After months of bickering between the coalition partners - the 5 Star Movement and the League - the government collapse was expected. However, the timing is surprising and carries some risks.
The League's leader Matteo Salvini, who is also deputy prime minister and interior minister, has repeatedly said that the government would serve its full five-year term. Making an about-face last Thursday, Salvini declared that the trust between the two coalition partners had disappeared and that governing under these conditions made no sense. On Friday, the League announced a motion of no-confidence in the government and asked to go to early elections as soon as possible.
The leader of the League aims to cash in on its popularity in recent polls, which has surged to 38% from 17% at the time of the last general election in March 2018. If the polls prove an accurate guide to the election outcome, Salvini could become Prime Minister of a League-only government or of a League-led coalition government. The most likely junior partner would be the right-wing Brothers of Italy party with which the League shares euro-sceptic and anti-immigration views.
Markets are understandably concerned. After Salvini's statements, Italian government bond yields have risen sharply relative to other eurozone countries and the Italian stock market has underperformed other eurozone indexes. There is a fear that a League-dominated government would pursue unsustainable budget policies and take a more confrontational stance with the EU than the existing government.
However, it is not obvious that new elections will happen soon. If they were postponed to the spring of 2020, Italian asset prices may get some temporary relief.
The calendar matters on how the crisis unfolds
The Italian Constitution calls for the president of the Republic Sergio Mattarella to manage the government crisis. Before the League announced its no-confidence motion, Mattarella had asked prime minister Conte to reconvene the Parliament despite the summer break and to verify the existence or not of a majority supporting the government. The resultant vote of no-confidence is expected soon.
In the likely event of a government crisis, president Mattarella will follow the procedure foreseen by the Italian Constitution. Before dissolving Parliament, he will consult with the presidents of the House of Deputies and the Senate, the leaders of all parties and of the parliamentary groups to evaluate how best to proceed.
The consultations are expected to show the absence of an alternative parliamentary majority to that of the outgoing government. The president of the Republic would therefore dissolve Parliament, probably between 20th and 30th August. According to the Constitution elections must take place between 45 and 70 days after the dissolution of Parliament. Furthermore, the law requires that residents abroad are given at least 60 days' notice of an election. Therefore, new elections could be called no sooner than the second half of October.
However, this is a risky time to go to elections because it coincides with domestic budget negotiations. If the next election takes place at the end of October, the new government and Parliament will have little time to approve the budget by year end and avert tax increases that are set to come into force as a result of previous safeguard clauses. President Mattarella may therefore conclude that the elections should be postponed to next year.
If Mattarella is able to muster enough political support to form a new government for at least a few months, this will probably include some technocrat ministers. The new cabinet would have the specific mandate of approving the 2020 budget.
In this scenario, the 2020 budget will likely respect the most important requests of the EU Commission. The Commission will be more likely to grant Italy some flexibility given the exceptional circumstances, as it has already done in the past with other countries. Even more important than a contained target deficit, a smooth interaction between the government and the Commission will reassure markets and benefit Italian assets as opposed to what happened last year.
Once the budget is approved, Parliament would be dissolved and new elections called in the spring of 2020. Provided that opinion polls do not change much from now, markets will focus again on the League's electoral promises and their impact on the sustainability of Italian public finances. It would be unsurprising if uncertainty around Italy rises again.
It is not certain that the collapse of the Italian government will be followed by immediate elections. The president of the Republic Mattarella and a majority of political parties may conclude that approving the 2020 budget and averting the increase in the VAT rate are the priority. This could give some temporary respite to Italian asset prices after the recent sell-off.
However, new elections would only be postponed to early next year. Uncertainty will rise again with the likelihood of a League-led government pursuing higher deficits and a more confrontational stance with the EU. The volatility of Italian asset prices will be higher for longer.
GianLuigi Mandruzzato is an economist at EFG Asset Management