Italian Referendum: What to Expect?

Italian Referendum: What to Expect?

photo: Bobby Hidy

In spite of the widely spread expectations of prominent analysts, pollsters, and economists about the likely victory of the “Remain” (in the EU) campaign in the referendum held in Britain on June 23rd, 2016 and the almost certain expected victory of Hillary Clinton in the U.S. Presidential elections of November 8, 2016, surprisingly, the results have been quite different, and for many, absolutely unthinkable.

So what went wrong?

Why did it happen?

Probably many analysts and economic commentators have concentrated their attention mainly on the media coverage “firepower” each candidate (USA presidential election) or supporters of the Yes/No vote (UK referendum) have been granted prior to the election or referendum, or on the astonishing financial contributions they received for their very aggressive political campaigns.

They have also probably expected that most people, faced with the perceived potential negative outcome of the election or referendum (at least from the perspective of most analysts and economists), and the high level uncertainty about the political consequences of a “Brexit” scenario or Donald Trump’s victory (i.e. more restrictions on immigrations policies, changes in the global trade policies, repeal of the Obamacare and Dodd-Franc Act’s, etc.), would have not dared to take a contrarian view or voting preference from the general propaganda of mainstream opinion leaders, political and leading financial institutions’ heavyweights, and elites.

Numerous leading media organizations and broadcasting networks have in fact heavily relied on a widespread rhetoric about the dangers of “populism,” discouraging voters from voting against mainstream ideologies and candidates. Thus, they probably expected that the massive media pressure on voters would have eventually convinced undecided ones to opt for the more reassuring concept of political stability, thus confirming the leadership and “status quo” of the existing political and financial elites.

…… but as these analysts have later found out, things just turned the other way.

Anti-establishment and anti-globalization movements declared to have paid the price of unfettered globalization and deregulation (i.e. manufacturing relocation and outsourcing of major parts of the value chain activities to low cost countries, illegal immigration which creates a source of cheap labor, the underground economy and the black market, and the race to the bottom and labor market deficits in advanced economies as a consequence of the lower labor rights in the emerging and developing markets).

After the initial emotional shock and great surprise of many, due to the unexpected victory of the “Brexit” campaign and Donald Trump’s presidential election, now the world is turning their anxious attention to the next possible casualties of the growing and widely spreading anti-establishment and anti-globalization movements.

As it is well-known, financial markets in general do not like uncertainty or political instability, especially when weaker economies still have a long way to go in order to fix their economic and financial imbalances; bolster their moderate GDP growth; reduce their huge debt burden (i.e. public debt and/or corporate debt); and improve their underperforming output with more solid growth trends, productivity, social mobility, and global competitiveness. All these weak structural factors, if not promptly and effectively addressed and solved by political leaders, might eventually threaten global investors’ exposures (i.e. firms equities, bank shares, corporate bonds, structured products, or sovereign bonds) in these riskier countries in case of a sudden leap into political instability.

So these days everybody’s attention is turning to the next series of elections which will be held in Europe in 2017 and to the soon to come Italian Constitutional Referendum of December 4th, in which the country will be voting on constitutional reforms proposed by the current government.

It’s true that today, differently from the days of the Eurozone debt crisis, thanks to the availability of the unconventional monetary policy tools of the European Central bank (i.e. QE program and OMTs); the existence of the main pillars of the European Banking Union (with the exception of the European Deposit Insurance Scheme); a stronger macroprudential regulation (although the shadow banking business stills lack adequate governance and oversight) and microprudential regulation; and the potential support of the ESM (European Stability Mechanism) in case of crisis, there is probably a more resilient financial system in a number of peripheral European economies. It is also true that economic recovery from recession has occurred in most European countries over the past few years thanks also to a number of external factors (i.e. the unconventional monetary policies of the ECB, low interest rates, and low oil prices). European leaders should also consider the benefits of the potential creation of a European Bad Bank in order to solve the complex NPLs problems of many European banks, as the author of this article proposed in an interview with Class CNBC on July, 12th, 2016.

The predominantly domestic ownership of the Italian sovereign bonds and the declared ECB’s commitment to assure financial stability and to reduce volatility after the vote certainly aims to reassure a number of foreign investors that there will not be dramatic headwinds in case of a “No” vote at the Italian Constitutional Referendum of December 4th 2016.

Yet, it is also true that in the last year the Italian banking system has been under a considerable pressure from the financial markets to solve its structural problems related to the high level of gross non-performing loans (The total NPLs before provisions – gross NPLs- amount to €360 billion, with net bad loans amount to €85 billion); low average profitability of banks; low productivity and efficiency in the industry; poor corporate governance; a few cases of banks’ securities mis-selling; and the failures and subsequent rescue of four small local banks (i.e. Banca Etruria, Banca Marche, Carichieti, e Cariferrara) which caused pain to numerous local retail investors (i.e. shareholders and subordinated bondholders) due to the European Burden Sharing Rule which is part of the BRRD – Bank Recovery and Resolution Directive, and which since January 2016 includes also the so called “Bail-In” rule. In fact, shares of Italy’s banks have suffered heavy losses in the last year.

