What does a new Italian government mean for the euro area?

What does a new Italian government mean for the euro area?

March election in Italy created a stir as the right-wing Eurosceptic party “League” and the left-wing anti-establishment Five Star Movement got a majority in a Parliament. The euro market was shaken and experts predicted dramatic consequences if the Eurosceptic sentiments overpower the pro-European politicians. The active government is not formed yet, but Italy is close to it. Let’s look whether worries remain.

On May 9, Silvio Berlusconi, a leader of a Forza Italia party that was a coalition partner of the League excluded his party from the government’s formation. As a result, only two parties: Five Star Movement and League started negotiating.

Parties were supposed to present a "government agreement" on Monday. However, they could not come to a decision on key issues and asked additional time to make a deal.

The main matters of the dispute are infrastructure, immigration and Italy's relations with the European Union. Leaders announced agreements on guaranteed income for the poor, a rollback of pension reform that will drop the retirement age, a flat tax, the expulsion of illegal immigrants and a closer relationship with Russia. Now they are working on a candidate on a Prime Minister position. If parties fully agree on all important issues and the President of Italy agrees on their candidate, the government may be finally formed after more than two months of a deadlock. Otherwise, Italy will have to vote again.

Will Italy exit the EU? There are doubts.  

Both ruling parties can be called Eurosceptic – especially the League that required to freely deal with illegal immigration the right to renegotiate the EU's fiscal rules. However, it seems like they are ready to drop their pre-election pledges to hold a referendum on the euro. According to experts, markets should not expect an exit of Italy from the EU. Let us remind you about the similar situation in Greece. A party that won an election in 2015 was Eurosceptic as well. However, Grexit has not happened yet.

The new Italian government may put pressure on the European Union and will manipulate it. Coalition parties promised to cut the budget deficit and reduce the government debt. To fulfill pre-election promises a new coalition will need a lot of money. That is why there is a possibility that the government will ask the EU to help. Moreover, the coalition may insist on the redistribution of refugees and migrants within the EU. Another negative factor for the European Union is that the new government is loyal to Russia. Such “friendship” may cause tensions in the European Union. These issues may affect the European economy and stability.  

What about the euro?

The euro is highly suffering since the middle of April as the European economic data appeared to be weaker than expected. Further pressure on the economy caused by Italy’s policy will pull the single currency down. Up to date, the EUR/USD pair is trading at the lows of the end of 2017.

However, there is another opportunity. According to JPMorgan, the euro will not go down extensively unless the government starts making explicit promises to abandon the single currency. As the Italian government has already eased its Euroscepticism, the risk of the immediate abandonment is low.

Making a conclusion, we can say that the Italy’s exit from the European Union is unlikely. The parties have already eased their Eurosceptic mood. However, risks of political and financial tensions still exist. The further movement of the euro will depend on the strength of the Italian government. If it is able to implement its election pledges, the European economy may suffer a lot. That will lead to a slowdown of the quantitative easing’s tapering. And as a result, to the weaker euro. But it won’t happen in the near future. As such negative effect of the one country will take a lot of time. 

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