As the United Kingdom pulls up its Brexit drawbridge, a political time bomb on the other side of Europe that’s weighing on financial markets is encapsulated by a bridge: a long-mooted, 3km one between Sicily and the Italian mainland.
Italy's prime minister of 2½ years, Matteo Renzi, has placed his political career on the line by calling a constitutional referendum on December 4th. He argues the plan to curb the power of the country's senate will make Italy, home of 63 governments in 70 years, more governable, and give him a chance to pass tough reforms to reboot one of Europe's weakest economies.
With polls suggesting Renzi will lose the referendum, as Italians use the plebiscite to vent their ire over everything but the issue at hand, he’s throwing out promises to increase spending – including rekindling former premier Silvio Berlusconi’s €6 billion Sicily bridge plan.
"I think, quietly, everybody's worrying more about December 4th than Brexit," said Guy Monson, chief investment officer at UK-based asset management firm, Sarasin & Partners, in an interview in Dublin during the week.
“Brexit’s done now. We’ve had the shock. It’s now down to the negotiations. But I think in terms of risk going forward, December 4th is much more significant.”
Stagnation
While Ireland's economy has rebounded strongly following the financial crisis – after the State was forced to clean up banks' balance sheets, albeit at the cost of a gross €64 billion to taxpayers that triggered an international bailout – Italy has been dogged by recession and stagnation since the onset of the downturn. The European Commission forecasts Italy's economy will expand by just 1.1 per cent this year, compared with 4.9 per cent for Ireland and 1.6 per cent for the euro zone as a whole.
And although Ireland’s headline gross domestic product numbers can be grossly misleading, due to the activities of multinationals in the country, it matters little to the euro zone as a whole. Italy, however, is the currency bloc’s third-largest economy. It is also the world’s third-largest bond market, after the US and Japan.
On the plus side, Italy is something of an anomaly in Europe in having run a primary surplus – where tax revenue outstrips spending, excluding interest payments – every year since 1995, with the exception of 2009.
However, anaemic economic growth has left its debt-to-GDP ratio hovering at record highs around 133 per cent – the second highest in the euro zone after Greece. Ireland, by contrast, has seen its ratio plunge from 123 per cent in 2013 to below 80 per cent this year, benefiting solely from economic growth as it continues to run an underlying budget deficit.
Renzi made the referendum personal from the outset of the campaign, pledging to quit if it is rejected. This would play into the hands of anti-establishment party, the Five Star Movement, which is riding high in the polls and is led by stand-up comedian Beppe Grillo.
A government collapse would stall budgetary measures to bolster growth next year and kill off its reform drive, according to economists.
Polls, on average, suggest that the No side currently has the support of 52.2 per cent of voters, up from 50.4 per cent last month.
"In the event of a No vote in the constitutional referendum and Italy experiencing a period of political gridlock, GDP growth in 2017 will fall from 0.9 per cent in our baseline to 0.4 per cent," Nicola Nobile, a euro-zone economist at Oxford Economics, said in a report on Friday. "Financial markets and private investment will react negatively."
EU deficit rules
With fewer than 50 days to go before the referendum, Renzi’s most immediate challenge is securing leeway from the European Commission over his 2017 budget plans. These are set to breach EU budget debt and deficit rules, as the country has extra spending pressures due to the migrant crisis and reconstruction after a devastating earthquake rocked central Italy in late August.
European Commissioner for Economic and Financial Affairs Pierre Moscovici has made it clear there are limits to how flexibly EU budget rules can be applied.
“We believe that raising public debt above the current level is not reasonable, because the burden is already very heavy,” he told Reuters.
To try and help the maths, the Italian government is relying on economic growth figures that the country’s independent public finance watchdog has described as too optimistic.
Politically, failure to get some concessions from the EU could add to the popularity of the eurosceptic Five Star movement, now the country’s most popular party, according to polls.
All the while, Italy’s banking system, burdened by some €360 billion of bad loans, equivalent to a fifth of the economy’s size, remains under pressure.
Renzi’s efforts during the summer to get EU support for Rome to inject money into some of its ailing lenders without triggering a so-called bail-in for creditors were strongly resisted. Small Italian investors own about a third of the banks’ bonds.
Still, a rejection of the referendum may have a silver lining, according to Monson.
“If Renzi loses, I think Europe will really, in double-quick time, have to get control of its banking legislation . . . soften [bank] bailout terms on state injections, and they’ll have to rush towards a common bank insurance platform,” he said, referring to the idea of a deposits guarantee plan long resisted by Germany.
“Only then can you start to put the pieces together.”
