Euro Watch – Italy after the referendum No vote

by: Nick Kounis , Aline Schuiling

  • The Italian public voted overwhelmingly to reject the government’s reform of the senate
  • Prime Minister Renzi has resigned and a caretaker government will likely be formed within two weeks
  • The new government will likely focus on finalising the electoral law for the lower house and elections in 2017H2 are probable
  • The likelihood of a Five Star government that ushers in a euro referendum is low and has diminished further after the No vote
  • A coalition government after the next election seems likely and the current economic policy stagnation is set to continue
  • Italy’s trinity of economic problems: lack of growth, high government debt and bank NPLs will unlikely be tackled…
  • …making the country vulnerable to economic shocks
  • Italian government bond spreads to remain elevated and we remain negative on Italian bank debt at all levels
Euro-Watch-Italy-Referendum-No.pdf (215 KB)


Italy’s electorate overwhelmingly decided to reject the government’s proposal to weaken the role of the senate in the legislative process. Around 60% of the public voted against the constitutional reform, compared to around 40% that voted in favour. Following the UK’s vote to leave the EU, and the election of Donald Trump to be the next President in the US, the No vote in the Italian referendum could be seen as the latest sign of a growing anti-establishment trend that is fuelling political risks. In this note we look at the implications of the No vote.

Caretaker government likely to be formed

Prime Minister Matteo Renzi resigned in the early hours of this morning as it became clear that voters had rejected his proposal to reform the role of the senate. He said he would he would hand his resignation in to President Sergio Mattarella later in the day. He also said he would not lead or take part in the formation of a new government. Although Mr Mattarella could dissolve parliament and trigger new elections, we think that it is more likely that he will aim for a caretaker government. This is because the electoral reform of the lower house (the Italicum) is currently being appealed in the constitutional court. The main parties may want to see the Italicum passed or amended before any new elections are held. Indeed, this could be the main focus of the caretaker government.
In the process of forming a new caretaker government, Mr Mattarella will first enter a consultation process with the various political parties. Following these talks he will ask someone to form a new government. According to various press reports, possible candidates include Finance Minister Pier Carlo Padoan, Senate Speaker Pietro Grasso and Culture Minister Dario Franceschini. The chosen candidate would then form a cabinet and seek confidence votes in both houses of parliament. If all goes smoothly, a new caretaker government should be in place before the Christmas holidays.

Next elections should see coalition centrist government

The next general election is scheduled in early 2018. It seems likely that there will be elections before then with a caretaker government likely calling elections once the reform of electoral law is finalised. We think the next election could be sometime in the second half of next year. The shape of the new government will partly depend on the specifics of the new electoral law. The reform that Mr Renzi passed would guarantee the winning party a clear majority in the lower house (see Box 1). However, it looks likely to be watered down by the caretaker government. For instance, the system could be changed to guarantee a coalition a clear majority rather than one leading party. If no reform of the lower house is passed, the next election would take place under a system of proportional representation.


The latest opinion polls suggest that the governing centre-left Democratic Party (PD) would still be the biggest party – see Figure 1. PD is currently polling at 33%, while the anti-establishment, anti-euro Five Star party (MS5) is at 28%. Still given the uncertainty of the polls and the potential for swings, MS5 still has a realistic chance of winning more votes than PD. The next biggest party in the polls is Lega Nord (LN – 12.1%) followed by Forza Italia (FI – 11.5%).

Our central scenario is that the Italicum will be watered down to give a coalition rather than any one party a clear majority in parliament. This would most likely mean that the government after new elections will be a coalition of the centre left and right (PD and FI). Alternatively, if the Italicum is left as it is, either a PD or Five Star government would result, though their policy agendas would be limited by the senate, which will maintain its power following the rejection of the reform. Finally, if no reform is passed and the next election is held under proportional representation, government formation would become very difficult. Assuming that PD and MS5 would not want to form a coalition, the other combinations look problematic, and would in any case need to involve a multitude of small parties. In this case, we could see a ‘Spain scenario’ where coalition negotiations are drawn out and a second round of elections become necessary.


Policy stagnation seems likely

The main implication of the No vote seems that there will be policy stagnation, which given Italian’s major economic problems, leaves the country vulnerable to shocks. Major economic reform before or – even after – the next elections seems unlikely. As noted above, the caretaker government will likely focus on the electoral law and will be in no position to pass major economic reforms. Meanwhile, a grand coalition of PD and FI after the next elections would probably have a relatively conservative policy agenda. Given they come from different sides of the political spectrum, it would be difficult for these two parties to agree on ambitious reforms, and it is any case unclear whether either have the appetite. Furthermore, the senate could also frustrate policymaking.

