Arrivederci Italia?

The constitutional reforms are designed to remove the ability of the Italian Senate to bring down governments via no-confidence votes. In most democracies such powers normally reside only in the Lower House of Parliament and this sensible reform would bring Italy into line with its peers.

However, the referendum is turning into a confidence vote for Mr Renzi, who has said he will resign if the referendum reforms are not passed.  Opposing him is the populist Five Star Movement, led by an ex-comedian who wants to take Italy out of the EU. Five Star is a rising political party that recently won mayoral elections in Rome and Turin. It is only just behind Mr Renzi's party in the opinion polls. If the referendum reforms are rejected the most likely outcome would be the fall of Mr Renzi's government and an early election.

Italy is big enough to matter. It is the third largest economy in the eurozone and the eighth largest economy in the world. Italy has a wealthy and aging population of over 60 million people, GDP of over $US2 trillion (in PPP terms) and, unlike the UK, uses the euro as its currency.

Italy has recorded virtually no economic growth since it became a eurozone founding member in 1999. Italy's youth unemployment rate is 39%, well above the eurozone average of 22%. In Greece and Spain youth unemployment is above 45%, a level that is clearly unsustainable. Italy's public debt is more than 130% of GDP.

In many ways, Italy's problems (and those of many other eurozone economies) highlight the inherent contradictions within the EU of tying disparate economies to the same exchange rate and interest rate.

As Deutsche's macro team points out, Italian banks entered the GFC on average in better shape than their peers in Spain and Ireland. While Spain and Ireland intervened to address their banking crises, Italy managed to avoid an expensive public bail-out.

However, the prolonged crisis has saddled the Italian banking sector with a large amount of non-performing loans (NPLs). Italian governments did not take the opportunity to force a systemic solution due to concerns about a political backlash. The stock of gross NPLs reached about EUR 200 billion and Italian banks have taken provisions on them up to an average coverage ratio of about 60%. That means an implied carrying value of about 40% of the nominal value. The problem is that the average market value of NPLs is currently just 20% of the nominal value, half the implied carry value.

In normal circumstances it would be unrealistic to ask banks to solve the NPL issue immediately. It is a process that generally takes years. However, there has been a major loss of market confidence in Italian banks. That means that any major macro stresses, whether internal or from Brexit or elsewhere, disproportionally weigh on Italian banks regardless of the direct channels of contagion.

The Italian government has taken some limited steps to support the banking system but it has not been enough to remove market concerns, especially after the Brexit decision. Italian bank shares have nearly halved in price since the start of the year, worse than for any other EU country's banking sector.

Deutsche estimates that Italian banks would have to book EUR 43 billion of additional provisions if NPLs were valued at current market prices. That is consistent with recent rumors, denied by the Italian government, of a EUR 40 billion recapitalization plan. The capital hit of the additional EUR 43 billion provisions would be about EUR 28 billion, 1.7% of Italian GDP.

Also in October (on the 2nd) will be a Hungarian referendum on the EU's controversial plan to farm out refugees across all EU member states, and a re-run of Austria's Presidential election, which a right-wing nationalist candidate nearly won last time. Not exactly a recipe for La Dolce Vita.

Marcus Tuck is Head of Equity Research at Mason Stevens (VIEW LINK)