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Smoke signals

11 November 2016 By Neil Unmack

After the U.S. election, Italy’s upcoming referendum is looking like the next anti-establishment conflagration. A “no” may topple Prime Minister Matteo Renzi, boost support for the anti-establishment 5-Star Movement, and leave both Italy and Europe weaker.

The season of anti-establishment conflagrations is not yet over. After Donald Trump’s victory in the U.S. elections, and Britain’s vote to leave the European Union, comes an Italian referendum on senate reform scheduled for Dec. 4. Eleven polls collated by Reuters during November all suggested a “no” vote was more likely.

Italy’s situation sounds less serious. After all, arcane changes to a country’s constitution should not trigger crisis or a change of government. Yet Prime Minister Matteo Renzi is struggling against similar forces: popular dissatisfaction with dismal growth, and the rise of anti-establishment parties. Whichever way Italians vote, Europe will feel the effect.

What are Italians voting on?

Renzi’s referendum proposes a bundle of reforms intended to improve Italian governance. The changes will reduce the size and power of the senate, which currently has equal power with the lower house, and can topple governments and redraft laws. It will also claw back authority from the regions. The catch is that not everyone thinks that’s a great plan. Renzi has enemies in his own centre-left Democratic Party who oppose his centrist views and want to get rid of him. Some critics argue that the reforms are badly drafted, or undemocratic.

The bigger problem is that the referendum has become a protest vote against Renzi’s leadership and the status quo. Many Italians are sick of dismal growth and youth unemployment of nearly 40 percent. The anti-establishment 5-Star Movement, which wants a referendum on the euro, continues to draw support. Founded by comedian Beppe Grillo, it has become Italy’s second-largest party according to recent polls, even though its organisational record is decidedly patchy. A recent scandal and accusations of incompetence in Rome, where 5-Star member Virginia Raggi is mayor, has done relatively little to damage its popularity.

Will this solve Italy’s problems?

It would help, with time. Italy needs a strong government to take tough decisions, and that may not be possible until elections in 2018 or even afterwards. But the referendum would be a big coup for Renzi, and help him purge his party of left-wing rebels. Over the medium term it should mean that laws work better and are better implemented. Regions should also be less wasteful and obstructive to infrastructure investments. That should help Italy’s growth, which is among the weakest in the euro zone.

Let’s say Renzi loses. What then?

The young Florentine would probably resign as prime minister. But it might not be the end of him. If he gets, say, comfortably more than 40 percent of the vote, and the turnout is high, he might argue that his personal approval level is still good, and try to form a new government. But there’s a good chance the left and right wing parties would form a government without him.

Any weak government would want to then push through a separate set of reforms: a change to the electoral law ahead of elections in 2018. Italy’s two houses currently have different electoral systems, which creates the risk of stalemate. Changing that would make it easier for a coalition to govern. For the establishment parties, this has the added advantage of making it harder for 5-Star to take power.

Will markets collapse?

Maybe a bit. But Italy has been here before, and Italian assets are relatively cheap. In 2013, elections produced no winner, and a fragile left-right alliance staggered on until Renzi barged his way in. During 2013 the spread between yields on Italian and German 10-year government debt – a sign of Italy’s perceived riskiness – hovered between 2 percent and 2.5 percent, not too far above the current 1.6 percent. The FTSE MIB equity index has fallen 21.5 percent this year, compared with a 7.6 percent decline in the broader Stoxx 600 European index. Even stripping out Italy’s banks, the local index has performed worse.

Oh yes, the banks. Aren’t they in trouble?

A period of uncertainty and market turmoil could make life harder for the lenders that need to raise capital, specifically UniCredit and Banca Monte dei Paschi di Siena. UniCredit can probably bide its time. MPS though needs capital quickly, and it has only secured underwriting commitments until the year-end. After that, the government may have to push through a messy and unpopular debt conversion. The odds of that now are probably about 50-50.

What will be the long-term effect?

Some Italians and investors would see Renzi’s failure as a sign Italy cannot change. Another year of waste, low growth and high unemployment may make Italians angrier, and more likely to support the 5-Star Movement. If 5-Star does take power, or influence government, Italy may have a referendum on staying in the euro. The party is likely to demand much looser fiscal policy, which would force Europe’s budget hawks, who vigorously oppose that kind of thing, into a tough spot.

If the referendum succeeds, it will be a big coup for Renzi. He will have triumphed over his intraparty detractors, and in the medium term, Italy’s growth should be a little bit higher. Five years from now, the constitutional reform may well be a moment that helped define the future of Italy, for better or for worse.

 

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