The Italian Referendum and Details of the Implications

The referendum in Italy on Sunday, December 4th, looms as the next big threat for Europe after the British voted to leave the European Union in June (Brexit). Financial markets are clearly concerned. The MSCI Italy index (Net) is down more than 18% year-to-date (as of November 30th), while the spread between Italian and German bond yields has been climbing – and is now at its highest level in two years, even higher than during the Greece debt crisis in June 2015.

Here we discuss the referendum, the players involved and the potential political, economic and financial ramifications.

What the referendum is about

On the face of it, the referendum is about constitutional reform and not directly related to Europe at all.

Italy’s constitution, carefully drawn up after Mussolini’s rule and enacted in 1947, made it very hard for a single party to control all the levers of government, not to mention last long enough in power. The country has had 65 governments in the 70 years since the constitution came into force.

The reforms that Italian voters will decide on this Sunday were proposed by Prime Minister Renzi in a bid to provide Italy with political and economic stability. His proposals essentially seek to limit the power of the Senate and regional governments, thus allowing decision making to become more efficient by concentrating power with the ruling party in Rome. The reforms also seek to activate a new electoral law that gives the winner of a general election extra seats in parliament, helping consolidate power and avoid the need for coalitions. If the “Yes” campaign wins and the reforms pass, most laws (including the budget) become a lot easier to pass for the party in power.

The reforms are significant, affecting a third of the constitution, and so this is a complicated vote, unlike the Brexit referendum. Prime Minister Renzi originally framed the vote as a referendum on his government, including a threat to resign if voters did not vote “Yes”, but this has backfired amid a rise in populist sentiment in the West.

The major players and their motivations

On the “Yes” side, obviously, you have Prime Minister Renzi and his allies in the centre-left Democratic party, as well as large business interests and investors, who support the proposals as necessary changes so that Italy can make significant tax and labor reforms, while also fixing its broken banking sector (more on this below).

In the “No” camp, there is just about everyone else across the political spectrum, who argue that reforms are essentially a power grab by Renzi. This side also includes those who are upset about a stagnant economy, the high unemployment rate (currently at 11.6% ) and Europe’s migration crisis. As the graph below shows, Italy’s economy is still 8% below where it was in late 2007, prior to the financial crisis, even as the rest of the Euro zone (and the U.S.) have surpassed those output levels. The economy has barely moved in the past three years.

The most vocal opponent is the leader of the populist Five Star Movement (M5S) party, Beppo Grillo, a former stand-up comedian/actor/blogger/activist. The party came into prominence only recently, gaining strength in the 2013 general election. While his party platform is extremely thin on details, rhetoric suggests that they would like Italy to exit the Euro and nationalize its banks. He has also proposed to renegotiate Italy’s enormous debt load (currently at 133% of GDP) by using the threat of default as leverage.

Grillo’s party is neck-in-neck with Renzi in general election polls – the next election is slated for 2018. A “No” win will provide a huge short-term boost to Grillo and M5S. At the same time, and rather ironically, it becomes even less likely that the party will win enough seats in the next general election to take power. They have stated that they would not lead or join any coalition government.

Who is expected to win?

Final polls , conducted more than a week ago (Italy, by law, is not permitted to have polling done within two weeks of the election) indicate that the “No” side is ahead. However, a large number of voters are undecided and there is a significant expatriate vote as well, which is expected to favor “Yes”. So there is a considerable uncertainty as to which camp will come out on top.

If “Yes” wins

This is the most straight forward scenario to analyze since Renzi simply gets a stronger hand, especially going into the 2018 general election. Note that he would still have to wait and see if Italy’s constitutional court rejects part of the reform. Particularly the reform to electoral law, which seeks to make the government more stable by giving the winning majority more seats and avoid forming a coalition government.

The Prime Minister would still have to navigate through the problems within Italy’s banking sector and its economy, as well as the pressures of remaining in the Euro zone and being tied to a fixed currency. Nevertheless, Renzi’s government, which has been the most reform minded in Europe since the introduction of the Euro, will be emboldened to push through labor market restructuring and banking sector reforms amidst changes to other institutions, even as the rest of the continent remains vulnerable to populism.

If “No” Wins

This will be an enormous blow to Renzi and any further reforms. Three scenarios could play out if the “No” camp comes out on top:

1. Renzi does not resign

While he has threatened to resign if the vote does not go in his favor, the Prime Minister could chose to hang around until the 2018 general election. This would clearly leave him in a weakened state, unable to execute any of his ambitious reform agenda and preclude any chance of a comeback in 2018.

2. Renzi resigns and Italy gets an interim government

If he does resign, which is not certain but more than likely, Italy’s president would have to talk with the country’s political parties and find a new Prime Minister to head a technocratic interim government. Note that Renzi would probably remain the leader of the largest party and still maintain a large role in any negotiations.

