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Can Italy be saved?

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Can Italy be saved?

Bill Witherell is Cumberland Advisors' chief global economist. He joined Cumberland after years of experience at the OECD in Paris. The views and opinions expressed in this piece represent only those of the author and are not necessarily those of S&P Global Market Intelligence.

On Sunday, Dec. 4, Italian voters rejected by a wide margin a constitutional reform put forward by Prime Minister Matteo Renzi. The result plunges Italy into a likely period of extended uncertainty and seriously threatens financial stability. While the vote was on a reform of the constitution that would streamline parliament by changing the makeup and role of the upper house (the senate), the underlying issues were more profound, with far-reaching ramifications: Confidence in Prime Minister Renzi; the prospects for needed economic reform, including addressing the crisis in the banking system; and even Italy's continuing membership in the European Union are all in question. The prime minister had taken the unnecessary step of staking his government's future on the vote, and he announced last night that he will resign today.

The opposition was led by populist, anti-establishment parties. As a Dec. 1 column in The Financial Times argued, following a Renzi defeat, "Italy will at best be left with technocratic but unambitious governments." We would emphasize "at best," for there is a real threat now of a populist government emerging during the next several years. Leaders across Europe must be shuddering.

For investors, the greatest concerns relate to the threat to financial stability in the eurozone's third-largest economy, after Germany and France. Italy is also the globe's eighth-largest economy, with a government that is among the largest issuers of sovereign bonds. There is no comparison between the threat that the small economy of Greece presented to the European or global markets and the threat that an Italian financial crisis will pose. Of course, there is nothing new about Italy's being in an ungovernable political mess. The country has averaged about one government per year since World War II. Its economic decline relative to its eurozone partners, particularly those to the north, is more recent, dating from 1999, when Italy adopted the euro and lost its ability to revalue its currency.

Looking at International Monetary Fund real GDP growth data, Italy averaged about 1.5% in growth annually from 1998 to 2007 and then contracted 1.04% annually from 2008 to 2015. That compares with the eurozone's real GDP growth averages of 2.4% and 0.18% and Germany's averages of 1.7% and 0.91% over the same two periods. Italy's dismal economic performance over such an extended period must have contributed to the dissatisfaction registered in Sunday's vote. Recent forecasts by the IMF and Organization for Economic Co-operation and Development assumed that a banking crisis would be avoided and Renzi's reforms would go forward; they projected real GDP growth averaging close to 1% annually over the 2016 to 2018 period. The downside risk to these forecasts now appears large.

The problems confronting Italy's banking system would have been formidable even if the constitutional reform had passed and Renzi had remained prime minister. Italy's banks have a huge nonperforming loan burden, estimated at some 18% of their total loans, and they need to double their available capital to cover this debt. The world's oldest bank, Banca Monte dei Paschi di Siena SpA, is trying to raise €5 billion in new capital, and the larger bank UniCredit SpA is planning to raise €13 billion. Success in such capital raising efforts by these and other Italian banks looked problematic in any event. Prospects now seem very limited.

And the situation of the Italian banks continues to deteriorate. It is not surprising that deposits are leaving Italy and flowing north. Italy's TARGET2 balance, which is a measure of the money leaving Italy and going elsewhere in the eurozone, was negative €355.5 billion at the end of October, compared with negative €263.3 billion at the end of March, a 35.0% change in six months. The November-end balance was very likely even worse. The Sunday vote can be expected to further aggravate this situation.

Fairly soon the Italian government and/or the European Central Bank will have to step in to bail out the banks. An estimated €40 billion would be required just to keep the banks solvent. If the government rejects the bailout (rather likely should the populists come to power), Italy would have to turn to the ECB. Yet the country would then likely be faced with onerous requirements imposed by the European Stability Mechanism, similar to those from which the Greek economy is still suffering. The Italians would strongly resist this outcome, and a serious eurozone political crisis could well arise.

To close on a more positive note, Austrian voters on Sunday delivered a surprise defeat to the far-right, anti-immigrant populist candidate for president, Norbert Hofer, choosing instead the former leader of the Greens political party, Alexander Van der Bellen, a liberal-minded, "pro-European" economist. While the position of president is largely ceremonial, the vote had been viewed as a test of the strength of populist sentiment in Europe. Had Hofer prevailed, Austria would have had the shameful distinction of electing the first far-right leader since World War II. The outcome of the election is a result all European leaders will welcome.