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Berlusconi's pledge to resign fails to improve Italian situation

Italy’s situation seems shakier than before, despite hopes that the prime minister’s departure would boost market confidence

Italian prime minister Silvio Berlusconi on Tuesday pledged to resign his post, causing a temporary improvement in market confidence in Italy.

However, by Wednesday, Italian bond yields had soared by more than 7% and there was a surge in credit default swap (CDS) levels. Berlusconi’s promise to depart has rendered Italy safe in the eyes of the markets.

Confidence in the country was never going to improve immediately, and Berlusconi’s promise to resign was never going to serve as a panacea to Italy’s problems. 

“The fact he’s staying on as prime minister may have something to do with the worsening situation," says Daniel Baker, head of FX and fixed income for Europe and emerging markets at Informa Global Markets. "He’s staying in place until austerity measures go through and this creates uncertainty. The clearest lesson from the crisis has been that markets do not like uncertainty.”

Indeed, markets may be prudent to react cautiously to Berlusconi’s pledge to resign. It is possible that, even if he officially resigns, he may continue to exert a great deal of control from behind the scenes.

“Whatever one says about Berlusconi, he is a survivor," says Alastair Newton, senior political analyst at Nomura. "It would be very unwise to say that it’s all over for him. He may stay on as the leader of PdL but not as prime minister, or he may step down and make a return to the top should PdL perform well at elections.”

Furthermore, Italy has been hit by a decision from UK clearing house LCH.Clearnet to lift the margins on its debt. The clearing house’s decision mirrors similar action it took in the run-up to the Ireland bailout, and is unlikely to inspire investor confidence in Italy.

Indeed, Italy’s situation is starting to look increasingly like that of Portugal, Ireland and Greece in the early stages of this year. Spreads between Italian 10-year bonds and German bunds have hit fresh highs at over 500 basis points and yields have gone over the 7% mark for the first time – seen as a critical tipping point for many – and the CDS level is nearing its all time high of 538bp. The yield curve on Italian bonds has inverted, with two-year yields extending above 10-year yields for the first time in eurozone history.

Yields over 7%, soaring CDS levels, widening spreads and inversion of bond yields were evident in Portugal, Ireland and Greece before their bailouts. A Barclays Capital report released on Monday stated that “Italy may be beyond the point of no return”.

The situation for Italy is bleak and the route the country takes in response to the Berlusconi government’s loss of its absolute majority and his promise of resignation may have a big effect on how the markets react. With elections unfeasible for around two to three months, the kind of interim governance put in place would also have huge ramifications.

An analyst’s report released by Citigroup on November 8 outlined two possible routes that could be taken in the event that Berlusconi resigned or lost a confidence vote: the appointment of a new centre-right government by the president, or the formation of a government of national unity composed of “trusted leaders and technocrats”.

The report suggests that the option of a technocratic government is the most favourable one, with a government of national unity being most likely to possess the durability necessary to act upon economic and structural reforms.

“A technocratic government of national unity could boost market confidence in the short-term and provide political cover for mainstream parties ahead of new elections," says Tina Fordham, senior political analyst at Citi. "This has worked in Italy in the past, and could have the public support both to act on unpopular reforms and to help bridge this volatile period. Markets may not take another centre-right government well, particularly if it was perceived as reluctant to implement austerity measures, and new elections may simply take too long for comfort.”

Nomura’s Newton agrees that a technocratic government is the best case scenario for Italy, but it would need majority support – which would likely necessitate the support of deputies from Berlusconi’s PdL.

“It is critical that a technocratic government have majority support, and this would mean support from at least some deputies from the PdL," says Newton. "A technocratic government would need to enact reforms to improve the international competitiveness of Italy. There would be concerns about a non-technocratic government’s capacity to continue such reform.”

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