Italian Referendum - Political risk moves back to Europe
The context—Political risk moves back to Europe. Elga Bartsch (Morgan Stanley) highlights the re-run of the Austrian presidential elections, the upcoming French and German (read EuroIntelligence on Merkel’s decision to run again) elections, the tribulations of Spain’s minority government (read Bonnie Field), and rising political support for protest parties. Mario Margiocco, in a Project Syndicate column, qualifies the stakes of the Italian referendum as enormous: the political future of PM Renzi (read here), a strengthening of Italy’s two major populist parties (the Lega Nord and the larger Five Star Movement), the possible exit from the euro—all far from the actual issues in the referendum itself.
The Italian referendum. On December 4, Italians will vote on a referendum with the following proposed changes (already approved by parliament, but only by a simple majority, hence the need for a referendum): a significant cut in the size of the senate, changing it from being a directly elected body to an upper house representing local governments, and reducing its influence to mainly constitutional and EU matters. The change will simplify regional governance and centralize a bigger share of decision-making (see Erik Nielsen at UniCredit). Massimo Morelli and Moritz Osnabrügge (VoxEU) looks at the institutional arguments for the constitutional reform: a reduction in decree laws and legislative decrees, less frequent use of the confidence question and important improvements in bureaucratic efficiency. Financial markets have generally taken the view that a vote in favour of the referendum would be positive for the Italian economy, as illustrated by the recent sell-off in Italian BTPs.
Italicum uncertainty. Italy is also facing uncertainty with respect to the future of the electoral law (the Italicum), which entered into force in July. The Italicum changes the electoral law for the lower house from a proportional system to a system, which grants a large number of bonus seats to the biggest party. Regardless of the outcome of the referendum on the constitutional changes and the legal ruling, the Italicum is expected to be revised. The “winning party takes it all” system it creates is risky in a multi-party system with an out-of-mainstream radical party in the running, according to Nielsen.
Criticism of an ill-designed reform. Silvia Merler (Bruegel) reviews the issues in a blogspot. Gianfranco Pasquino and Andrea Capussela (LSE) provide a comprehensive assessment of the proposed reforms, arguing that they would be unlikely to meaningfully improve Italian governance and could reduce levels of political accountability, thus concluding that the reform is ill-conceived and should be safely rejected. This point is also made by Valentino Larcinese (LSE) who argues that the proposed reform would remove much needed checks and balances on executive power in Italy.
The NO vote is gaining momentum (see EuroIntelligence), with key figures in support. Former Italian Prime Minister and European Commissioner Mario Monti has reiterated that he is voting “no,” based on the merit of the constitutional reform (in particular the Senate reform). The last opinion poll showed 42% for a no, 37% for a yes, and 21% still undecided.
The possible outcomes. Citi stresses that the near-term risks from the referendum outcome may be overstated, as a new government will likely be appointed if PM Renzi decides to resign. But political risk will continue and changes to the electoral law Italicum will be key, more than the referendum, in determining the probability of an anti-euro party coming to power in the next 12-18 months, especially as early elections in 2017 cannot be ruled out.
The resignation of Renzi. Reuters highlights the mounting pressure on Renzi to drop his threat to stand down and instead agree to remain in power to deal with the fallout from a 'No' vote (FT). Céline Colombo, Andrea De Angelis and Davide Morisi (LSE) illustrate how the personalization strategy did not work well for PM Renzi.
The replacement of Renzi with a technocratic government — with new elections slated for late 2017 or early 2018 — could ease fears, potentially headed by current Finance Minister Pier Carlo Padoan. La Stampa reports PM Renzi has stressed Italy will most likely get a caretaker government if the referendum fails to pass. The final decision to appoint a politician to head a caretaker government lies with President Mattarella (Il Sole 24 Ore).
The high probability of new elections—according to Citi , Renzi may resign even in case of a win, to seek a broader majority, with the new electoral law proposal supported also by Forza Italia.
Short-term political tactics may not work out. Even if the Yes vote were to win, it is possible for Matteo Renzi and Silvio Berlusconi to agree another electoral reform, and for Renzi to resign to trigger new elections under this newly reformed electoral law, according to Corriere della Sera (hat-tip EuroIntelligence)—to keep the Five Star Movement out, though this may backfire under the current Italicum.
Italian banks in a difficult situation. Lorenzo Codogno and Mara Monti have an optimistic take on the referendum, arguing that even a no vote will not produce political instability but could indeed create instability for the the Italian banking system. Politico’s Silvia Sciorilli Borrelli reports that the real worry is the country’s banks, with €360 billion in bad loans. Italian banks have experienced a further fall in their share price. The FT highlights concerns that up to eight of Italy’s risk failing if PM Renzi loses the constitutional referendum—ensuing market turbulence could deter investors from recapitalizing the institutions (La Stampa and EuroIntelligence).
The importance of Monte dei Paschi. The repair of the Italian banking sector is conditional on a smooth MPS recapitalisation, but this in turns requires a stable political environment. Monte dei Paschi di Siena (MPS) launched a voluntary equity conversion of €4.3bn of its subordinated debt—a process that will massively dilute existing shareholders because on the existing capitalization (Bloomberg and EuroIntelligence). Another possible reason for the fall of the share price may be the disclosures made by MPS in its prospectus for the debt-to-equity conversion (Reuters): high legal claims, a credit file review by the SSM with possible large loan writedowns, and a recent €14bn loss in funding (see also Luigi Zingales). For EuroIntelligence, a bail-in is inevitable if the recapitalization fails, with a possible nationalization (Federico Fubini), which could itself encourage market panic.
ECB contingency plan: yes, but limited. The ECB has prepared contingency actions in case of a NO vote (Reuters)—to defend Italian government bonds against speculative attack. However, this action is constrained by the capital key and the inflation mandate of the ECB.
A worst case scenario. While Goldman Sachs sees a muddling through scenario, with two options: a YES vote that improves institutions, and a NO vote that keeps the status-quo with muddling through the financial stress (which is not so bad), Carmen Reinhart is pessimistic and wonders whether Italy will default—looking at capital flight from the point of view of raising Target2 deficits (at a record of over 20% of GDP). EuroIntelligence describes a case where the referendum, a minor constitutional issue, could trigger a sequence of events (here and here) that would eventually accelerate Italy’s departure from the euro— because Italy is unsustainable as a consequence of low structural growth, high sovereign debt, weak institutions, and weak banks, and because it is too late to influence Italy's fate in the euro through structural reforms—according to Wolfgang Münchau.
