Economic challenges greet Meloni in Italy

Financial markets digested the victory of Italy's coalition, led by Brothers of Italy (FdI) leader Giorgia Meloni, largely without any major hiccups.

Italy's main stock market index, MIB, even gained slightly on the following Monday, while the closely watched spread between Italian and German 10-year debt barely moved over Friday's closing at 230 points. The gauge of interest rate differentials is a risk barometer for government debt and had last seen a dramatic spike to 300 points when outgoing Prime Minister Mario Draghi announced the collapse of his government in July.

Antoine Bouvet, senior rates strategist at ING, said on the Dutch bank's website that this was a sign the markets "have made their peace with the prospect of a government led by Giorgia Meloni." All the more so, he added, as the coalition had obtained enough votes to ensure political stability, but not enough to be able to change the constitution.

In a Reuters survey of economists' opinions, Ludovico Sapio from the British bank Barclays warned though that the risk of tensions within Meloni's three-party alliance were "modest, but could intensify in the medium term."

Grim outlook for growth

While Meloni's solid majority should expedite the process of forming of a new government, it's highly unlikely that this will take less than a month. During this time, the outgoing prime minister remains in charge and will likely submit a new draft budget to the EU by a mid-October deadline.

The proposal reportedly paints a grim picture for the EU's third-largest economy. Italy's GDP will likely expand just 1% next year — down dramatically from the 6.5% growth recorded in 2021 and the 3.3% projected for 2022. But international ratings agency Fitch sees the economy even contracting by 0.7% in 2023.

A weaker economy means Meloni will have less fiscal room for her own policies, including urgently needed interventions to help families and businesses cope with the current energy crisis and inflation shock.

Runaway costs could stall debt reduction

In March 2021, the Italian government's effort to protect its citizens from the COVID-19 pandemic brought the country's debt-to-GDP ratio to 159.4% — an all-time high and dwarfed in the eurozone only by Greece.

In the course of the past year, Mario Draghi succeeded in putting that onto a descending path, helped by inflation and a recovery that was better than expected. Meloni now faces the challenge of maintaining the downward debt trajectory just as the energy crunch caused by Russia intensifies.

This year, the government has spent more than any other country in the EU — about €66 billion ($63.6 billion), or 3% of GDP — for tax breaks and subsidies to help companies and poor households pay their energy bills. The measures, however, are due to expire in November, and extending them until the end of the year would cost €4.7 billion, the Italian Treasury has calculated.

Matteo Salvini, Lega leader and Meloni's main ally, declared after the election that the energy crisis would be "the first test for the new government."

State pension reform is another costly problem for the new government. A 2011 scheme of temporarily lowering the pension age to 64 is due to expire in December. Salvini wants to prevent the age automatically going back to 67 again by scrapping the law. Moreover, since Italian pensions are index-linked, soaring inflation is compounding the expected drain on state coffers.

Closely related to unsustainable pensions is Italy's demographic problem of an aging population and dwindling birth rates, which will increase the pressure on public finances.

As a result, Italy's spending needs are high and steeply rising. Just maintaining existing programs to reduce energy prices will cost around €14 billion next year, according to leading business newspaper Il Sole 24 Ore. Add in raising salaries and pensions as well as other commitments, and additional cost to the state rises to almost €40 billion in 2023, the paper reported.

Fiscal prudence and 'congratulations' from Brussels

What surely helps Meloni in her struggles is the EU's €750 billion post-pandemic Recovery Fund from which Italy will receive the lion's share with €200 billion in grants and loans over the next few years.

Just this week, the European Commission cleared the way for the payment of €21 billion after Rome had met a series of 45 targets in reform areas such as public employment, procurement, taxes and health care.

"Congratulations, Italia! Keep up the good work," Commission President Ursula von der Leyen wrote to Rome in a message of hope that the 45-year-old FdI leader would stay Draghi's reformist course and tone down her anti-EU rhetoric.

A die-hard euroskeptic, Meloni has said she wants to renegotiate part of the package to better reflect the impact of the energy crisis. At the same time, she has vowed to keep public spending in check and stick to EU deficit rules, which might help her in the talks with Brussels.

But Paolo Grigani, senior economist at Oxford Economics, doubts that the new Italian leader will resist the temptation of overspending, even more so as pressure from Lega leader Salvini to ignore EU demands is already mounting.

"Given that the right-wing coalition has not emphasized structural issues in its election campaign or manifesto, we doubt that it will implement the necessary reforms," he told Reuters.

The new Italian government's fiscal management and willingness to reform will be viewed with a wary eye by the European Central Bank (ECB). The bank has implemented a new bond-buying program to help debt-laden eurozone countries like Italy cope with higher interest rates as a result of the ECB's inflation-fighting policy.

The current calm on financial markets toward the coaliton suggests investors believe in Meloni's promise of fiscal prudence. But picking too many fights with the EU over spending and reforms could shatter investors' trust in her and call up an army of speculators waiting in the wings to test the ECB's resolve to bail out the coalition in Europe's south.

Edited by: Hardy Graupner