The results are in: The Italian referendum on constitutional reform held on Sunday has not passed, with the ‘No’ vote achieving 60% of the vote counted so far. Turnout was strong at 70%. Given that markets had largely priced in a ‘No’ result in advance, the immediate response from markets has been fairly muted with aggregate equities fairly flat but bank stocks down.
As promised Italian Prime Minister Renzi has stepped down following the “No” vote, increasing uncertainty around the political and economic agenda in Italy. The Italian President now has a number of choices; he may appoint an interim government to resolve the disjointed electoral laws between the Senate and House. By changing the current two-round majority bonus system (Italicum), the likelihood of the populist Five Star Movement winning a majority in the next general election, due to take place in 2018, would be reduced. Concerns about the democratic legitimacy of an appointed government may bring the election forward into 2017.
The President could also call snap elections, which would currently be held under ‘Italicum’ law. The majority-bonus system, combined with the Five Star Movement’s current popularity, would heighten the risk of a market-unfriendly outcome.
The temporary nature of an interim government likely takes substantive economic reforms off the table until after at least the next election. If the referendum result exacerbates concerns about the banking sector’s large non-performing loan (NPL) book, the government may have to act. Snap elections would introduce significant uncertainty to Italy’s economic outlook due to the significant divergence in party policies of Renzi’s Democratic Party, the populist Five Star Movement and other major parties.
If any political outcome is followed by a large rise in Italian (and other peripheral market) bond yield spreads, the ECB has options to step in. It could vary the pace of its monthly purchases to help provide some initial backstop, offer liquidity to the financial sector and supply supportive rhetoric. In a very acute scenario, Italy could apply for European Stability Mechanism assistance, which would make this member state eligible for the ECB's Outright Monetary Transaction (OMT).
Overall, the growth outlook in Italy remains muted in the short-term, with downside risks coming from the banking sector in particular that could be exacerbated by any snap elections. The failure to remove an obstacle to policy making by reducing the power of the Senate means that legislative inefficiencies remain but the result allows for continued checks on government power. The risk of a market-unfriendly surprise in the next election should be reduced if reforms to Italicum can be negotiated; however, the fractured political environment that remains makes impactful economic reforms very difficult from here.