By Deborah Ball 

ROME -- Italian Prime Minister Matteo Renzi's resignation on Monday after a decisive referendum defeat could herald the end of aggressive efforts to overhaul one of Europe's worst-performing economies, compounding the continent's woes and increasing the stress on its common currency.

Italian President Sergio Mattarella accepted Mr. Renzi's resignation on Monday evening, but asked him to remain in power to oversee the passage of Italy's 2017 budget, likely at the end of this week. Italy's lower house has already approved the bill, leaving the Senate to vote on it.

With populism on the march, whoever succeeds Mr. Renzi is likely to be politically weaker and wary of bold moves that could alienate voters as the European Union's fourth-largest economy contends with a severe banking crisis and strained public finances.

The premier stepped down after voters in a referendum on Sunday resoundingly rejected constitutional changes that would have stripped power from the legislature's upper house in an effort to streamline lawmaking and make for more stable governments.

Once Mr. Renzi steps aside, Mr. Mattarella will undertake consultations with political parties to determine how to proceed. He is widely expected to opt for the formation of a caretaker government to deal with urgent issues such as a banking crisis threatening to boil over.

That caretaker government, once approved by parliament, would conduct the country to new elections, which could be brought forward from their current timetable of spring 2018.

Economy Minister Pier Carlo Padoan and Senate speaker Pietro Grasso are mooted as possible candidates. Some argue Mr. Padoan has the edge in light of the risk that the government weeks may have to bail out troubled Banca Monte dei Paschi di Siena SpA in the coming weeks. Others say Mr. Padoan's candidacy would be a hard sell to parties keen for a clean sweep after the Renzi government.

Indeed, following Mr. Renzi's defeat, the antiestablishment 5 Star Movement, which had pushed for the "no" vote, called for snap elections. "We don't want and we won't support makeshift governments," said Luigi Di Maio, a leader of the group, on Monday. "Italians have demonstrated the desire to go to elections."

Mr. Renzi suffered a withering rebuke on Sunday, with 59% of voters rejecting his proposal, which would have stripped the Senate of most of its powers and replaced its 315 directly elected members with 100 local officials. The Senate would have also lost its power to hold votes of confidence on new governments, leaving that responsibility entirely to the lower house.

Mr. Mattarella's further consultations could move relatively quickly, a welcome development given rising pressure on Italy's banking system. A new government would then need to win confidence votes in both of Italy's legislative chambers.

Mr. Renzi had pushed through a number of key reforms since taking power in early 2014, notably a labor reform that loosens the rules to hire and fire employees. Those changes helped create some 600,000 new jobs, only partly offsetting the one million jobs lost since the crisis struck Italy in 2008. The Renzi government had also begun on an ambitious overhaul of Italy's tax rules and its notoriously inefficient state bureaucracy.

Now, business executives and policy makers fear a new government will shy away from anything so bold, given the fierce criticism directly at Mr. Renzi for his aggressive push.

Moreover, expected changes to the electoral law will make for weak coalition governments dependent on the sort of horse-trading that tends to dilute policy.

There is broad agreement on the need to scrap an electoral law passed by Mr. Renzi last year. That law awards a dollop of extra parliamentary seats to the party that wins a plurality of votes, thus granting the winner a clear majority in the legislature and increasing the probability that it survives a full five-year mandate.

Critics say the rules would concentrate too much power with the winning party. Those concerns have grown with the surge this year in the popularity of the 5 Star Movement, raising fears that the new law could help it could come to power. Polls show that about 30% of voters would opt for 5 Star candidates if parliamentary elections were held today.

As a result, Italy is likely to return to a proportional system that produces broad-based coalition governments lacking the strength to effect deep changes.

At the same time, the probable short-term nature of a new government and the likelihood of new elections mean little momentum in addressing Italy's economic problems for at least a year.

"Italy's trinity of economic problems -- lack of growth, high government debt and bank (nonperforming loans) -- will unlikely to be tackled," wrote analysts at ABN Amro.

Italy has long struggled to respond to the twin challenges of euro membership and globalization. Its hourly productivity has grown just 5% in the last 20 years, according to Alberto Alesina, a political economics professor at Harvard University, compared with growth of 40% in the U.S. and 15% in Spain.

In 2015, the economy grew for the first time in four years, but growth and job creation quickly petered out. Output is now so anemic that the IMF predicts Italy's economy won't return to its precrisis size until 2025.

Some in the Italian business community lamented the missed opportunity to further advance the pro-market reforms pushed by Mr. Renzi. "It's like when you set the date for a wedding and then you don't show up," said Andrea Illy, chairman of coffee maker Illycaffè. "This is a country that doesn't want to be reformed."

Finally the prospect of a 5 Star government, whose economic proposals include a nonbinding referendum on Italy's membership in the euro and a universal income for all Italians, will push parties to circle the wagons and shy away from major changes.

"I'm very worried about the 5 Star Movement," said Luca di Montezemolo, chairman of Alitalia SpA and vice chairman of Italy's largest bank UniCredit SpA. "They need to prove that they are able to run a country and that they don't only say 'no.'"

--Manuela Mesco contributed to this article.

Write to Deborah Ball at deborah.ball@wsj.com

(END) Dow Jones Newswires

December 05, 2016 15:03 ET (20:03 GMT)

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