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What is Italy’s political crisis all about and why does it matter?

  • Italy has been plunged back into crisis mode after several weeks of protracted negotiations between anti-establishment groups ultimately failed to produce a new coalition government.
  • Itay's economy, the euro zone's third-largest, has been anemic for a long time. That's been a significant concern for the EU as well as global markets more broadly.
  • For the first time since World War II, Italian populists are on the brink of securing an unprecedented popular mandate to govern the country.

Italy is embroiled in a dramatic power struggle between euroskeptic populists and pro-EU establishment lawmakers.

The country has been plunged back into crisis mode after several weeks of protracted negotiations between anti-establishment groups ultimately failed to produce a new coalition government.

As a result, Italy is back to square one.

What happened?

Italy has been without a government since an election in early March resulted in a hung parliament.

While there was no outright winner, the populist Five Star Movement (M5S) secured the largest chunk of the vote and soon sought to join forces with the far-right Lega (League) group in an effort to set Italy on a path toward forming a new coalition government.

However, government talks broke down over the weekend after the surprise resignation of Giuseppe Conte, a little-known law professor that M5S and Lega had selected as the country's next prime minister.

Conte officially stepped down Sunday, following President Sergio Mattarella's decision to reject the parties' controversial choice for economy minister.

How did we get here?

Italy's head of state, who was installed by a previous pro-EU government, refused to accept the nomination of euroskeptic candidate Paolo Savona for economy minister.

Instead, he set the country on course for another snap vote by appointing former International Monetary Fund (IMF) official Carlo Cottarelli as interim prime minister. Cottarelli, who became known as "Mr. Scissors" for his reputation regarding cuts to public spending in Italy, is now tasked with the planning of fresh elections and passing the next budget.

Luigi Di Maio, Five-Star Movement (M5S) leader, addresses the media after a new round of consultations, with Italian President Sergio Mattarella, for the formation of the new government at the Quirinale Palace in Rome, Italy.
Giuseppe Ciccia | Pacific Press | LightRocket via Getty Images
Luigi Di Maio, Five-Star Movement (M5S) leader, addresses the media after a new round of consultations, with Italian President Sergio Mattarella, for the formation of the new government at the Quirinale Palace in Rome, Italy.

The decision to appoint Cottarelli to form a temporary administration prompted M5S and League to switch back to campaign mode. It also triggered Luigi Di Maio of M5S to call for Mattarella to face impeachment charges, as he claimed Italy's president had betrayed the Italian electorate by blocking Savona's nomination.

Nonetheless, Di Maio has since walked back his plea for such drastic measures, amid an apparent lack of support from Lega leader Matteo Salvini.

What makes this a crisis?

Itay's economy, the euro zone's third-largest, has been anemic for a long time. That's been a significant concern for the EU as well as global markets more broadly.

"If you just look at the economic fundamentals of Italy, they are worrying," Mouhammed Choukeir, chief investment officer at private bank Kleinwort Hambros, told CNBC's "Squawk Box Europe" Tuesday.

"It is one of the biggest indebted countries in the world … it's got an unemployment rate of 11 percent and its economy is still lower than where it was in 2007, whereas most major economies have recovered. So, clearly there is a requirement for structural reform here in order to regain confidence," he added.

Meanwhile, the looming prospect of a snap vote continued to rattle financial markets Wednesday, amid renewed fears a forthcoming election campaign could be fought over the country's role in the European Union and the euro zone.

Italy's deepening political turmoil has also prompted some analysts to sound the alarm over signs of market "contagion," with countries such as Spain and Portugal thought to be potentially exposed — though so far the risk is seen to be somewhat limited.

Why is this Italian crisis unique?

Italy is certainly no stranger to political turmoil, but the ongoing stand-off constitutes new territory for the country. For the first time since World War II, Italian populists are on the brink of securing an unprecedented popular mandate to govern the country.

Yet, for some, Italy's current political convulsions can be traced back to one key moment in 2016.

"Italian politics has been our top political risk in Europe ever since then-Prime Minister Matteo Renzi started to lose support in mid-2016 for his ill-fated constitutional referendum," Holger Schmieding, chief economist at Berenberg, said in a research note published Tuesday.

Matteo Renzi, Italy's prime minister, pauses at a news conference following the constitutional reform referendum results in Rome, Italy, on Monday, Dec. 5, 2016.
Chris Ratcliffe | Bloomberg | Getty Images
Matteo Renzi, Italy's prime minister, pauses at a news conference following the constitutional reform referendum results in Rome, Italy, on Monday, Dec. 5, 2016.

Renzi resigned from office in December 2016, after the former prime minister staked his leadership on a referendum designed to overhaul the electoral system and functioning of the houses of parliament.

"The risk has become more acute now. The spectre that new elections in Italy in the autumn of 2018 or – possibly – in early 2019 could turn into a de facto referendum on Italy's place in the EU and the euro will hang above Europe like a sword from now on," Schmieding added.