by Alex Lee
10th November 2011

After seeing his parliamentary majority decline further in a routine vote earlier today, Italian PM Berlusconi offered to resign once Parliament approves new austerity measures, possibly towards the end of next week. We see three possible outcomes at this delicate stage, with different implications for the BTP market and Italian risk premium more broadly:

*Most likely scenario: In the coming weeks, the current centre-right coalition of the Northern League and PdL moves to rally round another candidate who can gain wider acceptance domestically and internationally. In order to broaden its support, the new government may reach out to smaller centrist parties which can advance their own political agenda.

A centre-right executive backed by a broader coalition and committed to implementing the ‘troika’s’ economic platform could eventually stabilize markets. But the newly appointed Cabinet would need to prove itself first, and the protracted uncertainty would weigh on economic growth. Furthermore, reforming the pension system could meet resistance from the Northern League. Still, it would be hard for the ECB and Italy’s EMU peers not to stand by a new Italian government genuinely trying to pursue reforms. Under this scenario, thanks to the ECB’s interventions, we would expect BTPs to remain capped at around current levels (400-450bp) over the average of Germany, France and the Netherlands until measures are gradually approved.

*Second most likely scenario: The centrist parties ultimately turn down the offer to join a broader coalition. In this case, more MPs from Berlusconi’s PdL party could join forces with formations at the centre of the political spectrum. This could pave the way for a government of national unity of sorts, led by a highly reputable ‘outsider’. Like during the crisis of the early 1990s, the advantage of such a ‘technocrat’ government is that it would be sworn in after some ‘initial contracting’ on its programme (economic reforms agreed with the ‘troika’, plus a new electoral law), which should lower the implementation risk. A technocrat government could use its credibility to introduce more growth enhancing measures that would pay off further down the road. Lastly, it could focus on improving governance (fiscal rules in the constitution, a smaller public sector, etc).

We view this as the most market-friendly outcome, as it would lead over time to a decline in sovereign spreads and in Italy’s risk premium more broadly. The front-end would re-price more than intermediate- and long-term maturity bonds because investors would likely take advantage of the rally to reduce exposure at higher prices. Nevertheless, we would expect BTPs to fall to around 350bp over Bunds in fairly short order.

*Least likely scenarios: After Berlusconi’s resignation, general elections are called. These could be held in mid-January at the earliest, although they would most likely be postponed until the Spring amid market turmoil.

This would represent the worst scenario for markets, in our view. Since President Napolitano is aware of this, he will probably try to resist dissolving Parliament at this juncture. Also, most centrist parties would want to change the electoral law before a new vote takes place.

All these scenarios will take some time to play out, a couple of weeks at least. In the meantime, the higher priced Italian government bonds will continue to be sold, as gradually higher margin requirements are applied. On our central case, intermediate to long-end bonds should continue to be supported relative to AAA-rated securities by the ECB.

In conclusion, 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.