No vote reduces chances of euro referendum

The Five Star party wants to hold an in-out euro referendum (see Box 2 below). However, the No vote in the constitutional reform referendum makes the scenario of a MS5 government that could implement this policy even less likely. Under a watered-down electoral law, it has a very low chance of forming a government even if it is the largest party as it would struggle to form a government as it does not want to be part of a coalition (and other parties would not want to participate anyway).

If the Italicum is passed in its current form, it would then have a majority in the lower house if it won the elections. Still passing the law to have a referendum through parliament would be very difficult. The constitution does not allow referenda on pulling out of international treaties, though it does allow advisory referenda. However, to launch an advisory referendum, there needs to be a two-thirds support in parliament currently. Even assuming the Italicum reform sticks and MS5 wins the election, they would still struggle to achieve that. MS5 would then have 340 seats. Given current polling, the other Eurosceptic party Lega Nord would have around 55 seats. So it would need to increase its share of the vote significantly (from the current 12.5% to around 16.5%) to push the combined MS5-Lega Nord to the two-thirds majority necessary. It would be even more difficult to get a two-thirds majority in the senate. If it does not get that majority, it would need to have a referendum to hold the advisory referendum.


Italy faces major economic problems

Italy badly needs an economic reform programme to boost its potential growth rate. Its potential growth is generally estimated at close to zero due to ageing and weak productivity growth (see Figure 2). Surveys of international competitiveness suggest it is structurally one of the weakest economy’s in the eurozone, with only Portugal and Greece ranked more poorly (Figure 3). The low potential growth rate exacerbates the country’s two other economic problems: its mountains of government debt and non-performing loans.

161205-ew4  161205-ew5

Government debt ratio could spiral in case of shock

We have made some debt projections set out in the chart below. In the base case, we assume that nominal growth averages 2.5% in coming years, that the primary surplus gradually rises from 1.5% now to 2.5% and interest payments roughly trend at current levels. That leaves the debt ratio trending down only slightly to around 130% GDP in 2025 from 133% now. Furthermore, Italy’s debt sustainability could come into question in the case of even relatively moderate shocks. For instance, assuming 1% slower nominal growth and 1% higher interest rate, would see the debt ratio rising to 160% GDP over that horizon. Arguably the nominal GDP growth we assume is rather ‘generous’ given current potential growth estimates and trends in inflation.


Banking system needs more capital

At the same time, Italy’s banking sector needs more capital given the high level of non-provisioned loans. The immediate issue is the re-capitalisation of Banca Monte dei Paschi (BMPS). The bank, which failed and came last in the EBA’s 2016 stress test, is under ECB pressure to urgently improve its balance sheet. Principally, it needs capital to dispose of its EUR 28bn of bad loans. The political uncertainty could put its EUR 5bn recapitalisation – based on an equity issue with a soft underwrite from a consortium of banks – on hold. There will be an announcement later today.

We estimate that if the banking sector sells its NPLs at 25-35%, given the current provisioning, this would imply a capital short-fall of EUR 88-124bn. This amounts to 5.5-7.8% GDP. This would significantly increase the government debt ratio if there was a direct re-capitalisation following a bail-in. Up until now, the government has been trying to find private sector solutions to re-capitalise its banks, but there are serious question marks about investor appetite. We will publish a more detailed note on Italian bank credit later today.

Market reactions limited

At time of writing, the market reaction to the No vote in the referendum was relatively contained. The yield spread of 10y Italian government bonds over their German counterparts rose 11bp, taking it to around 173bp. This is around levels seen before the tightening at the end of last week. The euro weakened by up to 1.5%, but has since made up most of its losses. European equities are actually slightly up.

Negative on Italian bonds

We think Italy’s government bond spread over Germany will remain elevated. Given the likely economic policy stagnation, Italy’s economic vulnerabilities will remain in place over the next year and very likely beyond. We also remain negative on Italy’s bank debt on all levels given the size of the unprovisioned NPLs and the lack of a clear broad strategy for recapitalisation.

On the plus side, the ECB’s ongoing QE policy should limit the upside for Italy’s government bond yields. There have been some reports that the ECB could modestly step up purchases of Italian bonds if needed for a short time. Given current sovereign credit ratings, Italy has a quite a buffer before all four agencies place its debt in the sub-investment grade category that would make its bonds ineligible for ECB asset purchases. The ECB bases itself on the highest rating, which currently is given by Fitch, which is three notches away from sub-investment grade (though with a negative outlook). Meanwhile, the risk of a euro referendum in Italy has become even smaller.

However, Italy remains vulnerable to an economic shock that leads to a sharp deterioration in the outlook for growth and hence government debt and bank NPLs. In such a situation, the ECB’s QE programme may not be a sufficient stabilising factor. If Italy needed long-term support, it would need to officially ask for help according to the report. This would presumably be via the OMT, though that would require Italy entering a reform programme, which would be politically very challenging.