Quando, quando, quando

Marcus Tuck

Italy's much-delayed constitutional referendum looks like it will finally go ahead on 4 December. It has the potential to destabilize the European Union if the "No" vote wins. As described in a report by State Street Global Advisors (SSgA), Italy's referendum effectively pits the technocracy against the masses who have been riding a wave of anti-government and anti-EU sentiment, similar to what is occurring across the continent. While there is general agreement with Prime Minister Renzi's diagnosis that Italy lacks the institutions to solve its problems, his prescription to reduce the number of political parties is not as widely accepted. With the stability and even the existence of the eurozone in question, SSgA anticipates that Italy's referendum may be another step on the journey towards a radical reorganisation of Europe. The opinion polls are very close, with undecided voters being in the majority (see chart). As was the case with the Brexit referendum, the result is too close to call, a Prime Minister has staked his political future on the outcome, and the consequences are potentially far reaching.

PM Renzi of the center-left Democratic Party (DP) is trying to reform Italy's political system. Two years ago he became prime minister by taking control through an internal coup of his party, which had formed after the Mani Pulite (Clean Hands) investigations in the 1990s led to a purge of corrupt politicians and public officials. The DP is considered a "broad church" organization with wide-ranging views encompassing the former Italian Communist Party, various regional parties and other hard-left parties. Governing in a coalition with seven other parties plus several independents, Mr Renzi has started an aggressive series of reforms across the Italian political landscape.

41 Prime Ministers and 92 Governments

Mr Renzi came to power arguing that Italy has a lot of problems but not the institutions to solve them. The main purpose of the referendum is to reduce the unusually strong powers of the Italian Senate, to make it more difficult to dissolve governments. In the 70 years since 1946, Italy has had 41 Prime Ministers and 92 governments. Mr Renzi's core reform efforts have been constitutional, targeted at the bicameral equality of Italy's two houses of Parliament. The Chamber of Deputies (Chamber) has 630 members who are elected from 100 regions or constituencies. The Senate has 321 members who are also elected regionally. As both houses can initiate and veto legislation, they generally represent two separate and equal governments. This equality is at odds with the traditional bicameral model, in which one house proposes and passes legislation while the other house reviews and ratifies it, as in Australia and the US.

In collaboration with former premier Silvio Berlusconi's center-right Forza Italia party, Mr Renzi championed the Italicum, a new proportional representation system that took effect in July 2016. This is designed to make the Chamber much less unwieldy and limit the rapid pace of political turnover.

The populist Five Star Movement (5SM) dislikes the new Italicum system, as it rewards the winning party in the Chamber with bonus seats. In the 2013 election, the 5SM won more votes than the DP, who needed a coalition to form a government, but the bonus system gave 345 seats to the coalition and only 109 seats to the 5SM. Believing coalitions to be a major source of corruption, the 5SM refuses to form one, and so they see the Italicum as a direct attack. The heart of the 5SM platform is a rejection of partitocrazia, which is the jockeying by Italy's political parties to acquire influence through money and power. They argue that direct democracy is a better model. Their fundamental issue with the proposed referendum is that one party, the DP, thought up the idea and has pushed it through as the only solution. Instead, the 5SM had demanded that the populace should have a clear say in the referendum proposal before it is voted upon.

The regional Lega Nord (Northern League) also opposes the constitutional referendum. Along with the 5SM, this federalist party is strongly against the EU in its current form. Lega Nord has supported some EU reforms but they oppose the single currency euro and favor regional power, which is anathema to the EU. A growing backlash against Illegal immigration is adding to their support.

Like David Cameron did in the UK, Mr Renzi will resign if the vote fails, making another election extremely likely. This is the big risk: the coalition government falls, and an election is held, with the 5SM taking the reins of power. The irony is that the Italicum rules could deliver a 5SM government. If no party gains 40% of the first-round votes, then a second-round vote occurs between the two leading parties, and the party winning a simple majority gets awarded the bonus seats, representing 54% of the Chamber's seats. A further irony is that a core 5SM policy is a referendum on Italy's membership in the EU. So if the 5SM wins that election, then a referendum on continued EU membership would likely soon follow.

A poster child for the EU

Italy is one of the poster children for the massive problems created by the EU when the euro was adopted, resulting in a fundamental structural contradiction between a single European currency and monetary policy for countries with very different fiscal conditions. Many critics describe Italy's membership in the eurozone as a disaster, since the country's traditional economic policy response was to frequently devalue the lira to improve its competitiveness. But adopting the euro removed that monetary lever. Over the past 20 years, Italy's real GDP (adjusted for inflation) has lagged Germany's GDP by a large margin, and price deflators have highlighted the tremendous competitive gap that Germany has opened up with the rest of Europe. In effect, Germany has hollowed out the industrial sectors of its EU partners. Italy has gone backwards as many of its industries have lost market share since 2008, leaving Italy's jobless rate in July at 11.4%, while Germany's is only 4.2%.

Longer term, SSgA questions whether the eurozone is sustainable if these structural contradictions are not resolved. SSgA's Chief Economist has argued that the euro may have doomed the EU. One alternative would be for the EU to start a series of fiscal transfers between member states. At this point, however, the EU's ability to negotiate a workable framework could be limited. Any solution would obviously affect how the monetary union operates or even survives. Without some fiscal transfers to smooth out the continent's disparities, we may see more countries look for avenues to return to their own sovereign currencies. While there is no clear mechanism for leaving the eurozone, popular opinion has a way of prompting politicians to take decisions and ignore legal technicalities.

The UK escaped many of Europe's problems by retaining the pound and yet still voted to leave the EU anyway. Brexit is a prime example of the sanguinity that markets can have ahead of large upheavals. Complex political and policy frameworks are difficult to model and understand - and even harder to predict. The UK referendum amply showed that financial markets prefer simple linear outcomes. The idea that the Leave campaign could win in the UK seemed so inconceivable that markets ignored the available polling information and failed to identify the limitations that pollsters faced, given the UK's noncompulsory voting system. Any changes bring uncertainty, and financial markets fear the unknown.

Brexit has already affected investment intentions in the UK and Europe because of the less predictable economic environment. From a tactical asset allocation perspective, SSgA considers Europe to be uninvestable post Brexit. Despite their valuation models indicating a potential opportunity to buy, SSgA choose to defer investing in European equities. By questioning what is not in the model, they assess the unknowns to be on so large a scale as to dominate their decision-making. The final outcome is unknowable, but SSgA believes the alternatives can be assessed and factored into investment decisions. If a failed Italian referendum leads to Mr Renzi's resignation as promised, followed by an election, a 5SM victory and a successful vote to leave the EU, this chain of events could have repercussions throughout European and global markets. With Italy as its third largest member, the monetary union would be affected immediately. The short-term market impact would likely be a depreciation of the euro against the US dollar, followed by the sell-off of European sovereign bond markets, possibly with German bonds going in one direction and the rest of Europe in another.

Faced with this potential outcome, investors in so-called riskless assets - like EU member bonds - may have to question just how defensive these assets really are. European yield curves could experience a parallel shift as investors consider a new risk premium, while European equities would weaken as analysts reduce earnings expectations. Ultimately, global growth could slow even further below trend, with negative revisions to global equity market outlooks following in turn. Such a scenario is far from certain, but it is just plausible enough for SSgA to judge that it is a risk not worth taking.Daily 20.10.16.jpg


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