As Italy heads to an election March 4 that could produce a grand coalition government in the eurozone's third-largest economy, bond investors are pricing the country at the riskiest levels versus its European Union partner Spain since the currency bloc's debt crisis.
The last opinion polls published before the start of a two-week blackout period placed a center-right alliance between former Prime Minister Silvio Berlusconi's Forza Italia and the euroskeptic Northern League on 37%, ahead of 27.5% for the radical Five Star Movement and 26% for the center-left.
While Five Star has toned down calls for a referendum on euro membership, the Northern League has said it wants Italy to pull out of the EU unless it makes concessions on immigration and fiscal rules.
The most likely outcome, according to analysts at Berenberg, would be a grand coalition spanning the spectrum of center-left to the right. This would not mean radical policy shifts, but could lead to reversal of labor market and pension reforms. Most of the parties are promising to reverse structural reforms.
However, Berlusconi, who is barred from holding public office until 2019 because of a 2013 tax fraud conviction, on March 1 ruled such an alliance out.
"We have all, each one of us, made an absolute pledge to reject coalitions ... with other parties, even if we don't achieve a majority on our own," Berlusconi said, referring to his allies, Reuters reported.
Bond investors have responded by asking for higher returns on Italian government debt than on bonds from Spain, whose banks had to be rescued by a European bailout in 2012.
The yield on Italy's 10-year debt was 1.97% Feb. 28, compared to 1.46% for Spain. The spread in favor of Spain hit as high as 63 basis points on Jan. 30, the highest since August 2017. Italian yields were below Spain's in mid-2016.
"We think a coalition consisting of the anti-establishment Five Star Movement together with other radical parties would have the most negative impact on Italy, but luckily, this scenario looks unlikely," Berenberg's European economist, Carsten Hesse, said in a note. The elections are "one of the key political risks for Europe this year," although he added that he did not expect them to provoke a systemic crisis or Italian exit from the eurozone.
Meanwhile, European Parliament President Antonio Tajani on March 1 accepted Berlusconi's offer to become Forza Italia's candidate for prime minister, Reuters reported separately.

