Italians overwhelmingly rejected a constitutional referendum on December 4, upon which Matteo Renzi had staked his prime ministership. Days later, after securing approval of Italy's 2017 budget, Renzi resigned, making good on his pledge to step down should he fail to gain voters' approval of proposals to streamline the nation's legislative structure and stabilize leadership.
Prime Minister Renzi had hoped to reform the legislative process so that Italy could implement the structural reforms it needs to achieve sustainable economic growth. However, for many Italians who rejected the changes, the referendum was a way to express frustration with their government, Italian politics generally, and the state of the economy, which has hardly grown over the past 20 years.1
Referendum's implications could extend beyond Italy
With the referendum's failure and Foreign Minister Paolo Gentiloni selected on December 11 to replace Renzi as prime minister, Italy must now address questions involving its electoral law and its banking sector. The outcomes are likely to have significant implications for the rest of Europe.
The constitutional reform was designed to shrink and downgrade the upper house of parliament, the Senate. Assuming that the referendum would pass, the government approved a new electoral law last summer. The law, called the Italicum, governs only the lower house (Chamber of Deputies).2 With the referendum's failure, the Senate is governed by one electoral law and the Chamber of Deputies another. Before it can hold an election, the government needs to draft a new electoral law to govern both houses of parliament. If the Italicum is reopened, it seems fair to assume each political party will negotiate in its own political interest; therefore, the most common outcome is a proportional system in both houses.
Ironically, the referendum's defeat was billed as a populist vote, but it actually blocked any realistic path for the biggest populist party, the Five Star Movement (M5S), to come to power. The M5S refuses to form a coalition and appears unlikely to win an absolute majority in any national elections anytime soon.
While a new electoral law is sorted out, any real policymaking is likely to be put on hold, and Italy is unlikely to achieve the liberalization of product and labor markets that it needs to generate robust growth. Still, economic stagnation is typical in Italy; the nation hardly grew during the boom years after it first adopted the euro as its currency in 1999.
While Italy is likely to avoid significant political instability in the immediate term, all bets are off once a new electoral law is enacted. Italians are scheduled to vote by May 2018, when the current legislature expires. All but one major party has said it favors an early election in February or March 2017, once the Italicum is ruled on by the constitutional court and the government has had a chance to revise it. Still, given that France and Germany are scheduled to hold elections in 2017, Italy might have an incentive to stick to its 2018 timetable. Just as with economic stagnation, political instability is business as usual in Italy.
The real worry—Italian banks
In the wake of the constitutional referendum, Italy must immediately address the weakness of its banking system. Last summer, Mr. Renzi's government cobbled together a private sector-led rescue of ailing Banca Monte dei Paschi di Siena (MPS). As part of the rescue, a consortium of investors agreed to shift nonperforming loans off MPS' balance sheet; however, the consortium has the right to withdraw from the deal in the event of adverse market conditions.3 The Italian government is also trying to secure the Qatar Investment Agency as a key investor. If any of these investors walk away from the deal, the private sector rescue of MPS would almost certainly collapse and MPS would need some form of a government rescue.
With 65% of MPS' outstanding subordinated debt held by retail investors,4 a bailout/bail-in solution would be politically toxic for the government. Another solution could be for Italy to request a banking sector bailout from the European Stability Mechanism (ESM), the agency that financially assists troubled banks and European Union (EU) member countries. However, it seems unlikely a bail-in could be avoided with ESM help. Italy's government could instead decide to nationalize MPS by either buying equity on the markets or buying the bank's retail subordinated debt and converting it into equity. This solution seems most likely, but nationalization would be incredibly expensive for Italy, which already suffers from a soaring debt burden.
If the solution for MPS is delayed or lacks credibility, there is a significant risk of contagion to other Italian banks. UBI Banca, one of Italy's largest banks, might walk away from its planned purchase of three of the four small Italian banks already put under administration.5 Three midsize banks, Carige, Popolare di Vicenza, and Veneto Banca, require additional capital and may have trouble raising it if MPS' troubles are not dealt with swiftly and credibly. Unicredit, Italy's largest bank, has also been seeking to raise capital. If it falls short of its goal, the contagion from Italy's banking crisis could spread across Europe.
Italy has been down similar roads before
While the international investment community might regard Italy's political instability and economic stagnation as high drama, the real story is with Italy's banks. The impact of bank rescues in Italy will be significant, and it could affect the rest of Europe. Political intrigue, soaring unemployment, and poor economic indicators are something Italians just shrug their shoulders over. When your history is as long and as rich as Italy's, you can always point to a time when things were worse and Italy persevered. A friend of mine asked his Roman colleague whether she was worried about a financial crisis, and she replied, “We've been through much worse. The 400s were pretty bad,” referring to the century when Rome fell and was sacked by barbarians. While such sarcasm is one way that Italians put up with their institutions, it may also help to explain why those institutions can remain so inefficient. Unfortunately for Italy, with a resounding defeat for constitutional reform, no Italian government will attempt similar reforms to streamline policymaking anytime soon.
1 The World Bank, 2016.
2 Lexicon – Italicum, Il Sole 24 Ore, as of 12/5/16.
3 Monte dei Paschi rescue thrown into doubt, Financial Times, 12/5/16.
4 An Italian take on banking crisis, Bruegel, 10/27/16.
5 UBI Banca receives initial ECB nod to buy three small lenders – sources, Reuters, 11/25/16.