Italy Caught Between A Rock And A Hard Spot

Italy is caught between a rock and a hard spot. A lot is riding on just how certain forces react to Italy's vote and looming in the background is the possibility it might set in motion a series of events that could break apart the Euro-zone. Several key EU figures, such as European Commission President Jean-Claude Juncker and German Finance Minister Wolfgang Schaeuble, have tentatively backed the passage of the referendum indicating a "no" vote could lead to a destabilization of the entire bloc. Many economic watchers believe an altogether quieter crisis lurks at the top of the worry list, and that is Italy’s battle to prop up its debt-laden banks. As proof of their concern, we have only to look at the Central bank which has told Reuters the ECB is ready to temporarily step up purchases of Italian government bonds if the result of the referendum sharply drives up borrowing costs for Italy.

Italian Voters Cast Their Vote

In recent years the economic conditions have not been kind to Italy where unemployment stubbornly remains at 11% and living standards have barely grown since the country became a founder member of the single currency 15 years ago. Nine years after the onset of the financial crisis in 2007, output remains 8% down from its pre-crash level. Italy’s debt, the second-largest in the euro region as a percentage of GDP sits at a whopping 141%. As expected much of this is reflected in Italy's unhealthy banking sector. Adding to the countries woes is the migrant crisis that has worsened with time, every month 25,000 people now arrive on flimsy boats traveling across the Mediterranean Sea from North Africa.

The December 4th referendum on constitutional reform was approved by parliament in April after almost two years of fierce debate. It effectively abolishes the Senate as an elected chamber and prevents it from bringing down a government via a vote of no confidence. Proponents say this will streamline Italy’s political system, clear a path for needed reforms and ensure a clear winner in the next general election. Under the current system, the upper and lower houses of parliament have equal powers and critics say this is one of the reasons why Italy has had 63 governments since World War Two. “We want a more stable and more simple country,”  Matteo Renzi, the Italian prime minister said in a statement after the date for the vote was announced. “Whoever desires change, lend us a hand.”

All opposition parties have lined up to denounce the constitutional reform, with some critics arguing that it strips Italy of vital democratic checks and balances currently in place. Matteo Salvini, head of Italy's Northern League a "no" vote is a "vote against the rules and regulations of Europe" adding that he felt Europe had let Italy down. imposing financial restrictions on its debt-ridden banks and providing little help over almost half a million migrants that had entered the country in the past three years. Yet while opinion polls in a survey in the newspaper La Stampa recently indicated that 71 percent of Italians think leaving the euro would make the country’s economy worse rather than better.

Eight years after the start of the global financial crisis when the UK’s banking meltdown was marked by the queues of panicking customers outside bank branches Italy is facing decisions that will shape not just the future of the Italian banking system but that of the banking system throughout Europe. Non-performing loans (NPLs), those on which customers’ repayments have fallen behind remain a problem. Banks across Europe's index of shares for 600 European banks is down 22% so far. But Italy’s bank stock index is down 35%, with its biggest bank down 40%. Italy has more than 500 banks, and more branches than restaurants lay scattered across the county. They are weighed down by €360bn (£305bn) of bad debts. These create a heavy cost that hangs over them at a time when revenues are under intense pressure since the ECB has cut rates to zero. All this creates a rather complex situation and driving wealth out of Italy.

As far-fetched as the thought Italy would  follow the U.K.'s example and leave the European Union may seem, capital flows suggest that some people aren’t waiting to find out. Europe's central banks track flows of money among the members of the currency union. If, for example, a depositor moves 100 euros from Italy to Germany, the Bank of Italy records a liability to the Eurosystem and the Bundesbank records a credit. If a central bank starts building up liabilities rapidly, that tends to be a sign of capital flight. Lately, Italy's central bank has been building up a lot of liabilities to the Eurosystem. As of the end of September, they stood at about 354 billion euros, up 78 billion since the end of May. The outflow isn't quite as large as during the sovereign-debt crisis of 2012, but it's still significant. The main beneficiary is, of course, Germany, which has seen its credits to the Eurosystem increase by 160 billion over the past year.

People are clearly worried about the state of the country's banks, which are suffering the consequences of bad lending, poor governance and a new euro-area oversight system that makes rescues difficult. Another is political: Italian Prime Minister Matteo Renzi has staked his fate on a December government-reform referendum that, if it goes against him, could strengthen opponents who want to force a vote on whether Italy should remain in the common currency, a key element of the broader union. In that context, it's not surprising that some depositors prefer not to hold Italian euros, given the chance that they might eventually be converted into lira. Either way, the capital flight doesn’t speak well of confidence in the European project. This is something EU leaders will have to keep in mind as they negotiate the terms of Britain's exit.

Austria is the first EU nation to hold a presidential election and face this growing populist sentiment since Trump's surprise victory in the United States. This means both the votes in Austria and Italy are also being viewed as a test of the momentum behind the people's revolt that has led to Donald Trump's presidential win and the historic British vote to leave the European Union. Anxieties over immigration, security and the economy have created vast support for anti-establishment parties and nationalist movements in Europe, the United States and across the world. French President François Hollande, whose popularity has plummeted announced he will not seek re-election next year, saying he wants to give his Socialist party a chance “against conservatism and, worse still, extremism.” The events taking place on the world stage are  indeed far from dull.