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A 'Happy New Year' for Italy? Don't bet on it

Investors could be forgiven for thinking that things could not unravel any further in Italy in 2014 after almost a year of political, economic and social turbulence.

Throughout 2013, Italy's coalition government has lurched from crisis to crisis since its awkward inception in April. It crashed and burned in November when former Prime Minister Silvio Berlusconi, who was facing expulsion from public office due to a tax fraud conviction, announced that his party had joined the opposition.

While political chaos has reigned this year, economic reforms have been undone, delayed or disputed and the country's budget deficit and debt pile has worsened. If the "annus horribilis" of 2013 was not enough for Italian politicians and public and international investors alike, analysts warn that next year could be just as bad.

Sunset over St Peter's basilica at the Vatican, Rome
Tiziana Fabi | AFP | Getty Images
Sunset over St Peter's basilica at the Vatican, Rome

Political rivalry

The current Italian government led by Prime Minister Enrico Letta might appear safer since Silvio Berlusconi was expelled from politics and his center-right "Forza Italia" party joined the opposition, but Letta is facing a new threat from within the Democratic Party (PD) in the form of the brash Matteo Renzi.

The 38-year-old former Mayor of Florence won a vote to become the PD's leader in December and political analysts are questioning how long until the charismatic figure will start undermining Letta's premiership.

(Read more: Italy's latest risk to stability: the 'Renzi Factor')

"The parliamentary base of the government will remain fragile and then there's going to be rivalry between between Renzi and Letta," Roberto D'Alimonte, professor of Italian Politics at Rome's LUISS Guido Carli University, told CNBC. "If this [rivalry] is not managed well, it could open the door again for the resurrection of Berlusconi," D'Alimonte said. Berlusconi was, he said, "a political genius" and could not be written off.

Renzi pledged his support for the government following his election, but there is speculation he could press for early elections in 2014 in the hope of leading the government himself. D'Alimonte said the country's leaders would be desperate to prevent such an occurrence given 2013's election debacle.

"The Letta plan - and that of President Giorgio Napolitano -- is for this government to last until spring 2015. Italy will hold the presidency of the EU from July 2014 and the president wants a stable government - or at least a government in existence -- for those six months at least. [The trouble is] that if we do not fix the politics we will not be able to fix the economy -- and we need economic reforms that only a stable, strong government can pass." D'Alimonte predicted. "Instead, it'll be a year of muddling through."

Demonstrators in December
Giorgio Cosulich | Getty Images News | Getty Images
Demonstrators in December

(Read more: Berlusconi's gone - but Italy's big problems remain)

The public might not be so willing to allow Italy to "muddle through" however, particularly as Italy remains locked in its longest post-war recession and unemployment stands at a record 12.5 percent in October.

Showing the rising tide of public anger at political impotence, a week of anti-government protests surged across Italian cities in Decemberprompting President Napolitano to warn that Italy could be plunged into violent social unrest unless the government swiftly introduced reforms to help struggling citizens.

'Bleak,' but less bleak

Political volatility in 2013 has meant that reforms designed to pull the euro zone's third-largest economy out of a prolonged recession have been pushed to one side. After Berlusconi's expulsion in November, Prime Minister Letta said his government would be "stronger and more cohesive" but he faces a tough test in terms of enacting reforms and turning Italy's dire economic fortunes around.

Jeff J Mitchell | Getty Images News | Getty Images

(Read more: 'Rome burns' as PM Letta wins confidence vote)

Third-quarter gross domestic product (GDP) data released in December showed economic output was flat compared to the previous three months -- signalling that Italy could be about to emerge from two and a half years of recession. But economists warned the economy has far to go.

In a note from HSBC setting out the bank's 2014 predictions for the euro zone, European economist Matteo Cominetta predicted that Italy's economy would grow but that "the lack of structural reforms means higher potential growth is unlikely."

"Consequently, we don't expect Italian growth to go beyond 0.4 percent and 0.6 percent in 2014 and 2015, respectively. Things could change should Mr Renzi become the next prime minister and implement his reformist agenda, but it is early to ponder on that possibility now," he said.

Nicholas Spiro, head of Spiro Sovereign Strategy, told CNBC that news that Italy exited its seemingly never-ending recession in the third quarter, "while symbolically important, is, to all intents and purposes, meaningless to the average Italian."

"Domestic demand is still contracting and the credit crunch continues unabated. The technical end of Italy's recession epitomises the state of affairs in the euro zone as a whole: it's not that the outlook is brightening but rather that it's simply becoming less bleak."

Indeed, Italy has a residual debt problem. The country has the second highest debt pile in the euro zone after Greece which is above two trillion euros -- around 133 percent of its economic output -- and a budget deficit hovering around the European limit of 3 percent, according to Eurostat.

"Italy's economy is likely to remain flat on its back in 2014, with little prospect of meaningful growth, to say nothing about structural reforms, any time soon," Nicholas Spiro commented. "The big improvement in Italy over the past year or so has been in the realm of investor sentiment, not in the real economy. This tale of two halves is likely to persist next year."

Speaking as the Italian Senate backed Italy's 2014 budget just days before the Christmas holiday, Prime Minister Letta appeared confident that the new year would herald a new start for the country and that a new generation of reform-minded generation of politicians would help Italy recover.

"I have been part of this change and I feel the full weight of responsibility. This generation will have the opportunity of changing Italy and I am convinced it can do it," he told an annual end-of-year news conference in Rome.

"We have the most complex part of this crisis behind us and we have to be in a position to take advantage of some important opportunities."

- By CNBC's Holly Ellyatt, follow her on Twitter @HollyEllyatt. Follow us on Twitter: @CNBCWorld

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