Italy’s Referendum Risks

The U.S. Ambassador to Italy, John Phillips, caused a minor uproar by telling the Italians that international investors were going to be disappointed with a ‘no’ vote in the upcoming referendum on constitutional reforms.  At about the same time, Finch announced that a popular rejection of the reforms would put downward pressure on the country’s ratings.  The Italians responded that the ambassador should mind his own business and that the ratings agencies should find some new analysts.  Italy will be fine whatever the referendum outcome, they insisted.  If anything, this unwelcome foreign intervention is going to encourage the Italians to vote against the reforms just to prove a point.  The echoes with Brexit were obvious – and widely noted.  So is Italy headed for disaster or is this just another storm in a teacup?

Scenario Planning

It is hard to give a straight answer to the question.  The reason is that there are so many forks in the road.  If you drew this out as a decision tree, it would look more like a giant redwood than a desert cactus.  There are so many ways that this could end up alright; and quite a few where it could go terribly wrong.  Alas, no single fork in the road can tell you which direction you are headed.

The first challenge is to see whether Italy will maintain the electoral law that was just introduced for the Chamber of Deputies.  That electoral law is important because it gives the largest political party that receives more than 40 percent of the vote in the first round of polling an outright 55 percent majority in the distribution of seats.  If there is no party that gets more than 40 percent of the vote, then the two largest parties will go into a run-off election to see who gets the majority bonus.  The country’s highest court is scheduled to deliver its ruling on the constitutionality of that law on 4 October.  That court could vote to keep the law, it could amend the law, and it could also decide to defer its decision until after the referendum.

  • If the Court keeps the law intact, then Renzi is happy but many of his adversaries are not. Indeed, many people within Renzi’s own Democratic Party have said that they would vote ‘no’ in the constitutional referendum if this electoral law is not amended.
  • If the Court strikes down the electoral law, then Renzi will be unhappy and his adversaries will be emboldened. Moreover the kind of changes that the Court can introduce into the electoral law are not going to make anyone suddenly fall in love with the constitutional reform process; instead they will make it easier for Renzi’s opponents to argue that Italy should go back to the status quo ante.
  • Since the Court cannot make a clear decision without having an impact on the referendum, it may decide to defer its ruling until after the referendum is over. It is not clear what impact this could have on voting intentions.  And, this deferral may provide an important relief valve should the referendum fail.

Once we know what is happening with the electoral law (up, down, or punt), the question is whether the voters will support the constitutional reforms.  The main reform is to demote the Senate so that the government only needs a majority in the Chamber of Deputies in order to pass legislation.

  • If the people vote ‘yes’ to support the constitutional reforms, then the Senate is demoted and whatever electoral law applies for the Chamber of Deputies will end up determining who runs the country – a single party or a coalition government.
  • If the people vote ‘no’ to reject the constitutional reforms, then any government will need a majority in the Senate as well as in the Chamber of Deputies. If the current electoral law is upheld, then those majorities will look very different – because the current law applies only to the Chamber of Deputies; the Senate will be elected under (what is left of) the old electoral law, which is more proportional.  This means one party will control the Chamber of Deputies the government will need a coalition to control the Senate.  That is a little like what Italy has at the moment – but the differences between who holds power in the two different chambers will be even starker because the current electoral law for the Senate is even more proportional than the electoral law that was used in the last election.
  • Fortunately, the people cannot vote to defer the constitutional reform issue and so they have only the ‘yes’ or ‘no’ options. But, if the Court did decide to defer its own ruling on the electoral law for the Chamber of Deputies, then it could use its judgment to strike down the current electoral law in the event that the ‘no’ vote wins the referendum and so return Italy to the status quo ante before either the electoral law or the constitutional reforms were introduced.

The third issue is what happens after the referendum.  Here it makes sense to combine elements to bring forward the discussion of both the constitutional reforms and the electoral law.  To keep this short, I am going to focus on the central scenarios.

  • If the Court upholds the electoral law and the ‘yes’ vote wins in the constitutional referendum, then Renzi will come out of the whole process with a great victory. But he will still have the same lopsided government and two years to run on his parliamentary mandate.  He will also have significantly less than 40 percent of the popular vote, at least if the most recent run of public opinion polls is accurate.  Worse, he looks unlikely to win a run-off against his largest opponent, which is the populist Five Star Movement (M5S).  So a short-term victory could turn into a medium-term problem.
  • If the ‘no’ vote wins in the referendum, then Renzi will resign from office no matter what the Court decides about the electoral law. The President of the Republic could refuse to accept Renzi’s resignation or, more likely, he could ask Renzi to form the next government.  But the blow to Renzi’s prestige would be considerable, he would face the same existing parliamentary situation, and he would confront the same opposition from the M5S.  Ironically, for Renzi, the situation would be worse if the Court upheld the current electoral law than if it used its authority to strike it down and replace the majority bonus for the Chamber of Deputies with a more proportional system.  So the question is whether the existing parliamentary majority is resilient enough to debate a new electoral reform before the current parliamentary mandate expires in 2018.

Twin Tail Risks

None of these scenarios sounds particularly promising.  Nevertheless, Italians tend to look at this as ‘business as usual’.  So the question is whether there are tail risks hiding in this morass of details.  Two risks are worth considering.

The first of these has to do with the patience of the Italian people.  There is a reason why the M5S is doing so well at the polls.  It is not their competence in local administration.  It is their ability to drive out the ruling elites.  The longer Italy remains immobile, the stronger this support for the M5S will become.  That is why it is not just important that Renzi wins the referendum and protects his other reform legislation (including the new electoral law), but also that his government takes advantage of their victory to show the capacity to change more and faster.  That is a huge challenge, but the possibility that the Italian people will elect a political party that is incapable of governing effectively as an alternative is all too real.

The second tail risk derives from the patience of the investment community.  If you have made it this far in the comment, then you are well above average in patience for this issue.  Most investors won’t waste either the time or the money that time represents.  That is the problem.  Most investors in Italian assets are holding onto their positions because it doesn’t really matter what happens in domestic Italian politics.  So long as the European Central Bank is engaged in its large scale asset purchases, they can afford to ignore the daily maneuverings of the Italian political class.  The problem is that the ECB is going to struggle to keep up the pace of purchases much beyond March 2017.  And in either of the central scenarios sketched above, this situation is likely to drag on until the end of the current parliament in 2018.  That means at some point either Mario Draghi is going to have to pull another rabbit out of his hat or large numbers of impatient asset portfolio managers (who would never bother to read this far) are going to wake up to an incomprehensible situation where an Italy beset by real world crises is engaged in unending debates about electoral system designs and constitutional reforms.  When that happens, they will look at price declines in the bond markets and start jogging toward the exit.

Bottom Line

The current Italian situation is more complicated than the headlines are saying and that complexity is the problem.  Italy will muddle through, no doubt, but the Italians themselves are getting increasingly fed up.  Whether or not the international investment community is paying attention now is not what matters.  I think Ambassador Phillips is wrong on that point.  What that investment community does when it wakes up to the Italian impasse, is more important.  Italy has a short window now where the ECB has bought it some indifference.  If Renzi can capitalize on that time to make meaningful reforms – including, but not limited to, the upcoming constitutional referendum – then he may even succeed in bringing the Italians along with him.  If Renzi falters, however, it won’t matter much whether or not he stays around.  Because it will only be a matter of time before either the Italian people or the international investment community loses their patience.