Four things to watch out for in Italy’s looming referendum

Posted on November 25, 2016

The clock is ticking.

Italians will be heading to the polls on December 4 in a referendum to reform the country’s constitution.

On paper, this is an arcane poll to shake up Italy’s parliamentary democracy and shore up government stability, but the referendum has become a proxy for the leadership of centre-left prime minister Matteo Renzi and is being seen as a one of the first major tests of Europe’s establishment in the wake of Donald Trump’s election.

The question on the ballot will ask Italians whether they are in favour of cutting the number of senators and reducing the costs of its political institutions.

Mr Renzi, who came to power in an internal party coup two years ago, has promised to step down and not lead a technocratic government should the ‘Yes’ campaign fail.

The reform proposals would, among other things, see the number of Italian MPs fall and more centralising powers handed to the executive over the country’s bicameral parliament.

As it stands, the polls give the ‘No’ vote a narrow lead of 5-7 percentage points. The Yes camp has fallen back significantly on the back of turbulence returning to Italian banks and electoral momentum for populist parties such as the left-wing Five Star Movement.

Here are the four most important things to watch out for:

1. Super central bank December

The referendum will come a week ahead of two major central bank meetings of the European Central Bank (Dec 8 ) and the Federal Reserve (Dec 14).

The December decisions are expected to highlight divergent policy paths for the world’s two major central banks. The ECB, which has held its rates and asset purchases at their current rates since March, is expected to announce a six-month extension and tweak to the rules of its QE programme to carry on its asset purchases beyond March 2017.

In its latest Financial Stability Review, the ECB warned that Trump-induced volatility could trigger a rout in European markets and lead to surging eurozone government borrowing costs.

Meanwhile, markets think the Fed will opt to carry out its first rate hike of the 2016 at its latest meeting of the year.

2. Watch banks, not bonds

Any immediate financial stress from a No vote is likely to be seen in the Italian bank stocks rather than government bonds, according to analysts at Goldman Sachs.

With the ECB’s measures set to keep a lid on bond yields until at least March 2017, political upheaval in Italy is set to concentrate investor focus back on the country’s troubled financial system.

Should Mr Renzi fall on his sword, the task of cleaning up the country’s lenders, who are lumbering under the highest bad loan mountain in the eurozone, is set to stall.

In an already turbulent year, Italy’s main banking index has already shed nearly 50 per cent of its value. In the immediate term, a No vote it could throw into jeopardy a planned €5bn recapitalisation plan for Italy’s most troubled bank Monte dei Paschi, potentially forcing Rome to take a stake in the lender and for creditors to undergo a debt-for-equity swap that would see investors endure losses.

“Should the No vote prevail, we see a weakened centre-left government muddling through until early 2018, possibly without Mr. Renzi at the helm” says Francesco Garzarelli at Goldman.

“In these circumstances, we believe the likelihood of successful market-driven recapitalisations of the weaker Italian retail banks – which are already likely to be pushed into 2017 – would diminish substantially” he adds.

3. Spain > Italy

European government bonds have endured a tough time in the wake of Mr Trump’s election, sparking fears over rising global inflation and concerns his victory could embolden eurosceptic populists in Europe.

Italy’s 10-year government bond yields have climbed above 2 per cent for the first time since 2015 this month but a major bond tantrum may not be on the cards, according to Goldman, who think Italy will remain a riskier bet than Spain for bond investors following a No vote.

Both Goldman and UBS expect Italian government debt yields to stay above their Spanish equivalents after Madrid broke a near 12-month political deadlock and appointed a new minority government last month.

“The political backdrop in Spain is currently more favourable than in Italy, and we maintain our preference of being long 10 year bonds of Spain versus Italy”, says Nishay Patel at UBS.

4. After a Yes or No vote: shades of grey

Even in the event of a victory for Mr Renzi, the aftermath of the referendum may not prove to be a game-changer for the struggling Italian economy which has had its growth forecasts slashed and lumbers under a 130 per cent of GDP debt pile.

Economic growth is expected to hit just 0.8 per cent this year and 1 per cent in 2017, according to the government’s most recent economic forecasts.

Analysis from Bank of America Merrill Lynch shows the reformist Mr Renzi has lost much of his verve this year, with progress on implementing new reform measures slipping as troubles in the banking system have come to dominate the domestic political agenda.

BAML highlights a landmark competition law and a revamp of public administration as two key measures that have all but stalled in recent months.

Should Mr Renzi scrape through the referendum, expect him to keep muddling along until a general election in 2018, says Barclays:

We expect the government to remain in office but do not anticipate the implementation of additional meaningful structural reforms, as we would expect the government to avoid costly political decisions before the next round of general elections is held.

Unless the Yes camp wins with a strong majority and very high turnout, we expect the government to be mindful of risks stemming from precipitating a political crisis.

Should the No side prevail, an immediate snap general election or even an upsurge for the populist Five Star Movement – Mr Renzi’s most potent political challengers – is unlikely, notes Fabio Balboni, European economist at HSBC.

Mr Balboni thinks Italy’s president will be reluctant to call an election in the aftermath of the referendum and instead will hold off until late 2017, which will be “only a few months before when [an election] would become due anyway”.

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