A few weeks ago, I wrote a blog about the forthcoming Italian referendum (Arrivederci Roma? The other vote you should be watching). That day is almost upon us. On Sunday, 4th December, the Italian public will be asked to vote on proposed amendments to their constitution that are aimed at simplifying the legislative system. While this may seem a relatively innocuous vote, markets are concerned that underlying this seemingly tedious question are potentially wide-reaching implications for the Italian economy, political system, and the European Union (EU) as a whole.
Here I summarise the key issues surrounding the vote and explain why I am less worried than the market (see the previous note for details about the referendum).
- All polls currently suggest that the “no” vote will win. Markets have absorbed this news over the recent weeks so a rejection of the constitutional reform would not be a surprise outcome. Political risk seems sufficiently priced in now.
- Losing the referendum would further delay urgently needed economic and public finance reforms, as well as the banking sector’s ongoing capital raising operations. This is one of the key reasons why markets have become increasingly concerned about the vote.
- Italian Prime Minister Renzi has pledged to resign if the reforms are rejected, making it a de facto vote on his popularity. There are worries that, if PM Renzi resigns, it will trigger a snap election, which would be strongly contested by Renzi’s Democratic Party (PD) and “anti-establishment” party Five Star Movement (5SM), meaning that there would be a significant risk of a 5SM victory. This is concerning because 5SM wants to hold a referendum on Italy’s membership in the European Union (EU). However, in my view, fears about a snap election are overdone because…
- … the decision to call a new election sits with the president, who would be unwilling to do so since the only beneficiary would be 5SM. As a result, it would be more likely that a transition government – perhaps a coalition supported by the current parties backing the government – takes over until the next scheduled election in 2018.
- One of the priorities for the interim government would be to reform or reverse the (new) electoral law “Italicum”: a new two-round electoral system for the Lower House of Parliament where, in the event of an election, the winner of the second round is entitled to a “majority bonus.” This new system enables a single party to have a significant concentration of power – a dangerous feature given the rise in popularity of 5SM. We would expect Italicum to be amended to strengthen proportional representation (which was the key feature of the original electoral law), making it more difficult for populist parties such as 5SM to have a majority in parliament. If you’re worried about anti-establishment, anti-EU parties coming into power, modifying the Italicum is more important than the referendum.
- A “yes” vote would mean PM Renzi does not resign, and there would be renewed support for necessary structural reforms, a positive for the Italian economy. However, in this scenario, there is a chance that Renzi would not amend Italicum, choosing instead to plunge on and ride his wave of popularity by calling an early election – a dangerous punt. Ironically then, a market-friendly yes vote may open the door to a 5SM victory.
- Also worth keeping in mind is that, even if 5SM were able to form a new government, the chances of Italy leaving the EU are small. The current Italian constitution does not allow for a referendum to annul international treaties, meaning that, essentially, Italian citizens cannot vote on an exit from the currency or trade unions.
- In addition, if there is a spike in Italian sovereign yields, there have been reports that the European Central Bank (ECB) is prepared to use its €80 billion per month quantitative easing (QE) programme to intervene in the Italian bond market. While I am dubious that the ECB would want to use its QE program to react to home-grown political risk (it has been designed to help achieve the inflation target), market turbulence would increase the chances that the ECB extends the QE programme for a further six months at its current pace (of €80 billion per month), rather than extending it at a slower pace of €60 billion per month.
So, in the event of a “no” victory on Sunday, I won’t be biting my fingernails down to the cuticles like I did following the Brexit result or Donald Trump’s victory. As I said at the beginning, the market has priced in a “no” result and, if anything, it could be a buying opportunity given that the risks, in my opinion, are overdone.
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