finally has a President of the Republic and has managed to agree on a prime minister are encouraging developments, especially after considerable uncertainty. Yet one key downside risk to forecasts is that sentiment might weaken again, if political instability were to return. Morgan Stanley recently cut  Italian GDP forecast by half a percentage point and now expect a 1.7% contraction this year vs. a more optimistic consensus .

Why aren’t investors too worried?

According to a recent investor survey, political instability, including (hypothetically) new elections if such instability were to increase, is an outcome market participants mostly fear but also regard as most likely; however, it is not an outcome likely to alter their thinking/positioning significantly (at least not at the time the survey was conducted).

This is because they seem to behave as if they perceive the ECB backstop as credible. As such, investors also believe that revisiting their stance and returning to where they were at the height of the crisis, before Draghi’s “Whatever It Takes” speech, is a relatively low-probability outcome. Similarly, the perception is growing that the eurozone is improving its institutional architecture in the medium term – e.g., on banking union.