While headlines this week have been dominated by a deluge of speeches on Brexit, the UK’s departure from the European Union is only the second biggest concern of Europe this week. This weekend, Italy will go to the polls to elect a new Prime Minister almost 18 months after PM Matteo Renzi resigned to initiate a fresh election. But why has this election got policymakers, and Euro traders, on edge?

The Italian election has been a long time coming. After former PM Matteo Renzi lost a referendum on constitutional changes, he kept a pledge to resign from office. His loss in the referendum came about not just due to the staking of his premiership, but also the emergence of a right-wing, populist Eurosceptic party named the Five Star Movement.

Founded by former comedian Beppe Grillo (right), 5SM was only a fledgling party back in December 2016 when it swung the referendum away from Renzi. Since then, they have consolidated support with Italians angry at the region’s economic underperformance compared with European peers, especially with neighbour France enjoying a sharper economic recovery under the newly elected Macron.

Now Italy’s largest political party by support, many of their supporters openly blame the EU for Italy’s woes – alongside immigration – and is expected to have the largest share of the votes for a single party on Sunday with 28%, according to the final polls published before the vote.

However, despite being Italy’s largest party, Five Star is not expected to win an outright majority of 40% allowing it to form a government and install their nominated candidate Luigi Di Maio as Prime Minister. Instead, as with many European elections in recent months, a coalition will likely have to be formed.

Renzi’s Democratic Party is currently polling at around 23%, again short of the 40% needed to enter government. As a result, the PD could either form a centre-left coalition along with other pro-EU parties, or a grand coalition with the other major parties (similar to the one attempting to be formed in Germany), with an option being to re-install current PM Paolo Gentiloni as the permanent head of the government.

However, there is enough support for populist parties for a major anti-EU movement to enter government. Furthermore, the re-emergence of another former PM, Silvio Berlusconi (left), has provided Eurosceptics a second wind.

Berlusconi has brokered a deal between three political parties which, should they receive enough votes, has already pledged to a coalition.

While Berlusconi – like Five Star’s Grillo – is not allowed to take a political seat after being charged with tax evasion in 2013, his centre-right coalition comprising his Forza Italia party, the right-wing League party (formerly Northern League) and neo-facist Brothers of Italy – both staunchly anti-immigrant and anti-EU parties – has a major chance of winning the election. Polls currently have support for the coalition at 35-38%, the largest of any group, and an outright victory for the coalition would see current European Parliament President and Berlusconi ally Antonio Tajani become Prime Minister.

Italians are angry at the lack of economic they have previously been promised, subsequently flocking to more radical political views and are likely to call for sweeping changes to the way the country is run. While Five Star were at first touted to call an EU referendum should they win on Sunday, candidate Di Maio has since pledge Italy would remain in the EU, despite looking at alternatives for the Euro.

This sentiment is echoed by the centre-right coalition, which could see its more radical elements push for a referendum on membership of the Euro, and maybe even the EU in a vote similar to the UK’s in 2016.

As a result, we’ve seen the Euro come off its highs against the US dollar (right) as anti-EU Italian populism has risen in support.

A strong showing for both the Five Star Movement and Berlusconi’s centre-right coalition could see further Euro weakness as fears about the future of the EU sky rocket, despite the former toning down some of their more extreme policies in the lead up to the election.

Furthermore, with Italian banks being of key concern to European financial stability (it was less than a year ago lender Monte dei Paschi di Siena was forced into a rights issue), anything threatening their ongoing operations could have a knock on effect for globally important European banks such as the UK’s Barclays and HSBC.

With so much on the line for Italy and the European Union, it’s understandable that many are wary of Sunday’s outcome.

Although, with the final polls too tight to call and no outright winner expected, there is a possibility that this election, similar to Germany’s in September, spawns a lengthy coalition negotiation, or even results in another election to solve the deadlock. It will likely come down to the votes of the 30% or so that are so far undecided. Whichever direction this mass chooses to go will likely sway the entire election result.

Whatever happens, however, politicians across the EU, European bankers and Euro traders alike will be closely watching events unfolding in Italy on Sunday, with an immediate reaction likely to be felt on Monday morning.

Henry Croft, Research Analyst, 2 March 2018