Don't Be Complacent About Italy's Elections

(Bloomberg View) -- Investors contemplating Italy's upcoming elections apparently see no cause for alarm, but their mood may not last. The vote looks set to produce a coalition government too weak to address the country's twin challenges of slow growth and high debt.

For now, calm prevails. The country's 10-year bond yield, which rose to more than than 7 percent during Europe's economic crisis, hovers around 2 percent. Italy's equity market has been battered by the recent global setback, but it's still outperforming its European peers.

Up to now, the European Central Bank's policy of quantitative easing has helped mask Italy's fragility. But the ECB is likely to stop buying new bonds in the fall. When that happens, Italy's deep-seated problems will return to the fore.

Granted, the economy has made progress recently. Growth is picking up, and the unemployment rate has fallen to 10.8 percent -- still far too high, but the lowest in more than five years. After protracted dithering, banks are finally trying to reduce their non-performing loans. That's essential, because it will make lenders more resilient to shocks and free up capital which can be used to boost lending.

The trouble is, the elections seem unlikely to help. Italian politics consists of three main groups: the center-left, led by Matteo Renzi; the center-right, headed by Silvio Berlusconi; and the anti-establishment Five Star Movement, led by Luigi Di Maio. According to recent polls, none will be able to form a government. The expected result is either a wobbly "grand coalition" or a prolonged stalemate, leading in due course to new elections.

Would that be so bad? Many investors seem to believe that, so long as Italy doesn't elect an openly euro-skeptic government, the euro zone will be fine. It's Italy, after all, where weak and unstable governments aren't exactly unheard of.

This time will be different. Italy's public debt stands at a towering 132 percent of gross domestic product, and the policies needed to put it on a sustainable downward track are nowhere in sight. When the next crisis hits the euro zone, Italy's broken public finances will be a focus of intense concern -- and investors will remember that Italy remains the euro zone's third-largest economy, and one of the world's largest manufacturing countries.

At the moment, the coming election looks like no big deal. Before much longer, there may be cause to regret this complacency.

--Editors: Ferdinando Giugliano, Clive Crook.

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