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Italy – time to start worrying?

On the surface, the outlook for Europe has not looked this bright since before the financial crisis. Fears that the Brexit vote would unleash centrifugal forces that would pull the European Union (EU) apart have proved to be unfounded. If anything, Brexit seems to have galvanized the EU into forming a stronger union. Populist parties were seen off in the Austrian, Dutch and French elections, while the Eurozone economy goes from strength to strength. The European Central Bank (ECB) is even looking to very gradually dial back the level of stimulus it is providing, and the euro has soared in foreign exchange markets. However, there is one very large cloud in this otherwise bright sky: Italian politics.

Italy must hold a general election by May 2018. However, there is some uncertainty over precisely when the election will be held. Currently the two houses of the Italian Parliament are elected by different voting systems. The Italian President has expressed a desire to harmonise the voting system before holding the next election. Back in May it looked like the various parties had come to a compromise on a new system, which is what raised hopes of an early election. However, that compromise has since collapsed so ruling out elections any time soon. It now looks likely the elections will take place sometime early next year.

The reason the elections poses such a potential risk to Italy is the anti-euro sentiment of a number of parties. Indeed, of the major parties, only the centre-left PD is unambiguously pro-euro. The Northern League is perhaps the most negative, and would probably like to pull out of the single currency. The ‘populist’ Five Star Movement plan on holding a referendum in which its likely prime ministerial candidate, Luigi Di Maio, has suggested he would vote to leave the euro. However, until recently it seemed that that most likely outcome of the election was that a vaguely pro-euro coalition government would take office after the election.

Berlusconi returns

But in a recent newspaper interview, former Italian Prime Minister Silvio Berlusconi called into question this outcome when he expressed support for introducing a parallel currency to circulate alongside the euro in Italy. This is not the first time Berlusconi has discussed the idea, but his intervention was particularly significant in the context of coalition politics and the likely shape of the next government.

Berlusconi’s proposal is an attempt to find common ground with the Northern League (and other smaller parties), potentially to foster a centre-right alliance with his own Forza Italia party. This unified grouping currently scores around 35% in the polls. Added to the roughly 30% polled by the Five Star Movement, something like two-thirds of votes could go to anti-euro parties.

This number almost certainly overstates the degree of genuine anti-euro sentiment in Italy, with anger seemingly more focussed at domestic political elites than European institutions.

Referendum time

Nonetheless, it is certainly plausible that an anti-euro coalition government emerges from the election, perhaps held together by a pledge to hold some sort of referendum on euro membership. Such a referendum would be far from straightforward. Italy's constitution forbids referendums on matters that are governed by international treaties such as Eurozone membership. So any referendum on euro membership could not be legally binding. But this leaves open a number of other options. The new government could call a consultative, non-binding referendum. This could create a political mandate that ultimately steamrollers any constitutional constraint. Alternatively a referendum could be held on changing the constitution which clears the ground for a subsequent referendum to be held on euro membership.

It is still highly unlikely that Italy would vote to leave the euro, but it is clear the whole referendum process would be extremely disruptive.

It is still highly unlikely that Italy would vote to leave the euro, but it is clear the whole referendum process would be extremely disruptive. It is likely Italian banks would face a bank run during the vote as account holders fear forced redenomination of their accounts from euro into lira. It would be hard for the ECB to credibly stand behind the system with “whatever it takes” guarantees in this circumstance when there is not the political commitment to the euro from the Italian government. This is likely to lead to a very painful economic shock and possibly temporary capital controls.

So while the overall outlook for Europe is very positive, investors would do well to remember that political risks have not disappeared and the question of the euro’s survival has not been entirely put to bed.

Image credit: Scott Rae / Alamy Stock Photo





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