3. Renzi resigns and the President calls for snap elections in early 2017

This is the third possibility, especially if members of Renzi’s party prefer new elections rather than support an unpopular interim government. We would clearly be settling into a period of significant uncertainty in the near-term, with any of the following possibilities equally likely: a comeback win by Renzi and his centre-left party, a win by the populist Five-Star party or a government led by the centre-right party.

Does “No” imply exit from the Euro?

Unlike Brexit, a “No” vote does not imply that Italy will exit the Euro. However, it does raise the likelihood of Grillo’s populist, anti-establishment, anti-Euro party making significant gains in the next general election, whenever that may occur.

More immediately, any interim government would have a huge task on their hands, including limiting the blowback in financial markets and to the banking sector, let alone pass the 2017 budget. Since the chief anxiety in financial markets would be a potential collapse in the Italian banking sector, and whether this could trigger financial collapse across Europe, let’s take a look at what is going on with Italy’s banks.

A distressed banking sector

Italy’s highly fragmented banking sector has amassed 360 billion euros in bad loans thanks to poor lending decisions amid a stagnant economy. These comprise a third of bad loans in the Euro area and 18% of all loans in Italy (thrice the Euro area average). Writing them off is not possible because doing so would make the banks insolvent, since they do not have sufficient capital on their balance sheets.

Euro area rules prevent any government from bailing out its banks – EU rules require bondholders and savers to take 8% of the liabilities before any government funds can be used to prop up banks in a bail-in , the aim of which is to prevent a bailout by taxpayers. Furthermore, under EU regulations implemented since 2012, it is also hard to move all the non-performing loans to a “bad bank”. However, Prime Minister Renzi is in the process of working out a solution for the banking sector, creating a backstop fund of 4.25 billion euros, named Atlante .

In the event of a “No” vote, it is an open question as to what happens to the backstop plan and whether Italy’s top eight lenders would be on the verge of collapse . A collapse in Italy’s banking sector could very easily spread and strain banks in other European countries with significant bad loans, including Austria, Spain, Portugal and Greece.

Banking institutions in other developed nations also hold a significant portion of Italian debt on their books, leaving them exposed. Die Welt reported in July that French banks are most exposed to Italian debt, to the tune of $280 billion. German banks reduced their exposure but are still the next most exposed, holding $92.7 worth of Italian bonds – Deutsche bank alone has over $12.5 billion worth of Italian debt. Other countries exposure include Spain at $49.4 billion, U.S. at $47.7 billion, U.K. at $32.9 billion and Japan at $30.5 billion.

It is almost certain that the European Central Bank will act to prevent contagion, perhaps prioritizing Italian bonds in its QE bond-buying program. The European Commission may also come under a lot of pressure to loosen some of the rules related to governments bailing out their banks.

However, any ECB move to stabilize Italian banks would simply be a band-aid. Even a deeper rescue of Italian lenders, essentially a bail-out by Europe – which requires votes in Germany and the Netherlands – would probably come only under the strictest of terms, like what we saw for Greece. These terms are likely be so onerous for Italy that it would trigger even more populist backlash against Europe.

Now a “Yes” vote wouldn’t put the banks out of the woods either. While there would certainly be a relief rally (Italian banks are down 20% since the Brexit vote), Prime Minister Renzi would still have to deal with Italy’s banking troubles. With Trump’s victory in the U.S. presidential elections, and bond yields jumping thanks to higher expected inflation in the U.S., Italian borrowing costs have risen recently along with U.S. yields. However, there is no expectation of fiscal stimulus and reflation in Italy. Italian banks own 400 billion euros of Italian government bonds and these are now worth less, eroding capital ratios. As Ambrose-Evans Pritchard writes :

“It is our old friend the ‘doom loop’. The banking crisis is driving up sovereign bond yields, and higher yields are in turn driving the banks into deeper trouble.”

This only gets worse if the ECB signals an end or taper to its bond-buying program. Any taper tantrum in Europe will essentially be a stress test of the union itself.

An uncertain future

Italy’s economic troubles are only magnified by the political theater surrounding the referendum. As we saw earlier, the country is stuck well below its output levels from almost a decade ago amid rising debt troubles. Thanks to its membership in the single currency, it is also unable to take the devaluation route. Deflating itself through fiscal austerity only steepens its already enormous debt load.

In the immediate-term, the outlook for Italy, and Europe, looks increasingly bleak. Ever-increasing pressures of remaining in the monetary union, without a fiscal union, banking union, joint debt issuance or absence of any fiscal stimulus, will only strain the peripheral countries further, and make them even more susceptible to populist movements against the common union.