The December 4 Italian Referendum : Critical for Italy and the EU

On Sunday, December 4, Italian citizens will vote on constitutional reform. Prime Minister Matteo Renzi is campaigning for a "yes" victory in an effort to make it easier to govern Italy, a notoriously difficult nation to govern, with more than 60 governments since World War II. What Renzi is proposing in the referendum is to remove power from the Senate so that proposed laws would only require the approval of the lower house of parliament, as opposed to the current system which requires approval from both houses. Renzi has gambled his political future on the referendum, saying he will resign if a "no" vote rejects his referendum. A "no" vote, championed by populist party Five Star Movement (5SM) founded four years ago by Beppo Grillo, a famous Italian comedian, would block the reforms to streamline Italy's public administration and the extensive checks currently in place would remain. • • • WHAT IS THE REFERENDUM? What exactly does Renzi want? A series of major changes to the Italian political system. These reforms, which affect a third of the Italian constitution, have been approved by parliament but by a slim margin, thus requiring that they also be passed by referendum. Under the current system, which was created under Italy’s 1948 constitution, there are two chambers of parliament with directly elected lawmakers, the Chamber of Deputies and the Senate. Both chambers have equal power -- it is called “perfect bicameralism” -- meaning that both houses must agree on legislation before it is passed. Simply stated, the system means that it can take a very long time for things to get done. For example, a law to give children born out of wedlock the same rights as children of married couples took nearly 1,300 days to be approved. Under the proposed Renzi reforms, the Senate would lose almost all its power -- the number of senators would be reduced from 315 to 100, and the remaining senators would no longer be elected directly. Instead, the 100 would be made up of lawmakers selected by regional assemblies. Some mayors would also serve as senators. This would cut the cost of politics by €500m ($530m) a year. If the "yes" campaign wins and the reform is passed, it would mean that most laws could be passed, including Italy’s budget, by the Chamber of Deputies without consultating the Senate, arguably making the whole process of passing laws a lot easier. The Senate would only have the power to vote on big issues such as other constitutional reforms and the ratification of EU treaties. It is a major decision point for Italians, which is why the latest polls before the required two-week poll blackout ahead of the vote showed about a quarter of Italians still undecided. Renzi has said that these voters will determine the referendum. But, analysts also suggest that young voters, who make up the majority of 5SM, may not bother to vote and this would favor a "yes" vote for Renzi. The latest opinion polls indicated a 53.5% to 46.5% victory for the "no" side. Sentiment among pro's in Italy is that there is a 60% chance that the "no" vote will win. • • • WHAT WILL HAPPEN AFTER THE REFERENDUM? Francesco Oggiano, the author of "Beppo Grillo Parlante," told CNBC on November 14 that he believed 5SM's opposition to the proposed reforms boils down to a new electoral system perceived to be attached to the reforms : "According to the 5SM, people won't be able to choose their own representatives in the parliament and this is the most important point. The result (of a 'yes' victory) would be a parliament full of bureaucrats chosen from their parties that, once elected, will just get to satisfy their leader instead of people's needs," he added. • What happens after the result depends to some extent on whether Renzi really resigns -- if the vote is close he may decide to stay on and push for a general election late in 2017. Financial markets see the vote as a test of the appetite for reform in Italy. Analysts from Barclays published a note Monday about the aftermath of a "yes" or "no" outcome. If the reforms are soundly rejected in a big "no" vote, then Renzi will most likely resign and early elections will be called in mid-2017. Should there be a big "no" vote and an election is called for mid-2017, 5SM appears to stand a strong chance of winning the majority of votes. Recent opinion polls show them 5% behind Renzi's Democratic Party. • • • THE ITALIAN BANK CRISIS. The vulnerable Italian banks are a big behind-the-scenes factor in the referendum. Officials and senior bankers, according to various media reports, believe that up to eight of Italy's troubled banks are at risk of failure should Renzi lose the upcoming referendum. Megan Greene, chief economist at Manulife Asset Management, believes that the referendum in Italy could provoke another banking crisis in Europe : "In my view the biggest risk is actually for the banking sector, even more so than political risk, and there will be some political instability." Italy, the third-largest Eurozone economy, has been weakened by a deep recession that caused 356 billion Euros ($377 billion) in problem loans, and Italian banks need at least 20 billion Euros in capital in the coming months to cover losses from fresh loan