Italy’s referendum is next test for Eurozone stability

Political developments

ItalyItaly was one of the 6 founding members of the European Union (EU) in 1957, along with France, the Netherlands, W Germany, Belgium and Luxembourg.  Its referendum next month will therefore be a critical test of whether the Eurozone and EU can survive the pressure from the Populists.

If the Populists win, then the future of the Eurozone and the EU itself will be in doubt.

As often happens at critical moments, the subject of the referendum is of relatively minor importance.  It was called by Premier Matteo Renzi to amend the constitution by approving a reform of Italy’s Parliament.  The problem is that he then made himself the key issue in the referendum, by promising to resign if he lost, as he confirmed to Italian media last week:

If the citizens vote no and want a decrepit system that does not work, I will not be the one to deal with other parties for a caretaker government”

Italy is now in a 2 week blackout period for polling before the vote on 4 December.  But the final polls showed the “No vote” with a comfortable lead.  There is therefore a major risk that Renzi will soon be following UK premier Cameron out of office.  3 quite different Scenarios could then develop:

Another premier takes over.  Italian premiers have historically not lasted long.  Before Renzi took over in 2014, there had been over 50 different premierships since Italy’s first post-War premier, Alcide de Gasperi, resigned in 1954. So maybe, the revolving door revolves again, and a new premier is appointed by the President
New elections are held, and another premier takes over.  Renzi was the 3rd Italian premier in a row to take office without have a personal mandate from an election (neither Mario Monti or Enrico Lette had this).  An election may therefore take place, after which perhaps the revolving door revolves again
New elections are held and an anti-euro coalition takes office.  This would seem to be the base case Scenario, with a probability of at least 50%.  It would likely means that Beppe Grillo’s anti-euro 5 Star Movement would take office with Berlusconi’s Forza Italia and the Northern League, and would then hold a referendum on leaving the euro – with the aim of capping Italian debts and nationalising its banks, as Grillo has promised

Given that around €360bn ($400bn) of all Italian loans are classed as “troubled”, and amount to around one-fifth of total loans, capping the debts would cause major disruption to the Eurozone and global financial systems.  Leaving the euro would also mean, that foreign holders of Italian debt would be paid in Italian lira, not euros.  And presumably this would be after a devaluation of the lira.  So as the Financial Times warned on Monday:

“Since banks do not have to hold capital against their holdings of government bonds, the losses would force many continental banks into immediate bankruptcy. Germany would then realise a massive current account surplus also has its downsides. There is a lot of German wealth waiting to be defaulted on.”

DEMOGRAPHIC REALITY IS NOW CONFRONTING STIMULUS FANTASY
Italy’s real problem is not its Parliament, but that its economic policies haven’t adjusted to the New Normal world. Like most developed countries, politicians of all parties have failed since the end of the BabyBoomer-led SuperCycle, to understand the trade-off that has taken place between increased life expectancy and economic growth.  Italy has a median age of 45 years, and as the chart above shows:

 It now has only 24m in the Wealth Creating 25 – 54 cohort, versus 22m New Olders in the 55+ cohort
 By 2030, it will have just 20m Wealth Creators and 26m New Olders
 This is completely different from the 1950 position, when there were 18m Wealth Creators and only 8m New Olders

In addition, of course, Italy has become the main route for migrants and refugees following the EU’s deal with Turkey. 168k people have already arrived this year, compared to 154k in the whole of 2015 and 170k in 2014. Resources have been further strained by the sequence of earthquakes, which are made worse by the lack of anti-seismic regulations for its buildings.

It is small wonder, therefore, that the 5 Star Movement is building support, having won Rome in this year’s elections, whilst the Lega Nord (Northern League) won the Veneto and Lombardy regions.

Nor is it surprising that investors are starting to panic.  As I discussed on Monday, Italy’s 10 year interest rate has doubled to 2% since the summer.  It could go very much higher if Renzi loses, as the prospect of a vote to leave the eurozone and cap Italy’s debts comes closer.

This is the Great Reckoning in action, and there is probably little that the European Central Bank (ECB) can do to mitigate the position.  In a few weeks’ time, investors may well wonder how they allowed Italian interest rates to trade below US rates for much of the past few years.  And in a few months’ time, it may well seem equally incredible that anyone ever believed ECB’s President Mario Draghi’s 2012 boast that:

“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”. 

It could be a very difficult H1 in 2017.  Next month’s Italian referendum is followed in March by Dutch elections and in May by France’s Presidential election.  Both may well be won by parties committed to leaving the EU itself.

It is therefore hard to ignore the possibility that by June, the EU could have effectively ceased to exist in its current form.  Developing a contingency plan, in case this develops, could well be the wisest move you make in 2016.

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