Investors are understandably obsessing over Britain's vote next month on whether to leave the European Union. Yet even as that heady question gets answered, another binary ballot will loom with potentially bigger financial risks for the European economy and global capital markets.
In October, Italians will be asked to give a simple “sŢ” or "no” on a series of reforms to the republic's constitution. It could have been a relatively parochial affair, of marginal interest outside Italy, except that Prime Minister Matteo Renzi decided to make it a plebiscite on his leadership. He has told voters that if the changes his administration has championed are rejected, “I will return to being a free citizen. If I lose, I will resign the next day.”
Making the vote personal is a dangerous gambit, with consequences that could reverberate beyond the Alps. The 41-year old former mayor of Florence is far from perfect, but his track record since assuming office in February 2014 is laudable in the context of Italy's recent sclerotic past. The absence of a credible alternative to Renzi from the mescolanza of parties opposing his reforms ensures his resignation would rekindle worries about Italy's finances.
Italy’s debt
After Greece, Italy has the highest debt relative to GDP in the Europe, at some 133 per cent. So any sign the country is backsliding on its commitment to structural and economic reforms could shake markets. Over the past month, as polls emerged showing rising opposition to Renzi's referendum, Italian 10-year bond yields had risen by 8 basis points to 1.47 per cent, the biggest upward move among the continent's major economies.
This also reflects expectations that Renzi's Democratic Party (Partito Democratico) will take a drubbing in administrative elections, to be held June 5, when Italians will choose mayors for big cities including Milan, Rome, Naples and Turin. While Renzi has downplayed the importance of these races, a series of high-profile victories by opposition party candidates won't help his chances in October.
Indeed, two weeks ago an Index Research poll showed the anti-establishment 5-Star Movement led by comedian Beppe Grillo had overtaken Renzi's party as Italy's most popular political force. The poll, conducted for a popular television show, showed 28.4 per cent of Italians would now vote for 5-Star in a national election, compared with 28 per cent for the PD.
Voters’ choices
Among the changes voters will be asked to approve by referendum are a reduction in the powers of the Senate, or upper house of parliament, which will no longer have a role in the approval of the budget or most other legislation. The number of senators will be cut to 100 from 315, and they will no longer be able to bring down a government by withdrawing its confidence.
Streamlining the legislative process by modifying the constitution is critical to expanding on many of Renzi's economic initiatives, including changes to make the labor market more flexible and fixes to the nation's weak and fragmented banking system. Still to come is a much-needed rationalization of the bloated public sector. Without that, no serious attempt to reduce country's enormous debt burden can begin. A Renzi resignation would throw all of this into turmoil.
Renzi's economic advisers are confident the fruits of the government's many reforms will become further apparent as October approaches, giving a boost to the referendum's chances. Fabrizio Pagani, head of the office of Finance and Economy Minister Pier Carlo Padoan, sees economic activity picking up later in the year. “And growth is the primary way in which we envision reducing the public debt,” he said in a recent interview with Breakingviews.
There are some signs Renzi's reforms are having an impact. In March, for instance, the unemployment rate fell to 11.4 per cent, its lowest level in three years, down from 11.6 per cent, according to the state statistical bureau. If that progress continues, along with a more robust increase in output, Renzi will have a strong case to make by the time October comes around.
In fact, a victory for his reforms might even give him the political capital to ask President Sergio Mattarella to call for elections, on the basis that he and his allies can expand their standing in parliament. The alternative is for Renzi to go - and with it the rare stability Europe's second-biggest debtor has enjoyed in the financial markets for the past few years.