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With Italian PM Silvio Berlusconi set to resign, Italian politics will quickly start to heat up.This has some serious implications for the implementation of economic reforms.
In a note out this afternoon, Goldman Sachs’s Francesco Garzarelli sets out three possible scenarios for what will happen next, from most to least likely (our summary):
1) A coalition based on Berlusconi’s old coalition would ally the parties that supported him—Northern League and the People of Freedom—and reach out to a few smaller parties. This coalition has already shown support for EC/ECB/IMF austerity measures, but it will need to do a better job in order to be an improvement from Berlusconi. Sovereign bond yields would remain around current levels.
2) A coalition of centrist MPs would form a “technocrat” government. This could produce a government more amenable to reforms that encourage growth and improve governance. Markets would approve of this kind of coalition and bond yields would fall quickly by 50-100 bps.
3) General elections are called after Berlusconi’s resignation (which will likely take place once the 2012 budget is passed next week) for January at the earliest. This would be the worst-case scenario for markets.
However, Garzarelli writes that all of these outcomes will take time:
We are most probably approaching the highs in Italian yields (currently around 500bp over German Bunds in the bellwether 10-yr sector, and 600bp in 2-yr maturities), but a volatile and unsettled market remains our base case until Italy’s sovereign creditors can be reassured that long-awaited structural reforms to lift the country’s growth rate will be put in place.