The Daily Update - Renzexit?

The yield on the 10 year Italian Government Bond (BTP) is 2.01% against 1.54% on the Spanish 10 year bond reflecting concern about the upcoming Italian referendum on constitutional reform on December 4.  Given the recent ‘surprise’ anti-establishment votes for Brexit and Donald Trump as US President the market’s nervousness is understandable.  Opinion polls have proved unreliable but these suggest a ‘no’ vote, albeit with a large number of voters still undecided, will win the day in Italy.

The referendum is about implementing constitutional change and has been a key initiative of Prime Minister Matteo Renzi’s government.  It aims to streamline the government law-making process so the Lower House (Camera) becomes the main law-making body and the downsized Senate will have more limited powers, a much more consultative role.  Proponents of the reform allege that the bicameral system currently makes it difficult to get any laws and reforms passed and by removing the veto power and confidence vote from the senate it will make the government more stable.  While the referendum is on these reforms alone there is also a new electoral law, Italicum, coming into force which would award a majority premium to the party that gets 40 percent of the votes; although the Italian Constitutional Court still has to ratify/reject/amend the proposal.  Opponents claim the reforms in conjunction with the new electoral law could concentrate too much power in an executive without enough checks and balances.

The risk with the referendum is also that it becomes a protest vote about the existing government and the tougher times voters are experiencing.  Growth has been a disappointment as the Italian economy is not expected to return to the pre-GFC levels of output until the mid-2020s.  The economy did manage to grow in Q3 but only at 0.3 percent qoq but Italian growth faces a lot of headwinds: an ageing population, high debt levels, low productivity growth, weak levels of technological innovation, high youth unemployment and a weak banking system beleaguered with non-performing loans.

Renzi’s repeated pleas for the relaxation of fiscal policy have so far gone unheeded. Italy’s budget submission shows the structural deficit (excluding one-off items and economic cycle adjustments) increasing from 1.6 percent in 2016 to 2.2 percent in 2017 and 2.4 percent in 2018: the EC guidelines require countries to cut a structural deficit by 0.5 percent per annum until it is balanced.  The public debt forecast also edges up to 133.1 percent of GDP which goes against the debt reduction rules.  The EU’s response has been to warn the budget is ‘at risk of non compliance’ with the rules.

A large part of the population remains undecided so it is still possible for the vote to edge in Renzi’s favour but the no vote looks more likely to win.  Matteo Renzi stated this week ‘If the citizens vote no and want a decrepit system that does not work, I will not be the one to deal with other parties for a caretaker government.’  In this event, the Italian President Sergio Mattarella would have to choose another head of an interim government until elections are held.  Having had 63 governments since World War II Italy is no stranger to political instability and caretaker governments but markets hate uncertainty.  Mirroring the rise of populist politics around the world, the anti-establishment Five Star movement has gained momentum in Italy.  They are anti-euro but any speculation about leaving the euro seems premature; they would have to win enough votes at an election, a supermajority of two thirds or a majority and win a referendum.

Italy, the Eurozone’s third largest economy, is core to the success of the European Project so a ‘no vote’ should increase the urgency for the Europe to re-evaluate its ‘raison d'être’.  For us, the current euro structure tying all members to one exchange rate set against strict convergence criteria and trigger levels for budget adjustment (3 percent budget deficit and 60 percent debt to GDP) has left austerity and structural reform as the main adjustment levers in a downturn.  Fiscal policy, an important economic stabiliser, is underutilised under the current structure so instead of bringing Europe closer together by promoting growth, employment and stability the current structure has allowed imbalances and inequality to build and set creditors against debtors.  Pierre Moscovici, the European Economic and Financial Affairs Commissioner, described the election of Trump as a ‘political wake-up call’ to which Europe must respond: we agree.