2016 has been a crazy year for governments with the United Kingdom voting to leave the European Union and Donald Trump winning the presidency here in the states. Now Italy is moving towards uncertainty as polls show Italians do not want Prime Minister Matteo Renzi’s referendum.
Renzi promised to step down if his referendum fails. These referendums will “reduce the role of the Senate and transfer powers to central government from the regions.” The Wall Street Journal reports a rejection could tumble bank shares and weaken the euro.
The markets have already shown distress since “the spread between the yields on German and Italian government bonds has widened to more than 1.6 percentage points, the widest it has been since the European Central Bank started buying bonds in March 2015.” So what could all happen to Europe’s third largest economy?
The worst-case scenario goes something like this: A defeat for Mr. Renzi would lead to a period of political instability. Mr. Renzi could follow through on a pledge to resign or be forced into a new coalition until elections are held in 2018. Either way, markets would interpret his defeat as proof that Rome is incapable of reform, raising doubts about Italy’s ability ever to deliver the kind of growth needed to put its debt burden of 135% of gross domestic product on a sustainable footing.That in turn would make investors even more reluctant to put capital into the Italian banking system, forcing banks to impose losses on bondholders, many of whom are ordinary savers. That would create a spectacular political backlash that could bring the deeply euroskeptic, antiestablishment 5 Star Movement to power in 2018, putting Italy’s euro membership in doubt.
Remember, Italy has Europe’s third largest economy, which means it “is simply too big to save with repeated European and International Monetary Fund (IMF) bailout packages:”
Similarly, with sovereign debt totaling around $2.5 trillion, making the country the world’s third largest sovereign debt market, it would seem inconceivable that an Italian credit event would not have major spillover effects to the rest of the global economy and that it would not trigger contagion to the rest of the European economic periphery.
Experts believe Italy’s economy needs to survive to save the EU:
“Italy is bigger than Brexit,” said Guy Monson, chief investment officer at Sarasin & Partners. “Until Italy is growing, we can’t really say the decade of European crises has passed us.”
However, investors might see a no as a terrible thing. The markets panicked after Brexit, but quickly picked back up. The stock market tanked after Trump won, mainly because it expected Hillary Clinton to win, but now the stocks have seen record high closings:
To be sure, some investors have pointed to the positive stock market response to the U.S. election and the recovery in risk assets after an initial selloff following the U.K. referendum in June as reasons to expect any referendum selloff to be short lived. And the political fallout could be less severe than feared if a credible caretaker government takes over and support for the 5 Star Movement fades.“When [investors] understand there are a lot of steps in between and the chain of events isn’t automatic, they realize the outcome of the constitutional referendum is much less risky than they thought,” said Giovanni Zanni, head of economic research for southern Europe at Credit Suisse.
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