Italy's vital reform agenda hangs in the balance. Elections at the end of this month could split power between the Left, in the lower house, and Silvio Berlusconi's centre-right coalition, in the Senate.
Such an outcome would effectively kill the government's ability to push through the structural reforms that Italy urgently needs to revive growth. A divided parliament may even reverse the tentative progress already made under Prime Minister Mario Monti. It would make Italy a country with two Popes, but no clear government.

Though a coalition of Monti and the Democratic Left (PD) is still ahead in the polls and remains favourite to win the popular vote on 24 February, the situation is less stable than it seems. As in 2006, Berlusconi's People of Freedom party (PdL) has been gaining ground over the past few months with promises of populist policies that would undo the painful, but necessary, measures piloted by Monti. Promises to reduce taxes and offer a rebate on Italy's hated property tax are a last minute sleight of hand that put a whole year of reforms at risk.

The big electoral uncertainty is the Senate, which is chosen in a series of winner-takes-all regional races. A small surge for the PdL in Campania and Puglia – Italy's Florida and Ohio – could deliver almost a sixth of the seats to the PdL, and with it control of the Senate. Our simulation of the likely results shows a one-in-four chance of this happening. But downside risk is increasing as Berlusconi gains ground.
Financial markets have taken note. Yields on Italian 10-year government bonds are again creeping back up towards 4.5 per cent, shadowing the PdL's rising support. Is the market right to place such emphasis on the reform agenda? If anything, it should worry even more, in our view.

Italy's economy suffers from both high debt and low competitiveness. Italy is among the world's largest borrowers, suffering from a €1.65tn debt overhang (120% of GDP). This constantly weighs on Italy's balance sheet, making it dependent on foreign demand for its bonds and vulnerable to market stress. The situation was so bad in November 2011 that Il Sole 24 Ore titled its front page FATE PRESTO – act now – an S.O.S. headline used previously in 1980, seeking help after a terrible earthquake struck the country. Even after the OMT, Italy's ability to sustain its debt remains strongly dependent on bond markets.

This year alone Italy's treasury needs to refinance €400bn of debt: should spreads increase by 1%, the government would have to pay €4bn more in funding costs – roughly equivalent to one year's revenue on property tax. Adding to high public debt are low growth and competitiveness, where Italy has lagged every other developed economy over the past two decades. It ranks only 73rd out of 185 countries for competitiveness, according to the World Bank – below Romania and Bulgaria.

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