Will Renzi still be laughing on Monday?
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By Geoffrey Smith
December 2, 2016

Italians might end up saying “Ciao,” to their country’s recent economic resurgence this weekend, but they won’t be saying, “Buona sera,” to the Eurozone.

Clearly, there is a lot at stake for Prime Minister Matteo Renzi when Italians head to the polls to vote in this weekend’s constitutional referendum, which takes place on Sunday. The outcome could could blow the country’s tentative recovery off course and make it harder to keep the EU’s signature integration project alive. But there might be less at stake than it appears.

That’s because even a ‘No’ vote—which is what the polls have been suggesting Italian voters will side with—would, analysts say, probably leave the country largely where it is now: Unlikely to form a mold-breaking single-party government and still banned, by its constitution, from holding a referendum that would take it out of the single currency area.

The trouble for Italy is that ‘business as usual’ isn’t an option if it wants to share a currency with Germany, the Netherlands, and others for the next 50 years. It needs Renzi’s reforms to allow urgent repairs to its zombified financial system that would let its economy breathe. As the chart below illustrates, Italy is hardly any better off than Greece after 17 years of euro membership. It just didn’t have the same pre-crisis boom.

Financial markets have become decidedly jittery in the past month at the prospect of a “No” vote. After the Brexit referendum and Donald Trump’s election victory, investors seem in no mood for another country to throw out economic orthodoxy and consensus politics in search of a radical answer to the ills of the modern world.

The premium demanded by investors for holding 10-year Italian government debt—a reliable indicator of political risk—soared in November to as much as two percentage points over comparable German bonds. Admittedly, that’s nowhere near the levels of its crisis in 2012. Then, spreads—the difference between the interest rates on similar bonds from the two countries—rose to over five percentage points. Even so, two percentage points is enough to revive concerns about how the country will carry a debt burden that is already higher, proportionately, than Greece’s was in 2009. Italy’s budget deficit is still too wide for the Eurozone’s rules. It’s not clear how it would finance higher servicing costs that come with higher interest rates on over 2 trillion euros of public debt.

Spreads have narrowed in the past couple of days, as markets have absorbed that the referendum is no ‘Brexit’ moment. But a ‘No’ will still have negative consequences in the near term.

According to Nicola Nobile, an economist with Oxford Economics in Milan, the first casualty is likely to be the 5 billion euro ($5.3 billion) recapitalization of the country’s third-largest bank by assets, Banca Monte dei Paschi di Siena, which failed the ECB’s stress test in July. If that fails, then other planned mergers and recapitalizations planned will also be harder to achieve, and the economy will continue to hobble along, starved of credit.

Renzi had been counting on the Monte dei Paschi recap injecting some momentum in the process of clearing up nearly 200 billion euros ($212 billion) in bad loans that clog the balance sheets of Italy’s banks. As Merler notes, MPS is the elephant in the room, with 35% of all loans classified as ‘non-performing’.

MPS is currently trying to persuade bondholders to swap their holdings for shares. A second step involves a big issue of new shares, preferably with an ‘anchor investor’ (such as Qatar’s sovereign wealth fund) taking a large bloc. But investors will be hard to find if the referendum leaves the country without a government, says Nobile, and that would force Rome to carry out a highly sensitive ‘bail-in’ of junior bondholders, including many small-scale retail investors to complete the recap.

Silvia Merler, an analyst with the think tank Bruegel in Brussels, notes that Renzi had deliberately left this leg until after the referendum, hoping to have a fresh mandate before needing to make such a controversial call.

Under new European rules, governments are required to impose losses on shareholders and junior bond-holders before they inject taxpayer money into a struggling bank. But when Renzi tried that out on a smaller bank last year, the suicide of a ruined pensioner and other stories of hardship caused such an outcry that he beat a hasty retreat. It’s hard to see who would dare repeat the experiment if Renzi loses and resigns.

The question would then become whether the EU authorities and other governments, notably Germany’s, would be willing to bend their new rules to spare a new and weak Italian government the pain of an explosive round of bail-ins.

“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,” says Holger Schmieding, chief economist with Behrenberg Bank in Berlin.

The populist and unpredictable ‘5 Stars Movement,’ as well as the anti-euro Lega Norde of Matteo Salvini, are waiting to exploit any failure of Renzi. As such, says Schmieding, “a political crisis could open up a bigger can of worms in Italy than it would elsewhere.” And that is never good for economic growth.

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