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Analysts at Rabobank explain that the Italy’s troublesome politics have kept financial markets busy for a while now, but the spark of the tumult was last weekend when Italy’s President Mattarella vetoed the choice of populist parties Five Star Movement (M5S) and the League for the eurosceptic Paolo Savona to become Finance Minister.

Key Quotes

“After, Mattarella’s rejection of Savona, talks of forming a government coalition between M5S and the League broke down and Mattarella appointed former IMF official Carlo Cottarelli to head an interim government in order to handle the most pressing government matters and draw up and pass a government budget for 2019.”

“However, Cottarelli’s appointment first has to pass a vote of confidence by the Italian parliament, in which M5S and the League (at least together) now have a majority. Both parties have stated they won’t give this vote of confidence, which means Italy will likely see early elections (probably in September this year). Markets understandably fear these elections because the League (who is more eurosceptic than M5S) has been gaining popularity recently.”

“The latest Political Thermometer poll numbers indicate that if an election were held today, the League would get 27.5% of the votes, while M5S’s share of the votes would decline to 29.5%. So both parties might try to double down on their populist policies to win votes, M5S to regain votes and the League to keep the momentum going.’

“Some of M5S’s and the League’s policies are appealing to many Italians, such as basic income for the poor, a reduction in the retirement age and a reduction in income tax to a flat 15%. The problem is, they are unaffordable for Italy, as our economists Maartje Wijffelaars and Stefan Koopmans argued in an earlier note. If the League and M5S would implement all their policies at the same time, we estimate that this would cost Italy between 6% and 9% of GDP. The rest of the EU will not accept this, which will only fuel more discontent against the EU. In a worst case, scenario this could lead to Italy leaving the EU.”

“We don’t think this scenario is likely. Even the League’s leader Matteo Salvini denied yesterday that he wants Italy to leave the EU. Nonetheless, markets are clearly jittered. Contagion has been relatively contained still, but yesterday some spill-over into other peripheral markets was evident.”