write-downs and planned bad debt disposals, according to a Reuters report. A "no" vote could conceivably cause financial instability and possibly even panic among investors which would be significantly negative for Italy's banks, whose bad loan ratio hovers near 18%, compared to a 2% bad loan profile of French banks, and a 1.6% bad loan profile of German banks. There is increasing alarm that the political upheaval created by a potential "no" victory would disrupt plans to recapitalize Italy’s most troubled banks. Italian banks have already suffered a lot in 2016 because of nonperforming loans, ultra-low interest rates and slow economic growth. The FTSE Italia All-Share Banks Sector Index is down 48% this year and has lost 5% in the past month alone. The poster child of the Italian banking crisis Banca Monte dei Paschi di Siena SpA has wiped out 83% of its market value in 2016 on fears the lender -- Italy’s oldest -- would become insolvent because of its high levels of bad loans. Shares in Italy’s beleaguered banking sector are down more than 20% since Brexit, in large part because investors are worried about the referendum outcome. Green says : "If you have a crisis in the Italian banking sector kicking off again, not only that could spread across Europe but also the solution that Renzi may come up with to just break the rules and bailout the banks, in which case he would be massively undermining (the) banking union, which is actually the only area where they made progress in Europe since the beginning of the crisis." Investors agreed earlier this year to contribute to a solution that addresses some of Italy's weakest banks -- asset managers, insurers and banks agreed to set up a 5 billion euro fund ($5.30 billion) to bail out weaker lenders, helping calmed concerns over the stability of the Italian banking sector and its burden of a high level of non-performing (bad) loans, but they might not to continue to contribute if there is a "no" vote on Sunday. Meanwhile, Italian officials have downplayed the impact the referendum result might have on banks and on Europe. Paolo Gentiloni, the Italian foreign affairs minister, told CNBC Monday that market concerns of a potential default are not justified. Gentiloni said such fears were reasonable in 2011 but the country has improved since then. He added that there are no risks of contagion to Europe : "In any case we will have a weaker and more unstable country, but not a threat for the European economy." • • • HOW WILL THE EU REACT? The wider European political system will be impacted if Italians vote “no” in Sunday's referendum. A victory for “no” will lead to Renzi's resignation and the dissolution of Italy’s government. On the same day, Austria votes on its next government and a populist-nationalist is expected to win. So the EU will be hit twice on the same day. Holger Schmieding, chief economist at Berenberg, said in a note early this week : “Ever since the Brexit vote, we have viewed a potential political crisis in Italy as the top event risk in Europe for 2017. ‎Unlike Brexit, which poses a severe risk to the UK but not to the Eurozone, Italian problems could theoretically spark a systemic crisis in the Eurozone. Furthermore, a protracted period of political uncertainty after a ‘no’ vote could exacerbate the Italian banking issues, unsettle the Italian bond market and weigh on business and consumer confidence." The broader Italian stock market is down 21% this year, and the borrowing costs on 10-year Italian government bonds have jumped back above 2% for the first time since the summer of 2015. But even those moves may not have prepared markets for a “no” outcome, according to analysts at Deutsche Bank. In a note dated November 28, they said “there is a risk that the market is too complacent” and that investors are “underestimating the probability of a significant negative reaction” in the case voters reject the reform proposal. Deutsche Bank says : “If we are correct, markets will have to deal with a ‘no’ and the risk of a government vacuum. Markets could react negatively, with significant stress on the banking sector.” Analysts have also pointed to a potential selloff in the Euro if voters reject the reform proposal, although the currency already has shed a lot of value in the run-up to the ballot. On Wednesday, it was down 3.2% against the dollar for the month at $1.0639. • On the other side of the argument, both Schmieding from Berenberg and Deutsche Bank put a 60% probability that Italians will vote against the reforms, and JP Morgan, economists see only a 30% chance Renzi can get enough backing for a “yes” vote. That means a potential “no” outcome should come as no surprise to investors and therefore do little harm to financial markets. Mislav Matejka, JP Morgan’s chief European equity strategist, said in a note : “In contrast to the UK EU referendum, or the US elections, where the results were a surprise, the markets are likely to be much better prepared for a negative outcome this time around.” Matejka believes the recent slump means most of the bad news are already reflected in prices. And, the European Central Bank meets on December 8 and is widely expected to extend its bond-buying program. The bank is also ready to temporarily step up its purchases of