Italian Prime Minister Silvio Berlusconi has pledged to step down after Parliament approves austerity measures.
His failure to win a majority in Tuesday’s budget vote had already signaled that his tenure in power is over. In addition, he has lost the confidence of his finance minister, Giulio Tremonti, and his coalition partner, the Northern League.
With the resignation of Berlusconi expected soon, there will likely be a short relief rally in stock markets. Already financial markets have reacted quickly and positively, with the euro rising against the dollar and other currencies.
Italy will not be out of the heat of bond markets until a solid and stable government actually implements austerity and undertakes reforms with strong credible leadership, says Jan Randolph the IHS Global Insight Head of Sovereign Risk.
Only after this happens will the ECB come in to support Italian bonds, rewarding measures taken to improve credit-worthiness, Randolph added.
The markets don't believe Italy is able to approve measures that Europe has asked of us, Berlusconi said in a broadcast phone call to an Italian evening newscast. We have to show markets that we're serious.
At the same time, it has to be noted that there is no bailout in prospect for Italy as it is too big for the eurozone bailout fund to rescue. The recent run of weak economic data suggests that Italy will soon fall back into recession.
Capital Economics, a macroeconomics research consultancy, expects the Italian economy to contract by 1.3 percent or so next year and about 2 percent in 2013. In such a scenario the government will struggle to balance its budget by 2013.
Consequently, unless the eurozone is willing to provide Italy with years of expensive financial assistance, Italy will eventually come under tremendous pressure to default, irrespective of who is in power.
A lack of political and popular consensus could put the successor of Berlusconi is additional pressure while faced with the endeavor of putting across nasty austerity measures.
Next week, Parliament will sit down to begin the approval of the 2012 budget along with the austerity measures, which could be an indicator of further developments.