Reform Will Be Challenging—But Draghi Can Make a Strong Start
Now, with devaluation ruled out, it’s going to take a gargantuan reform effort to turn the Italian ship around. Still, early signs are encouraging. The new prime minister’s immediate focus is, rightly, on steering the economy out of the pandemic and drafting a recovery and resilience plan to unlock NextGenEU funding from the EU. (This new money will be focused on digitization and speeding up the green transition.) After that, Draghi will turn his attention to long-overdue reforms of the judicial, public administration and taxation systems, areas in which there’s ample scope to improve Italy’s governance score and longer-term economic outcomes.
Of course, the further Draghi stretches, the more difficult it will be to sustain the political consensus needed for deep-rooted change. Even so, with most of Italy’s main political parties supporting him (and representing roughly 80% of parliamentary votes), the new prime minister has room to maneuver.
But focusing too heavily on the longer-term outlook risks ignoring some very important near-term positives. First, while Italy’s political parties will start jostling for position ahead of the next general election (due by June 2023), a period of political stability lasting a year or more now looks almost guaranteed. And in a strong show of unity even the right-wing populist League has joined the government and adopted a more constructive stance towards the EU. Finally, with Draghi at the helm, there’s now a much lower risk that Italy will squander the opportunity presented by NextGenEU funding. Assuming grants worth roughly 4.5% of GDP over the next three to five years, this new money won’t be enough to solve all of Italy’s problems. But it would provide a welcome start and might even act as a catalyst for further reform.
Financial Markets See Positive Change
These developments represent positive surprises for financial markets, and it’s quite possible that the Italian treasury bond (BTP) spread versus Germany will narrow even further from recent lows (Display below, left). Indeed, our risk rankings (Display, right) suggest that there’s still a material premium embedded in Italian sovereign bond yields.