News: It was the last crucial political event of 2016. After Brexit and Trump’s surprise victory, the financial markets are turning their attention to Italy, which has just overwhelmingly rejected constitutional reform (by nearly 60%), plunging the country into a new period of political uncertainty. Prime Minister Renzi announced his resignation, which he submitted to President Mattarella. The latter is now responsible for consulting with representatives of Parliament in an attempt to form a new government and avoid early elections that could bring the populist Five Star Movement to power. The euro showed little reaction to the news, Italian 10-year bond yields did not rise as much as expected, and the spread relative to German bond yields widened by only 3 points. This suggests that the markets are waiting to see what happens next before becoming more risk-averse. In this note, we review the stakes of this referendum and its implications, in a fragile macroeconomic context and an extremely vulnerable banking system.
Italy’s weaknesses
There are many problems that make Italy a very vulnerable economy: the country has low productivity (even before the crisis, productivity growth was 0.1% compared to 0.4% for the eurozone average), record public debt (133% of GDP, making it the second most indebted country after Greece), and above all, a banking system weakened by insufficient capitalization ratios and a high level of non-performing loans (18% of total loans compared to 5% on average in the eurozone). Banking fragilities weigh particularly heavily on Monte Dei Paschi, which is on the verge of reaching an agreement on its recapitalization and the exchange of part of its debt for shares. This fragile environment is weighing on consumer and investor confidence and slowing down the recovery process: GDP growth remains sluggish and unemployment levels are high (11.7% in October), especially among young people (who suffer from an unemployment rate of over 35%).
Italy’s institutional system is partly to blame for its vulnerability. In Italy, it takes an average of three and a half years for a law to be passed, for two reasons: firstly, electoral laws encourage the formation of coalitions, which make the main parties dependent on the goodwill of smaller parties, rendering the entire political system unstable. Second, because of a perfect bicameral system between the National Assembly (the camera dei deputati) and the Senate (Senato), any reform undergoes a tedious back-and-forth between the two chambers until it is finally adopted.
Renzi’s ambitious reforms
Prime Minister Renzi wants to tackle these two institutional obstacles through two reforms that are central to his mandate. The first is a reform of the Assembly’s electoral law, but we will come back to that later. The second is a reform of the Constitution, which provides (among other things) for reducing the scope of the Senate’s prerogatives in order to give the Assembly decision-making power on key issues. The combination of these two reforms, which were adopted separately, would have made Parliament more effective by entrusting power to the party elected to the Assembly.
It was this latter reform that was the subject of a referendum last Sunday, as the law did not reach the required threshold of two-thirds of the votes in Parliament. Matteo Renzi had suggested that he would resign if he lost the referendum, refusing to remain in power in a shaky institutional framework that would prevent him from acting.
Beyond its implications for the functioning of Italian institutions, this referendum is also important for the country’s political stability. A victim of chronic instability (as evidenced by the latest episode in 2013), the country finally seemed to have found the path to stability by appointing Renzi. However, by linking his fate to the outcome of the vote, the prime minister is once again plunging the country into worrying political uncertainty, at a time when populist and anti-establishment movements are flourishing throughout the developed world. In Italy, this movement is embodied by the Five Star Movement.
And now?
The first step is to find a new prime minister. The parties in power have every interest in avoiding early elections and replacing Renzi with another member of the existing coalition, given the Five Star Movement’s surge in the polls… However, if President Mattarella fails to garner enough support in Parliament to form a new government, he will have to dissolve Parliament and call early elections in an institutional system that is not very robust, due to differing electoral laws in the two chambers. Hence the urgency of the second step, so as not to fuel short-term political risk that could trigger a reaction from the financial markets.
The second step for the next prime minister will be to quickly amend the electoral law in force in the Assembly. As mentioned above, Renzi’s first institutional reform concerns the electoral law of the lower house (Camera dei deputati), known as Italicum. It gives the winning party a bonus of seats, ensuring it an absolute majority and thus avoiding the need for parties to form coalitions. This law was passed by Parliament and has been in place since July 2016. However, Renzi has said he is prepared to amend it regardless of the outcome of the referendum. The new electoral law would continue to provide a bonus, but it would be awarded to the winning coalition rather than the party.
With the victory of the « no » vote, the need for amendment becomes even more obvious: how can we imagine a Parliament with two equivalent chambers, but governed by two electoral laws that do not lead to the same majority? This would be neither desirable nor sustainable. Furthermore, this law is subject to review by the Constitutional Court, which is expected to be published in the coming weeks and could lead to adjustments to the law, certainly in line with the amendments already proposed by Renzi.
Conclusion
Surprisingly, and unlike the Trump and Brexit votes, it was young people who overwhelmingly rejected the constitutional reform: the results show that 81% of 18-34 year olds rejected the reform, compared to 47% of those over 54. By rejecting this reform, not only will the existing institutional system remain inefficient, but the period of political instability that lies ahead will also constrain the implementation of other structural reforms that are essential to strengthening the Italian economy.
In the coming months, neither the financial system nor fiscal policy will be able to fully absorb the implications of the political shock that occurred on December 4. But Italy will undoubtedly be able to count on the ECB, which is expected to be conciliatory at its meeting on Thursday, extending its asset purchase program by several months.
[1] In order to satisfy the interests of the smaller parties and provide the traditional parties with a bulwark against the populist party, whose foundations are based on an absolute refusal to join a coalition.
