Renzi Referendum Frenzy – Storm in a brittle tea cup

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All eyes are riveted to the Italian referendum on constitutional reform due on Sunday 4th December.

The “no” vote is still ahead in the polls, even if the past 18 months should have taught us to be weary of polls’ predictive powers.

The worst-case-scenario advanced centres on reformist Prime Minister Renzi’s resignation, the rise to power of the euro-sceptic Five Star Movement (M5S), a jump in Italian bond yields, the fragile banking sector and economy’s collapse and Italy’s eventual exit from the eurozone and EU.

The more likely political, financial and economic outcome from a “no” vote is perhaps less dramatic, in my view, and financial markets, including the euro, have been reasonably well behaved in the run-up to the referendum.

A “no” vote may well usher in a less reform-minded technocratic government and fuel support for the populist M5S and its leader Beppe Grillo but their path to the top will not be straightforward.

The banking sector, riddled with bad-loans and planning a recapitalisation of its balance-sheet, can ill afford the negative press a “no” vote may bring. But both Italian and eurozone policy-makers have a strong incentive to shore up Italian banks and the economy, even if posturing may precede an eventual solution.

The ECB may well extend its QE program at its policy meeting on 8th December in order to help alleviate any stress in eurozone markets but I don’t expect other major central banks to follow suit with monetary policy loosening of their own near-term.

Finally, while the future of the eurozone and EU has been written off many times, I don’t envisage Italy being the trigger for a break-up of either.

Italian referendum on constitutional reform has taken on life of its own

Back in early 2016 a referendum on Italian constitutional reform may have largely passed unnoticed or at most been of interest principally to those trading Italian government bonds, equities and perhaps the euro. But fast forward eleven months and the world, and in particular Europe, are riveted to Sunday’s referendum – the result of which is constitutionally binding. The referendum proposes to curb the powers of the upper house of parliament (Senate) and regional governments and cut the number of Senators who would no longer be elected but appointed by regional governments.

Markets and policy-makers are weighing the potentially far-reaching implications for Prime Minister Matteo Renzi, the Italian banking sector and broader economy and even the future of the eurozone and EU should, as polls suggest, the “no” vote win. Last year’s Greek crisis, the vulnerability of the Italian banking sector which came to the fore over the summer, the shock outcome of the UK’s referendum on EU membership and the Italian government’s unpopularity have clearly given a new, broader dimension to a vote on a mostly technocratic issue. Add to the mix Donald Trump’s surprise victory in the US presidential elections and the global wave of popular support for nationalist and populist policies and perhaps unsurprisingly this referendum is seen as yet another watershed moment which will up-end the status quo.


“No” vote inching it as popular discontent outweighs big business support

Recent opinion polls show that the “no” vote, which is widely viewed as proxy-vote against Renzi’s unpopular government, is ahead by about four percentage points, with strong opposition from voters in the poorer South of Italy. Conversely, there is support, particularly from big business, for a reform which would mitigate the current institutional paralysis characterised by proposed laws often endlessly bouncing back and forth between the lower and upper houses of parliament or being highjacked by powerful regional governments. But there is seemingly a majority view amongst the public that Prime Minister Renzi’s business-friendly government should not be spear-heading this reform drive.

One note of caution is warranted at this stage. If there is one lesson to be learnt from the British general elections in May 2015, UK referendum in June and US presidential elections in November it is that opinion polls cannot always be relied on. There is no hard evidence to suggest that Sunday’s vote will go against the run-of-play but about a third of voters are reportedly still undecided and this four percentage point lead is still within the margin of errors typical in such popular votes.

In any case, should the Italian electorate vote against the proposed reforms, it is not immediately obvious that the political, financial and economic ripples will be felt way beyond the shores of Italy, let alone the eurozone or that these ripples will morph into a full-scale flood.


Political implications – (another) technocratic government and Five Star ascendancy?

Prime Minister Renzi has been unequivocal that he would resign in such a scenario. If he is true to his word, President Sergio Mattarella would have to appoint a new prime minister or dissolve Parliament and bring forward legislative elections due before 23rd May 2018 (the same path trodden when Prime Minister Monti’s resignation led President Napolitano to call snap elections in February 2013). The most likely scenario would be the appointment of a care-taker prime minister – not ideal but hardly a break with the past for a country which has had five prime ministers in the past decade.

The bigger issue perhaps is that a weak technocratic government would step back from much needed political and economic reform in Italy while further fuelling support for the populist and euro sceptic Five Star Movement (M5S) and its leader Beppe Grillo. Like many European populist parties M5S has been in the ascendency in recent years and is currently polling around 30%, broadly on a par with Prime Minister Renzi’s Democratic Party.

This level of popular support could in turn, thanks to the new electoral law introduced in 2015, in theory result in M5S becoming the largest party in the 630-seat lower house of parliament at the next elections (M5S came third in the 2013 general elections with 25.5% of the popular vote but, under the old electoral rules, this translated into only 109 seats – well behind Prime Minister Renzi’s Democratic Party which has over 300 seats). However, M5S has been beset by an electoral fraud scandal involving three of its deputies. Moreover, if President Mattarella succeeded in getting mainstream parties to agree to a technocratic government, one of their priorities would likely be to tweak electoral laws to hinder the odds of M5S winning a more significant number of deputies in the next elections.


Predictions of EU’s demise still premature

A euro-sceptic Prime Minister at the helm of the Eurozone’s third largest economy (behind Germany and France) may, all other things being equal, weigh on the euro and raise further questions about the European Union’s future. The UK government’s stated aim of exiting the EU in 2019 has already cast a shadow on the European project. Moreover, there is much speculation about the possibility of France exiting the EU should Front National leader Marine Le Pen, who has vowed to call a referendum on France’s EU membership, win next May’s French presidential elections. If the leaders of other major EU economies start to move in a similar direction and a critical mass of countries seeks to exit the EU, its future will hang in the balance.


