Italy votes “No”… but it’s not all bad

Italian voters voted “no” in yesterday’s referendum on constitutional reform, for once in line with opinion polls. By rejecting the reform bill, Italy has entered yet another round of political instability with potentially negative implications for growth and the banking sector. However, the result should imply a change to the current electoral law, thereby reducing the chances of Populist Party, Five Star Movement (5SM), winning the next election.

At 59.1%, the percentage of voters voting “no” was around 5% higher than polls had indicated, while the voter turnout was significantly higher than projected (66% versus 55%). In response to this resounding defeat and in line with his previous pledge, Prime Minister Renzi has announced his immediate resignation.

Populist forces have already started calls for a snap election. However, more likely is that a new government will eventually be set up. The President of the Republic will now begin consultations with the different parties in search for a new prime minister who can be supported by a majority. This process may take several attempts before it is successful and can last a long duration, meaning a potentially prolonged period of political instability.

The key mandate for this new “interim” government will be to change the electoral system before the next scheduled election in 2018, since voting with the current set of electoral laws (two different electoral laws in the two houses) would most likely result a “hung” Parliament. Furthermore, the current electoral law (“Italicum”) enables a single party to have a significant concentration in power – in the Lower House at least – a dangerous feature given the rise in popularity of 5SM (please read Arrivederci Roma? The Other Vote You Should be Watching and 8 Key Issues for the Italian Referendum This Weekend for more details). Unsurprisingly then, 5SM has been the most vocal in calling for a snap election.

As a result, we would expect the majority of Parliament to want to avoid a snap election, and to support an amendment of the Italicum that strengthens 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.

Of course, if the president fails to find someone who can gather a majority, a new election must be called – without reform to Italicum, thereby opening the door to a 5SM government. This is an unlikely scenario for the reasons given above, but certainly it is a dangerous one.

Economic and Market Implications

Whatever happens, Italy has entered a period of political instability, and urgently needed economic and public finance reforms will be delayed. The banking sector is also vulnerable in the near term to the latest developments. Indeed, the market will be focused on those banks in the process of raising capital, namely Monte dei Paschi, Unicredit, and several smaller banks that will find it more difficult and more expensive to do so following the “no” vote.

However, in most cases the European Central Bank (ECB) has a role to play in deciding how and when these recapitalisations need to happen and we would not expect the ECB to push for solutions that trigger unnecessary financial instability. Furthermore, beyond these names the Italian banking system is sufficiently liquid, sufficiently capitalised and likely to see continuing improvement in asset quality despite any moderate deterioration in the Italian economy.

Market reaction is likely to be volatile. While a “no” vote was largely priced in, the margin of victory was greater than expected and, as a result, we would expect to see a sell-off in Italian sovereign bonds as an initial reaction. However, as the market realises that elections will likely only take place once the electoral law has been changed and thus the chances of a populist victory are reduced, we think the sell-off will be limited. Furthermore, continued asset purchases from the ECB via its quantitative easing (QE) programme, which is expected to be extended on Thursday, should prevent any sell-off of Italian bonds reaching systemic levels.

While the Italian referendum result was worse than expected, I would consider this as only a half point to populism. An interim government will likely change Italicum, reducing the chances of a populist victory at the next election. And let’s not forget the one positive piece of news over the weekend: in the Austrian presidential election, the left-leaning environmentalist defeated the far-right candidate. A significant blow to similar parties in Netherlands and France which are preparing for their own elections in 2017.


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