It’s not the end of the world, just the end of Matteo Renzi

Just before midnight local time, Italy’s Channel 5 projected a 60% “No” vote in the country’s constitutional referendum, a crushing defeat for the Socialist Prime Minister Matteo Renzi. The euro dropped by 1.5% on the news, but has recovered slightly; the yen gained initially, but has quickly fallen back to Friday levels and below. Asian stock benchmarks were lower in Monday morning trade, but there has been no catastrophic Italy reaction, indeed, no indication that index declines were Italy-related at all.

Renzi had promised to resign if defeated, and the overwhelming vote against him left him little choice. An hour after the size of his defeat became known Renzi announced he would resign as of Monday morning. There had been some speculation that Renzi would stay on as a caretaker prime minister, but it now seems clear that either a “technocratic” government will be installed or a center-right coalition of parties will form a transitional government with early elections likely.

The referendum coincided with Italian government efforts to avert a crisis in Italy’s banking sector, where roughly a fifth of all loans are in some stage of default. Italian bank stocks have lost almost two-thirds of their value in the past year. That is worrying because Italian banks own more than a fifth of Italy’s more than US$2 trillion of sovereign debt. The banks have been bailing out the government while the government is supposed to bail out the banks.

That has led some observes to warn of a financial crisis if Renzi’s reforms were rejected. There are two possible detonators for a crisis. First, the market could refuse to fund Italian banks in the wholesale market, forcing the European Central Bank to support them with temporary loans without restoring confidence. Second, the yield on Italian government debt could rise sharply, ballooning Italy’s budget deficit. Italy’s deficit now stands at -2.6% of GDP. With government debt at 130% of GDP, a 2 percentage point increase in Italy’s bond yield would double the deficit, leading to more upward pressure on bond yields in a vicious cycle.

Neither of these dire scenarios is likely to occur — at least not in the short term — precisely because the market and European official institutions have had months to anticipate them. The result is in line with opinion polls prior to the vote and was widely expected. The yield differential between ultra-safe German 10-year government notes and Italian sovereign debt of the same maturity had widened to more than 1.8 percentage points in the week prior to the referendum, but narrowed modestly in the days before the vote.

European rules forbid governments from bailing out banks unless bondholders lose money, that is, are “bailed in.” Italy’s banks have about 40 billion euros of outstanding junior debt, and more than half of this is owned by small investors, mainly retirees. The political ramifications of wiping out the savings of several hundred thousand Italians would be devastating, and no Italy government could survive such a move.

German government sources indicated that Berlin would be flexible in helping a new technocratic or center-right government in Italy to resolve the banking crisis. In the short run, that involves allowing the Italian government to put capital into its technically insolvent banks without bankrupting small savers, in a waiver of the rules. A great deal depends on the December 8 meeting of the European Central Bank, which now purchases 80 billion euros of securities each month under its quantitative easing program. Prior to the Italian vote the market consensus expected the ECB to announce a six-month extension of its program at the same volume. After the Italian vote, Germany will almost certainly support this measure, and leave open whether the program might be extended once again.

Although Renzi had wrapped himself in the mantel of reform, his European partners worried that the specific constitutional changes that he offered would give him quasi-dictatorial powers. These misgivings were summed up in a November 26 editorial in the Economist magazine:

“Mr Renzi’s constitutional amendment fails to deal with the main problem, which is Italy’s unwillingness to reform. And any secondary benefits are outweighed by drawbacks — above all the risk that, in seeking to halt the instability that has given Italy 65 governments since 1945, it creates an elected strongman. This in the country that produced Benito Mussolini and Silvio Berlusconi and is worryingly vulnerable to populism.”

Despite official statements of support for Renzi in the days before the vote, Germany’s coalition government under Angela Merkel is far more comfortable with a center-right coalition in Italy and more willing to show flexibility after Renzi departs. The much-anticipated Italian financial crisis appears to have been preempted and — at least for the next several months — Italy will have a backstop from its European partners while it undertakes a bank reorganization.