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New Italian Prime Minister Creates Uncertainty for Investors

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Italy could be in for a bit of a rough ride in the days immediately ahead, thanks to the resignation of its longest-serving president, Giorgio Napolitano.

The 89-year-old president consented to remain in office at the expiration of his last term after lawmakers were deadlocked on trying to choose a successor. But he said early on that he would not stay for the full six-year term, which ends in 2020. He tendered his resignation on January 14, leaving Prime Minister Matteo Renzi facing a tough slog in finding a supportive replacement.

Renzi has been pushing through unpopular economic and political reforms to keep Italy from having to seek a bailout. While Napolitano has been a backstop for Renzi’s efforts to push the economy back toward recovery, and could have been a valuable ally should rebellion arise—even some members of Renzi’s own party aren’t particularly enamored of his efforts, particularly since they have been slow to show results—the prime minister might not be so lucky with another president.

Despite its largely ceremonial nature, the office of the presidency carries some real powers, including the ability to dissolve the government and call for snap elections, as well as put forward candidates for prime minister. In fact, that’s how Renzi himself entered the office—at Napolitano’s hands.

Should Renzi have to resort to drastic tactics, such as calling for elections, to push through his reform programs, he would definitely want someone in office who is willing to back him to the hilt.

As it stands, to win such a candidate Renzi may have to compromise with Silvio Berlusconi’s Forzo Italia party or even Beppo Grillo’s Five Star party, both of which stand in opposition to his own Democratic Party. Currently Senate Speaker Pietro Grasso is serving as a caretaker president in Napolitano’s stead.

Elections are scheduled to begin on January 29, but with the way voting requirements are structured, it could take several rounds to come up with a likely candidate. And while numerous possibilities have been named as potential successors to Napolitano, including ECB President Mario Draghi, who has already declared himself out of the competition, compromise may be the only way to resolve a stalemate. But that could endanger the reforms that Renzi has been working so hard to implement.

Among other names voiced as potential presidential candidates are former Prime Minister Romano Prodi; Pier Carlo Padoan, economy minister; Ignazio Visco, governor of the Bank of Italy; and constitutional court judge Sergio Mattarella.

According to analysts Gergely Kiss, Ed Parker and Raffaele Carnevale of Fitch Ratings, political turmoil is just one of the pressures on the Italian economy—and thus on its credit rating. The analysts said in a report, “Disrupted economic and fiscal policies or weakening political support for the medium-term fiscal consolidation path would put downward pressure on the ratings.” Since ratings are already sensitive to “[r]educed confidence that GGGD/GDP will peak in 2015” and “[f]ailure of the economy to return to growth,” Renzi has his work cut out for him.

With “GDP … currently close to its level in 2000 and 9% below its peak in 2008,” the analysts said, “[i]t contracted again in 1H14, in contrast to Fitch Ratings’ previous expectation of a weak recovery, after 0.1% growth in 4Q13. Fitch forecasts GDP … growth of 0.6% in 2015 and [that] unemployment will remain above 12% until 2016. The risks around the baseline scenario are skewed to the downside.”

And the risks are not limited to Italy, what with elections approaching in Greece and the European Central Bank deciding on actions to combat deflation. Worries over the outcome of the situation in Athens already brought copycat declines in the stocks of Italy and Spain at the beginning of the year.

But there’s good news amid all the uncertainty. According to Jyrki Katainen, vice president of the European Commission, Italy may be the beneficiary of more flexible interpretations of EU fiscal regulations. A little leeway would be a good thing, considering that the country’s economy has contracted rather than expanding, and that the search for a new president could result in a period of turbulence, if not deadlock.

Italy’s 2015 budget faces a review by the EC in March, and Katainen was reported telling Italy’s parliament that while it would be difficult to evaluate the condition of the country’s economy before the EC puts out its next group of economic forecasts, “I could imagine that Italy could benefit from flexibility like other countries.”

Such flexibility might give Italy enough time to sort out its issues and calm, at least temporarily, its troubled political waters. And Rome will need it. Not only has Italy proposed a less drastic cut in its structural budget deficit than that required by EU rules—0.5% of GDP per year—but the Bank of Italy has cut its forecast for growth in 2015, saying that deflation would continue for the year ahead.

Its most recent quarterly economic bulletin predicted growth of 0.4% in 2015, its first expansion since 2011, but even that would be subject to “great uncertainty”—unsurprising considering not only its own internal political difficulties but the weakness in the eurozone as a whole.

While Renzi’s government is predicting growth of 0.6% for 2015, and the IMF is even more optimistic at 0.8%, the Organization for Economic Cooperation and Development (OECD) only foresees 0.2%. And the Bank of Italy said that consumer prices in the country not only fell in December but were likely to lose another 0.2% from where they were in 2014.