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Prodi's Daunting Task

It was a tight race, but final unofficial results confirm that Romano Prodi is likely to replace Silvio Berlusconi as Italy's Prime Minister. But the victory celebrations may be tempered by some daunting facts. Prodi has to govern with a small majority, and must hold together a coalition of more than 10 parties, which will complicate prospects for structural reform. This could hamper Italian growth prospects, and have a negative impact on the credit rating agencies' outlook for the eurozone's third largest economy.

Final unofficial results show support for Prime Minister Berlusconi's coalition "House of Freedom" at 49.7%, while the "Union" of challenger Romano Prodi mustered 49.8% of the votes. Under the new election law, even this small majority secures Berlusconi a total of 348 of the 630 seats in the Chamber of Deputies.

In the Senate, the upper house, Prodi will have a very small majority of 158 against Berlusconi's 156. Considering that the Senate has to pass all legislation, this highlights just how tight the outcome is. Berlusconi still has not conceded defeat, and is calling for a recount and check of around 80,000 votes, but it seems pretty clear now that Prodi will take over as the new Prime Minister.

DEATH AND TAXES. Prodi has already served as Prime Minister. Back in 1998 he managed the near-impossible and helped Italy pass the Maastricht criteria and secure a place in the Economic & Monetary Union. Subsequently, Prodi was president of the EU Commission, and many are relieved that the flamboyant and often controversial Berlusconi will be replaced by a politician with extensive experience in the international arena.

Looking at domestic policies, the election program of Prodi's coalition included a promise to cut labor costs by 5% in the first year, but also to raise taxes on capital gains from certain bonds and shares. The center left is also planning to reintroduce the inheritance tax for the very rich, and implement stricter controls against tax evasion.

There are also plans to soften some of the measures contained in the country's 2004 pension reform law, which lifted the retirement age to 60 from 57. The latter will be watched very carefully also by rating agencies, as it will have an impact on Italy's ability to cope with the budgetary consequences of an aging population.

STRUCTURAL REFORMS. The business sector reacted positively to the prospect of Prodi's election. Berlusconi may have been the longest serving Italian Prime Minister since World War II, but he relied too often on one-off measures to boost the economy, rather than implementing lasting, structural reforms that would secure stronger growth in the medium to long run. Italy reported average GDP growth of just 1.5% in the period from 1995 to 2004, below the 2% average for the eurozone as a whole. The Italian economy moved out of recession in the course of 2005, but GDP remained stagnant, vs. 2004.

Inflation has been high despite modest growth, and this has undermined Italy's competitiveness. This once export-oriented country struggles to compete in international markets. Unemployment is high and the industrial sector is hoping for a continuation of the privatization process. Structural reforms could help make labor and product markets more flexible, and boost exports and overall growth in the long run.

The country is also fighting high debt and deficit levels. There were substantial fiscal consolidation efforts in the 1990s, in the run-up to the start of the monetary union, and the government deficit was cut from almost 12% of GDP in 1990 to below 2% at the end of the decade. However, already in 2001 the deficit/GDP ratio was once again above the 3% limit called for in the Maastricht Treaty, and reached 4.3% of GDP in 2005. This came despite the help of one-off measures, which the EU commission estimates at 1.4% of GDP.

AGING POPULATION. The EU commission started a procedure against Italy in June last year for its excessive deficits, and the country's latest stability program, prepared by the Berlusconi government, aims at reducing the deficit to below 3% of GDP by 2007. The structural balance -- which is the cyclically adjusted budget balance -- is expected to improve by around 0.75% of GDP each year to 2009. This will require further reforms and not just temporary measures.

There has been some progress with regard to pension reforms, and the EU commission judges Italy to be at medium risk from the effects of an aging population. However, Prodi pledged to reverse part of the pension reform, and this will put further pressure on medium term finances.

Italy's debt level amounted to around 108.5% of GDP in 2005 and this highlights the urgent need for the country to get public finances under control. Indeed, rating agencies have already warned that there could be a downgrade to Italy's debt rating if there are no fundamental reforms, which so far Prodi's program has not promised.

SMALL MAJORITY. The incoming Prime Minister managed to bring public finances under control in the past and it seems there is more chance of structural reforms rather than one-off measures than under Berlusconi. So the switch from Berlusconi to Prodi is clearly a positive one. Also because it will very likely bring Italy once again into the heart of Europe as Prodi will intensify contacts with the other big eurozone countries, Germany and France, and heal the rift that developed over Italy's stance on the Iraq War.

However, Prodi has to govern with a very small majority. If he wants to tackle controversial structural reforms, a conflict with some of the more extreme coalition parties seems likely. This means the new government is unlikely to last the full term, which would further delay reforms -- and make the task of strengthening the economy that much more difficult.

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