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What Is at Stake in Italy’s Upcoming Referendum?

Jacob Funk Kirkegaard breaks down this weekend’s vote in Italy, which, despite its rather technical nature, has financial markets concerned about another flare up in the country’s slow-burning banking crisis.
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Unedited transcript

Pedro Da Costa: I’m Pedro Da Costa. This is Peterson Perspectives. We’re here to talk about the Italian referendum coming up this Sunday and I’m joined by Jacob Kierkegaard; a senior fellow here at the institute and our resident European political economy expert.

So can you tell us a little bit what this referendum is all about and why markets and these global financial watchers seem to be very concerned?

Jacob Kirkegaard: Big picture-wise, this referendum is about changing the Italian constitution and it’s about trying to make the Italian political system work in a more nimble way so that there is less opportunities for gridlock and veto points, if you like.

Pedro Da Costa: Yeah, and more centralization if I understand it correctly.

Jacob Kirkegaard: More centralization because Italy now has what’s called ‘Perfect Bicameralism’ it means that the two chambers of parliament are exactly, legally equal. So it means that they have to vote on exactly the same bills and if one changes a comma, it goes back to the other chamber and then you kind of have a cycle of potential inevitable or a never-ending parliamentary debates over a particular bill.

So it’s basically, what you’re trying to do here is you’re trying to reduce the political wait of one chamber, namely the senate, by no longer making it directly elected and making it appointed and reducing its influence to only regional affairs and things like that.

So you want to centralize in one chamber, and then you have another related issue which is not the constitutional change, which is on the referendum, but the change in the election law for the lower chamber of parliament. Which is not the same, but it’s politically linked and that change right now has a provision that says that if a party gets more than 40% of the vote, they get a majority. So it’s basically trying to create more majoritarian and stable governments that can actually do something.

Pedro Da Costa: So why is it measured? It seems fairly technical, such a politically hot potato or flash point. And two, if it seems like a fairly reasonable change, why is it controversial?

Jacob Kirkegaard: Well the first question is quite simple. It’s because the sitting prime minister Matteo Renzi made a huge strategic blunder. He basically said that if this doesn’t pass, I will resign.

Pedro Da Costa: So this is a very Brexit like situation with David Cameron, right?

Jacob Kirkegaard: I mean, he for whatever reason decided to make this all about him and voters responded. So part of the reason why this fairly innocuous, technical change, I mean, it’s a pretty big change, but is now raising a lot of public opposition is that the problem being that, like with most referendums, people no longer vote about what’s actually the question what’s on the ballot. They vote about what they think the question is and right now, for a lot of Italians, this question is do we like the government of Matteo Renzi, yes or no? And quite a lot of people are now saying no.

Pedro Da Costa: What about Italy in the broader context? I’ve talked about Brexit but there’s this general fear that after Brexit, Donald Trump was elected here in the US and there’s a fear that there’s a nationalist or populist wave of whatever you want to call it. And that Italy maybe the next non-domino to fall and that France with elections early next year, maybe next. Is this part of that concern?

Jacob Kirkegaard: Not directly because this is not sort of the establishment versus populists or fringe parties. There is actually a lot of establishment opposition to this law. Some people believe that it gives too much power to potentially the prime minister. Some people don’t like the fact that you appoint the senate by regional governments because they claim that regional governments in Italy are corrupt. And so it’s not either or, but there is clearly a risk that if it’s a no, the prime minster resigns, the government steps down as a result, which is not a given, but maybe.

You have early elections and then the Italian version of a populous party, which is the so-called 5-star movement might win such an election. So there is a domino potential effect that somewhere down the line in the future, yes Italy could have a populist government but it’s not directly related to this vote, which as I said, is more complex in nature. So in that sense, I don’t think it’s correct to say that Italy, irrespective of the outcome, that this is really the next domino to fall, but there is this added element that, right now, you have a banking crisis.

Pedro Da Costa: This is my next question so, how does the banking system fit into this because Italy has been in the banking morass for a long time. It’s kind of a slow burning crisis, there’s never a full-on meltdown and bond yields are fairly low still and they can borrow but the banks are in trouble and they’re known to be in trouble. So how does a political situation affect that?

Jacob Kirkegaard: It affects it because Italy is essentially the only country in the crisis part of the periphery of Europe that hasn’t cleaned up its banks yet and they haven’t done that because Italy has a particular political problem with banking cleanups which is that in Italy, for a number of years, the Italian authorities, the central banks, basically allowed banks to sell retail depositors bonds.

So that banks were basically telling retail depositors, you know what? Let’s swap your insured deposits for this higher yielding bank bond. Don’t worry, it’s perfectly safe. Except that, of course, it’s no longer safe because, right now, you have a new set of rules—

Pedro Da Costa: And normally these bank bonds are traded more by, “sophisticated investors” or big banks and not by mom and pop.

Jacob Kirkegaard: Exactly, I mean this was essentially fraud and it was a fraud that was for many, many years basically, permitted by the Italian government and the Italian central bank partly in order, ironically, to allow Italian banks to raise money so that they could take over each other and prevent foreign takeover of Italian banks.

So this is fraud, there’s no doubt about it. But, I mean, the political problem now is that you have a case of a new set of European banking rules that says that these bonds are now bail-in-able.

Pedro Da Costa: Which means that they can be called upon—

Jacob Kirkegaard: Called upon to recapitalize the banks and basically all these retail depositors who perhaps clearly thought that, actually, their deposits were safe, now have run the risk of losing all their savings.

Pedro Da Costa: They thought they had money in the bank and now it’s a risk.

Jacob Kirkegaard: Which is a huge political problem. So this is why the Italian government had resisted basically dealing with this issue and so what happened over the summer was that Italy’s third largest bank, MPS a month Banca Monte dei Paschi di Siena which failed in the ECB stress test. And then, the Italian government, because they didn’t want to resolve it, came up with this convoluted scheme that allowed for some loans to be sold off, but fundamentally, this bank needs to raise 5 billion euros in new capital by the end of the year.

And the Italian government actually does have an agreement with JP Morgan and a syndication of international banks to underwrite this capital if the referendum passes. So if the referendum passes, this bank is saved or at least lives to be restructured and potentially, in the long run, be made viable. But if the referendum fails, it’s highly unlikely, in my opinion, that there will be 5 billion euros of investors’ money willing to go into this bank.

Pedro Da Costa: Got it. So then you need more state funding and that’s the core of the crisis.

Jacob Kirkegaard: That’s the core of the crisis because in order to get to state funding, you still under European law, had to do bail-ins. You’ve got to do bail-ins first and then maybe you can do state funding. So you get the political problem, if the referendum fails. And the other broader issue is that this is the biggest bank, it’s the third largest in Italy, but there’s a number of smaller regional banks that face the same issue. And the fear is that there is going to be a sort of -- I think this is probably not very credible, but there is a risk that there is going to be a generalized deposit run on a lot of Italian banks.

I doubt that will happen, but the risk is that depositors would suddenly wake up and think, oh wait a minute, they just got bailed-in, my deposits aren’t as safe, we’re taking it home and stuffing it in the mattress; if that happens, well then you could have a more systemic crisis. It’s a small risk but it’s a very directly, unlike the political populism argument -- it’s very directly related to the outcome of this referendum.

Pedro Da Costa: Well thank you so much for untangling this really complex issue for us.

Jacob Kirkegaard: My pleasure.

Pedro Da Costa: I appreciate it.