The post-referendum market response to Italy’s referendum mirrored the reaction following the Brexit and U.S. election votes: calm after a knee-jerk negative reaction. After all, not much has changed—Prime Minister Renzi stays on in a caretaker role (perhaps through end year), after which it is expected a new government with similar political orientation would take over with a rather narrow mandate to pursue a revised constitutional reform plan, address critical governing issues such as migration, and complete a fix of the banks. Most market participants do not expect snap new elections. Italy today in this sense does not look much different than it did yesterday.
The fact that tail risks have been avoided this time is heartening. It in part reflects confidence in the European Central Bank (ECB), which is expected to extend quantitative easing this week and could consider other measures (such as advancing purchases) to support Italian bonds should market spreads come under pressure. Tail risks are by definition unlikely but dramatic if they occur, and sometimes they do. Like the Brexit rebound, today’s market calm doesn’t reduce my concern about the economic risks going forward.
The central economic risks facing Italy today are the same as before—banks and growth. Efforts to recapitalize the Italian bank Monte dei Paschi di Siena (MPS) now look in danger of collapse, as heightened political uncertainty may undermine investor’s willingness to back a €5 billion bank recapitalization plan strongly supported by Prime Minister Renzi. If so, a defacto nationalization by the government is likely required. MPS’s problems by themselves are not a systemic risk for Europe, but they are a bellwether for broader risks facing an undercapitalized and barely profitable Italian banking sector that, collectively, is systemic. Under new European Union (EU) banking rules, Italian banks need to recapitalize by end year, and the risks of a broader shortfall are now significant (most importantly, if market turmoil undermines efforts by Unicredit, Italy’s largest bank, to complete its €13 billion capital raising effort). Europe should consider extending that deadline, or otherwise creating additional leeway for state support, as a broader bail-in of private bank creditors, if required under the rules, would be destabilizing in the current unsettled environment.
All this occurs against the backdrop of incomplete monetary and financial union. It is almost cliché to argue that the current state of economic and financial integration is unsustainable—Europe must move forward or back, but can’t stand still. For now, easy money from the ECB enforces a quiet stability, and bond spreads for Italian banks (and for the government as well) remain quite low, but they are vulnerable to spiking higher. Still, with the ECB buying program in place it may be news flow about recapitalization and stock prices, rather than government bond spreads, that could be the leading indicator of an emerging banking crisis.
Banks without adequate capital don’t lend, and that means that perhaps the most significant legacy of the current vote is a continued headwind to anemic Italian growth. Unemployment likely will remain sky high, and disaffection with the current mainstream (and pro-EU) policies is likely to remain similarly high. That means that Italy remains an economic risk—perhaps the most significant one—for the future of the euro and Europe. There may also be broader spillover effects—notably in hardening views in Germany and other creditor countries towards debt relief and an International Monetary Fund deal for Greece—but the euro can survive Grexit. Italy is another matter.