But, despite the clear challenges which the EU faces in coming years – including the pressing issue of immigration – calling its demise still seems premature. The acute political, economic and financial uncertainty associated with the British electorate’s decision on 23rd June to leave the EU may, if anything, have cast doubts about the relative merits of triggering a seemingly irreversible and potentially damaging process. Moreover, while Le Pen may make it to the second round of the presidential elections, the odds of her becoming president are still very low, as I argue in Nationalism, French elections and the euro (18 November 2016). So far the majority of EU leaders have actually stood firm in their defense of the EU.


Pressure on Italian banking sector but a fudged deal still most likely outcome

Beyond the political ramifications of a “no” vote on Sunday, the concern has centered on the potentially significant impact on Italy’s already weak banking sector. The prevailing thinking is that investor interest in Italian banks’ debt-for-equity swaps would dry up, putting greater pressure on the balance sheets of a banking sector saddled with €360bn (20% of GDP) in non-performing loans.

Specifically, Banca Monte dei Paschi di Siena (BMPS), Italy’s third largest bank, is due to launch on Monday a €5bn debt-for-equity swap. Failure to recapitalise these banks would in turn increase the risk of one or more banks being nationalised or shut down at great expense to the government and tax-payers and of credit growth being further curtailed.

Moreover, this backdrop would likely see a further widening of Italian government bond yields, adding to the pressure on the finances of a government which has debt of over 130% of GDP (see Figure 1) and on tepid Italian economic growth. This would again likely play in the hands of left-wing and right-wing populist policies, including M5S.

Eurozone policy-makers have so far stood firm that European law forbids the Italian government (and ultimately tax-payer) from bailing out the banking sector and instead imposes bail-ins – effectively a haircut on banking sector bond and equity holdings. German Chancellor Merkel and Finance Minister Schauble have played hard ball and pushed for an aggressive consolidation of the Italian banking sector.

But an outright collapse of the Italian banking sector is still a far-fetched outcome, in my view. For starters, Prime Minister Renzi, or whomever is in power, would fight to protect retail investors who reportedly hold €170bn of bank debt and would be hit hard in the event of a pure bail-in. The Italian prime minister could use Brexit as leverage, making his/her support for Merkel (regarding a future deal with the UK) conditional on Italy being able to by-pass the most stringent aspect of the bail-in rules.

As was the case with Greece and its negotiations with the Troika last year, I would ultimately expect some kind of fudged solution to help stabilise the Italian banking sector and reduce the risk of Italy inching towards the eurozone exit. Such an agreement would admittedly take time to be reached, which would do little for Italian and by extension eurozone growth and in turn increase the pressure on the ECB to once again deliver more monetary stimulus. The ECB’s next policy meeting is on 8th December, with the expectation that it will extend its current quantitative easing program due to expire in March 2017.


Equities, Euro and emerging market currencies stable

Financial markets have so far acted calmly in the run-up to Sunday’s referendum. The share price of BMPS has been pretty stable around €20-21 in the past three sessions while the Italian equity market has bounced back near the top of a range in place since 1 November.

Despite the uncertainty about ECB monetary policy, stress in the Italian banking sector, soft eurozone GDP growth of 0.3% qoq in both Q2 and Q3 2016, the rise of nationalism and doubts about the EU’s future, the euro has been pretty resilient since mid-year. While it has weakened against an appreciating US dollar and EUR/USD parity is no longer in the realm of the fanciful, in nominal effective exchange rate (NEER) terms the euro has traded in a narrow band (see Figure 2). Put differently, the euro has been pretty stable against the currencies of its major trading partners.

More generally, financial markets are showing few obvious signs of stress only 48 hours before the referendum, with volatility reasonably subdued. Emerging market currencies, a helpful proxy for global risk appetite, have actually been broadly stable against the US dollar in the past ten sessions (see Figure 3) – a point which I had already flagged in EM currencies, Fed, French election and UK Reflation “lite” (25 November 2016).


ECB may extend QE but other major central banks likely in holding pattern

While the ECB may well extend its QE program, I maintain my view that developed central banks are likely to refrain from loosening monetary policy further near-term (see Global central bank easing nearing important inflexion point, 26 September 2016). I would certainly expect central bank policy rate cuts to become increasingly less frequent – the RBNZ, which cut rates 25bp on 9th November, was the last developed central bank to do so (see Figure 4).

The modest pick-up in global GDP growth in H2 2016 and dollar strength in the past three weeks have somewhat eased the pressure on developed central banks to further reflate their economies. At the same time, the recent up-tick in international oil prices and inflation expectations may have at the margin reduced the scope for looser monetary policies.

In emerging markets (EM), low real central bank policy rates and signs of slowing economic growth gave a number of central banks, including in Brazil, India and Indonesia, the room and incentive to cut rates in recent months. US President Donald Trump’s penchant for protectionist policies has exacerbated concerns about regional trade and growth and provide a strong motivation for EM central banks to ease monetary policy further.

But the collapse in EM currencies following Donald Trump’s election victory has probably closed the door on rate cuts in the near-term. At the very least, EM central banks will likely want to ascertain the impact of a probable Federal Reserve rate hike on 14th December before contemplating their next steps.



Olivier Desbarres

Olivier Desbarres currently works as an independent commentator on G10 and Emerging Markets. He has over 15 years’ experience with two of the world’s largest investment banks as an emerging markets economist, rates and currency strategist.

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