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Italy braces for referendum that risks Brexit-style consequences

Michael Collins  |  22 Nov 2016Text size  Decrease  Increase  |  

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The Eurozone's third-largest economy could be beset by similar political turmoil to that unleashed in the UK when the Brexit vote succeeded.

 

Italy's populist forces scored their biggest success so far in 2016 when candidates for the Five Star Movement were elected mayors of Rome and Turin in June.

An anti-establishment mood on top of decades of economic stagnation helped secure these victories for the euro-sceptic protest movement led by comedian Beppe Grillo.

The same disgruntlement could soon trigger an even bigger triumph for Italy's populist forces. Prime Minister Matteo Renzi of the centre-left Democratic Party has called a referendum on December 4 on proposals to make the biggest revamp of the country's system of government since World War II.

To emphasise the importance of the proposals centred on reducing the power of the upper house, Renzi has repeatedly promised to quit if voters reject the measures.

Five Star, which heads the "no" forces, has pledged to keep the 41-year-old prime minister to his word--and polls show the referendum heading for a narrow defeat.

The seven-year-old movement, which wants Italy to quit the unpopular euro, said it would seek a snap election if Renzi were to step down, sensing it could do better than its second place in the 2013 elections.

The danger for investors is that a country of 61 million, which has sick public finances, a crisis-prone political system, weak institutions, a stalled and inefficient economy and a wobbly banking system, could face political upheaval within weeks.

If Renzi departs David Cameron-style after a lost referendum, the Eurozone's third-largest economy could be beset by similar political turmoil to that unleashed in the UK when the Brexit vote succeeded.

To be sure, the prospect of a Renzi defeat hasn't rattled Italian government bonds. Spain functioned during the first 10 months of this year without a government so Italy too could withstand political paralysis.

Rather than backfire, Renzi's threat might marshal voters to back his contentious proposals.

If the opposite happens, perhaps Renzi will be skilful enough to hang onto power atop his centrist coalition.

If he were to offer his resignation, Italy's President Sergio Mattarella has options besides a snap election to resolve a political impasse--he could reject the resignation if Renzi can command a majority in parliament, place Renzi in charge of a caretaker administration or replace him with a technocrat as happened when Mario Monti replaced Silvio Berlusconi in 2011.

But Italy's economy has floundered for another five years since then and the banking system is in crisis. Italy can ill afford a political detonation right now.

A "no" vote could unnerve global investors and shake confidence that Europe can resolve its financial and political crises.

The twist

Italy's post-war political system was designed to prevent the rise of another Benito Mussolini. To help thwart would-be autocrats, the political system in operation since 1946 gives equal power to parliament's two houses, the lower Chamber of Deputies and the Senate.

A government is only formed after a vote of confidence in each house and such backing can be revoked at any time. (An Australian government, by contrast, only needs the confidence of the lower house.)

While few of Italy's 63 governments since World War II have fallen because the upper house has withdrawn confidence, the Senate's ability to thwart and ultimately torpedo the executive adds instability to a politically fractured country.

Italy is so riven along regional, ideological, party and other political lines that governments are usually unwieldy coalitions incapable of passing landmark legislation.

Renzi's solution is to reduce the power of the Senate. Via the referendum, he wants to abolish the Senate's ability to vote on confidence in the executive and reduce its legislative scope and power, including its capability to delay legislation indefinitely.

Renzi is seeking to have senators appointed from regional legislative councils and mayoral offices (rather than elected), while reducing their numbers from 315 to 100.

The referendum is complicated by Renzi's parliamentary success last year in changing the way the lower house is elected. The law (known as the Italicum) enshrines two rounds of voting using proportional representation for the lower house.

It's most controversial aspect is that to prevent governments of unstable coalitions (a danger with any proportional-voting system) the law gives the winning party bonus seats to ensure it has a 54 per cent majority. The incoming MPs are chosen by the winning party, not by voters.

Among liberal democracies, only Greece has such a bonus system. Mussolini, however, introduced something similar in 1923 (although he didn't need it to gain absolute power) whereby the winning party was to receive 75 per cent of seats as long as it secured 25 per cent of the vote.

The upcoming referendum has become a de-facto vote on the new electoral law (which is subject to a legal challenge before Italy's Constitutional Court), making the decision on 4 December more provocative.

Among the issues voters have to weigh is that Italy has three major political groupings or parties (Renzi's Democratic party, the fading centre-right Forza Italia party created by Berlusconi, and Five Star, which denies it's a party).

Yet the electoral law is more suited to a two-party system much like Australia's is in practice. It is easy to envisage, for example, the lower house controlled by a party that gained as little as 30 per cent of the popular vote in the first round of voting, before winning the run-off and bulking up with the bonus MPs.

Voters have to decide whether they might usher in a prime minister who is perceived to lack legitimacy, yet who is protected by handpicked MPs and can swat away a tame Senate. In a sense, they have to weigh whether they would like a more autocratic leader.

Sick banks

Renzi's other hurdle to securing a "yes" vote is the anti-establishment mood raging in Italy, typified by the success of Five Star. Many social, political and economic grievances give rise to such populism. Italy sure has an economy to fuel its emergence; the economy has idled since the mid-1990s.

The adoption of the euro in 1999 hurt because it reduced Italy's competitiveness and removed the usual cure for stagnation--a plunge in the lira. Italy's economy has shrunk in five of the past seven years and is now 8 per cent below its pre-crisis output, while GDP per capita is down 12 per cent since 2007.

Italy's latest recession and decades of fiscal squalor have driven Rome's debt to the default territory of 132 per cent of output, the highest in the Eurozone after Greece.

Italy's feeble economy has damaged its banks. Problem loans extend to about 20 per cent of bank loans, and about the same percentage of Italian GDP. Italy's 400-odd banks hold about 10.4 per cent of their assets in government debt so Rome's finances are entwined in this mess.

Rome has taken steps to fix Italy's banks, most notably this year when it created a privately funded banking backstop. But the fund is undercapitalised and has linked healthy banks to the fate of the sick ones because the sounder banks had to donate capital due to EU rules against government bailouts.

Politically, Rome can't let any banks fail because bank retail customers hold (often unwittingly) about half of Italian bank subordinated debt. Under EU rules on state aid, these investors must lose their money before a government can rescue a lender, which happened in 2015 when four small lenders folded. Italy's neighbours can't let Rome weave past these rules because they will face the populist outcry.

Italy's EU and euro membership thus compound the country's political and economic woes. Italians are turning away from the superstate they joined eagerly as a way to bypass their country's political dysfunctions.

Renzi's proposals might reduce these. Or they might become far greater if a comedian-led populist movement can exploit Italy's euro-scepticism to take charge of solving Italy's problems.

More from Morningstar

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• The victory few saw coming and its impact on markets

 

Michael Collins is an investment commentator with Schroders. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind.

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