Europe Braces For Italy’s Referendum

On December 4, Italians will vote on constitutional changes aimed at streamlining the country’s complex political system. Prime Minister Matteo Renzi has said he may resign if the reforms are defeated, raising fears of prolonged political instability in Italy and renewed economic turbulence across Europe. If Renzi’s government falls, the government’s bank rescue efforts could be impaired. “That uncertainty could easily generate a self-fulfilling run on the banks as capital pulls out of the country,” says CFR Senior Fellow Robert Kahn in a written interview. Italy’s problems reflect the vulnerability of the broader European economy, he says, and trouble in its banking system could tip the continent back into crisis.

Italian Prime Minister Matteo Renzi campaigns for his constitutional reforms during a rally in downtown Rome on October 29, 2016. (Photo: Remo Casilli/Reuters)

How would these constitutional reforms change Italy’s political system?

The reforms would change the way Italy’s legislature is elected, most importantly through reducing the powers of the Senate and replacing its 315 members with a more manageable 100-member body drawn mainly from regional councils. Currently, Italy’s Senate and lower house together are responsible for passing legislation, which many argue leads to gridlock. In addition to eliminating overlapping powers between the lower and upper houses of the country’s bicameral legislative system, the reforms would force the Senate to cede to the lower house its power to block legislation and bring down governments through votes of no confidence. In line with other changes to the electoral system, the measures would centralize government and strengthen the power of the prime minister.

Why is Prime Minister Renzi pushing them now?

The timing of the referendum is largely driven by domestic politics. Prime Minister Renzi has pursued these reforms since coming to office in 2014, and this referendum was called after parliament failed to pass the changes by a two-third majority earlier this year. He argues that a “yes” vote will provide critical political stability, streamline decision-making, and make it easier to pass essential structural reforms.

However, following the Brexit vote and ahead of upcoming elections in 2017 in France and Germany, where anti-establishment parties have been gaining steam, it hardly seems like a propitious time for another European referendum that gives vent to populist, antigovernment sentiments.

What is behind the fears that the outcome could put additional stress on the Italian banking system? Is that fear justified?

The government’s plan to recapitalize its weakest banks relies on significant private-sector funding, including through a five-billion-euro fund established earlier this year. The failure of the referendum could lead to the collapse of the Renzi government, and that would raise questions about whether the bank rescue effort would go through. That uncertainty could easily generate a self-fulfilling run on the banks as capital pulls out of the country.

As with Brexit, fears of an immediate crisis may be overblown. If the referendum fails, Renzi could be replaced with a technocratic government that would seek to provide continuity in governing. But there is little doubt that a “no” vote would would usher in a period of sustained political uncertainty that would complicate efforts to right Italy’s economic ship. And a weak Italian economy means more nonperforming loans, weaker banks, and a continuing banking crisis.

How big of a contagion risk do Italian banks pose to the rest of Europe?

Less so than in the past, but the risk is still significant. Since the global financial crisis hit Europe in 2009, a lot of progress has been made  in reforming and recapitalizing the continent’s banks, but we are far from the finish line. Further, while Italian banks are a small percentage of the broader European banking problem, their fundamental problems—large amounts of nonperforming loans, weak profitability, and inadequate capital—are endemic to the continent. 

If the European economy were strong, it could easily weather problems in Italy. But against the backdrop of slow growth and the wide range of other political and economic challenges facing the European Union, a systemic problem in Italy’s banks could tip the region back into crisis.

Is the European Central Bank prepared to take further action if markets react poorly and bond yields continue to rise? What options remain for the ECB?

There is no doubt that the ECB staff has had late nights war-gaming how to respond to a “no” vote this weekend and will have well-developed contingency plans. In some respects, the playbook is likely to borrow a page from the Brexit response: seek to reassure markets, provide ample and visible liquidity, and stand ready to adjust monetary and credit policies to ensure the smooth functioning of markets.

The harder challenge will be how to respond to the possible bankruptcy of an Italian bank, which would raise questions about the “bailing in” of bank creditors. EU banking rules are strict in asserting that struggling banks must be recapitalized, or bailed in, by their investors before state aid can be provided, but in Italy many bank shares are held by ordinary depositors who were not informed of the risk involved. Such a bail in would be politically toxic, and so Renzi was pressing for flexibility on this point. But in a crisis EU governments may struggle to get a consensus on how to proceed. This is a question that governments, not the central bank, will need to answer.

Italy has had one of Europe’s most stagnant economies in the past decade, beset by slow growth and high unemployment. How can it escape this trajectory? 

There is broad agreement that Italy needs a comprehensive set of labor, product, and service market reforms to break out of its low growth trap and bring down its sky-high debt ratios—at over 130 percent of GDP, Italy’s public debt is the second highest in the EU. That Renzi’s proposed reforms will make this easier to achieve is the best argument for the referendum.

But even if Italy can maintain political stability, growth is expected to only be a little over 1 percent over the next several years, insufficient to bring down soaring youth unemployment and to restore confidence in the longer-term trajectory of the economy. Italy also needs strong European growth not only to boost consumer demand, but also to support reforms of the Italian economy that will be difficult and disruptive in the short term.

This interview has been edited and condensed.