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Italy finds itself in a proverbial catch-22. Its electoral system has been gutted by the Constitutional Court, but it needs an election to sort out the changes that have taken place. These changes have included the split in the center-right, the formal ejection of Berlusconi from the Senate, and a new head of the center-left.

The Constitutional Court knocked down the 2005 electoral reform that had been pushed through by the Berlusconi government at the time, on two grounds. First, it said the bonus that gives the largest coalition 55% of the seats in the Chamber of Deputies was "manifestly unreasonable". It was open to manipulation by pre-vote deals that were not enforceable after the extra seats were secured. Second, voters should chose their representatives and not simply vote for lists of candidates that have been picked and ranked by the party leaders.

The center-left (PD) will hold a leadership meeting tomorrow to reach an agreement, under the new head Renzi, so that it can have a strong negotiating position when the Chamber of Deputies meets on January 27 to take up the issue.

Politics do make for strange bedfellows. The key divide does not appear ideological or even personality, but something more base: size. That means that Renzi and Berulsconi may turn out to be allies in the electoral reform struggle as they represent the largest groupings. Their natural interest would seem to favor more extensive proportional representation, with a large number of relatively small constituencies and a small bonus seats for the winner. It is true that Berlusconi

In contrast, smaller parties like Alfano's new center right party (which is supported by around 4% of the electorate, according to recent polls), would be better served by adopting a model inspired by France. It allows for two rounds. It is currently be used for selecting mayors in some Italian cities.

Grillo's 5-Star Movement, which appears to have been mostly outflanked by the establishment parties, can play a key role here as it represents a large bloc. Yet, its interests are more aligned with some of the smaller parties and clearly is antagonistic to the entrenched interests. If there is not agreement than a pure proportional system without the elements rejected by the Court. Small parties would likely fare better with the model favored by Renzi and Berlusconi.

Although Italian and Spanish asset markets continue to outperform, Italy's political and fundamentals are weaker. Italian asset markets have begun under-performing Spain. This is most evident in the bond market. Already this year, Spain's 10-year yield has dropped 35 bp, while Italy's has fallen "only" 18 bp. This is mirrored at the 2-year sector too. Since last summer, the cost of insuring Italian debt (CDS) has been a little more expensive than insuring Spanish debt.

Italy's under performance is less pronounced in the recent equity performance. Year-to-date both are up 5% (vs. 1.1% in the DAX, 0.7% in the FTSE and -0.5% in the S%P 500), though Italy was marginally underperforming until today. Over the somewhat longer term, the past six months, Spain has outperformed Italy by nearly 500 bp.

Source: Electoral Reform: Italy's Soap Opera Takes New Turn