Italian debt if Sunday’s referendum result prompts an increase in the country’s bond yields, according to Reuters. • • • WHAT IS 5SM? One reason observers think the Italian referendum vote is so important is because it could open the door to the election of the Five Star Movement (5SM), a populist, anti-establishment party that has said in the past it wants to call a referendum on Italian membership of the Euro. But even if the 5SM took over the Italian government, it would not mean Italy could abandon the Euro quickly. Doing that would require a constitutional amendment and another referendum. Euroscepticism is definitely on the rise in Italy, but there is no overwhelming political consensus against the single currency right now. 4SM has played on Italian frustration with high unemployment and the migrant crisis, much of which falls on Italy's shoulders. • The "yes" camp is led by Renzi and most of his backers in the Democratic party. Big business interests support the changes because they think it will make Italy more stable and help the government pass legislation that they argue is necessary but may not be popular, including tax and labor reforms. Investors generally support the proposals because they see the referendum as a test of whether Italy is capable of change. • Almost everyone else is against the Renzi reforms for various reasons. Some constitutional experts believe the changes are essentially a power grab that will make Renzi, or whoever is prime minister, much more powerful. They argue that the changes would obliterate the delicate balance of power that was designed in 1948 by people who had witnessed the rise of fascism under Mussolini. And, all of Renzi’s political opponents on the left and the right oppose the constitutional reforms, in large part because they want to force his resignation. • Of these, the most vocal critic is the 5SM, led by Beppe Grillo, who is essentially arguing for the parliamentary structure to stay as it is -- which makes for an unusual line-up because the populists are supporting the status-quo while the establishment is supporting change. If the "no" campaign wins, it will definitely be a defeat for Renzi and a win for Grillo. But it’s more complicated because a "no" victory would -- for technical reasons -- force the current government to make a change to a totally separate electoral law. This, in turn, means that if 5SM were to win the next general election it would probably only get to take a proportionate number of seats in parliament. Under the present rules, the winner takes the majority. In other words, a "no" victory could hamper the 5SM from assuming power in the future, even though it would be a big win in the short term. While there is a strong chance 5SM could win based on current polls -- the movement has already won key mayor races in Rome and Turin -- it is not a certainty. The party’s lack of experience could worry Italians. One senator, Francesco Palermo, thinks that whoever wins -- including 5SM -- would be far to the right of Renzi, putting much more pressure on Italy’s relationship with the EU, and leading to big changes in the country’s handling of the migration crisis. • Foreign Minister Paolo Gentiloni, a Renzi ally, says : "I think that every single Western country should consider very seriously the risk that people who are suffering from the globalisation process can react against the traditional parties." The opposition 5SM argues that it helped to create the current international wave of populism. The party was founded in 2009 by the comedian Beppe Grillo, whose shock of hair and loud opinions remind Italians of Donald Trump. A few steps behind the deliberate chaos of Beppe Grillo is a younger, more serious figure. Whenever the next general election is called, Luigi Di Maio may become 5SM's candidate for prime minister. He is only 30 years old. • • • DEAR READERS, the Sunday referendum vote in Italy will be one of the increasingly frequent votes that pit establishment politics-as-usual against nationalist-populist movements and individuals who want to put an end to the establishment's way of doing things by bringing politics closer to the people and looking out for their interests as opposed to those of the elites. Like Britain’s referendum to leave the European Union that has spread angst through the EU, and the election of Donald Trump that has shaken Western allies, Sunday's referendum, called by Prime Minister Matteo Renzi, could send tremors through the EU. If “no” prevails, Renzi has vowed to resign, but some Europeans fear that his resignation could set off a banking crisis in the Eurozone’s third-largest economy and open the door to the populist, anti-European Union Five Star Movement. That has, in turn, has led to pressure on Renzi to revoke his vow to quit, including President Obama’s statement in October that he should “hang around for a while no matter what.” Renzi cannot undo his questionable push for a referendum, a political shortcut that too often ends up biting its originator. But he can mitigate some of the potential fallout by declaring that he will stay in office for a while no matter what the outcome. That would calm the markets and Italy’s neighbors and help smooth transition to the reality the referendum ushers in.