Italy has arranged to create in the last year a sort of private rescue fund and recapitalization fund (Atlante I and Atlante II) whose goal is to hoover up the worst of the toxic debt off the banks’ balance sheets. Yet, currently, Atlante I and Atlante II do not seem to have enough firepower to steady even some of Italy’s smallish regional banks, which means that the larger banks at the center of Italy’s banking crisis such as Monte dei Paschi (i.e. the 500-year old bank who currently has nearly worthless shares at €0.29) or Unicredit, have tens of billions of euros of nonperforming loans (NPLs) festering on their books.

Although the turbulence and volatility in the Eurozone is not currently elevated to systemic risk level, policy makers and regulators are probably not underestimating the impact of a rising potential economic and political instability in the coming months and years driven by the anti-establishment and anti-globalization movements.

In this complex context, political leaders, regulators and supervisory authorities should probability focus their attention on balancing the need for their countries’ growth and fiscal consolidation measures, with also sustainability, increased capital investment, and social inclusion goals in order to lessen the pain of the less educated and competitive segments of society. They should also continue to enforce effective reforms in order to restructure and recapitalize troubled banks’ weak balance sheets, their business models and poor corporate governance in order to bolster innovation, profitability, and sustainable growth. For this purpose M&A strategies, turnaround plans, near-banking and alternative lending solutions and the development of more advanced cross-border capital markets might certainly provide an additional competitive edge for the economic recovery of the Euro zone and the reduction of the lasting credit crunch problem affecting many SMEs and households. It is also important that many SMEs will progress in their effort to strengthen their capital structure, innovation capabilities, business models, and traditional small-size constraint through mergers, global value networks, and enhanced access to capital markets.

In the USA, as well as, in Europe policy makers and regulators need to address and solve the rising problem of inequality and anti-establishment movements while keeping a focused attention to preserve the benefits of globalization, global competitiveness, and free market economy towards more sustainable and balanced global economic growth, prosperity and innovation-driven environment thanks also to the revolutionary and disruptive competitive advantages triggered by digital manufacturing (industry 4.0), IOT, mobile devices, smart technologies, robotics, automation, open innovation, circular economy, green economy, clusters, and global value networks, and improved education.

The immediate resolution of the banking crisis and the restructuring of the banking industry in Italy now is critical since, in addition to help revamp a steady growth trajectory in a country which has been hampered by a moderate growth and high public debt in the past decades, it will eventually reduce the risk of potential spill-over effects to other European fragile banking systems, which might in the worst-case scenario turn into systemic risk. The ECB can certainly provide a firm support to keep sovereign debt sustainable with very low or negative interest rates but, one way or another, it remains critical to achieve a definitive solution to the banking crisis in this European fragile industry, in spite of the “Bail-In” rules which make more sense under normal economic and geopolitical conditions.

If the private rescue fund and recapitalization fund (Atlante I and Atlante II) will not succeed to address the Italian banking crisis, and the EU rules will not allow to soften the “Bail-In” regime due to a potential systemic risk, State aids or the recourse to a European financial backstop mechanism (i.e. ESM or a European Bad Bank) will probably be needed in order to avoid banks resolutions and to ensure bank recapitalizations, but probably it will not be possible to avoid some pain for the investors under the existing regulation (i.e. haircut on securities’ value, or unfavorable debt-to-equity swaps deals, and other measures).

International sovereign funds and global investors (hedge funds, mutual funds, insurance firms, endowment funds) can certainly help solve the problem of recapitalization.

In an adverse scenario, the state aid solution, which in general is not perceived to be a fair solution for taxpayers to solve bank crisis since it might trigger “moral hazard,” and the violation of the existing BBRD rules (“Bail-In” rule), it may turn out to be the only way to help mitigate systemic risk in the Euro zone, since alternative solutions might result in the long-run even more expensive economically and socially (i.e. political risk).

After the severe and prolonged economic slowdown that followed the global financial crisis of 2008, which now we commonly call “the Great Recession” this economic shock has had a lasting impact on the Italian economy.

Eight years after the financial crisis, the Country is still struggling to overcome its banking troubles and to revive its modest growth trajectory. In the period 2008-2016, Italy has lost approximately 9% of its GDP, over 20% of its manufacturing capacity, and it has reached a double-digit unemployment rate at approximately 11,6%, versus the average Euro zone unemployment rate at 9,8%, with youth unemployment at 36,4%.

Since Italy is part of the Eurozone, it cannot rebalance its current account by adjusting the exchange rate. As a result, the country is using a system of adjustment called TARGET2. This system replaced the private capital flows with public capital flows and allowed the troubled countries to run current account deficits and avoid balance of payments crises. This solution gave Italy the opportunity to gradually adjust its current account balance.

These days analysts observe that the anti-establishment and anti-globalization movements (the so-called global populist revolution) are rapidly spreading across the world and, strengthened by the “Brexit” vote and Donald Trump’s victory in the US presidential election, are gaining more legitimacy. Thus, many economic observers expect that this wave of protest and resentment towards the elites and their “clubby system” and “revolving door” practices is likely to have a powerful influence on the soon to come Italian Constitutional Referendum of December 4th leading to a “No” preference by the majority of voters. After Italy, a similar trend might spell troubles in France and other European countries with coming up political elections in 2017.

The financial markets and the international community seem to be scared by a powerful rise of the anti-establishment and Eurosceptic parties in the Euro zone and in particular in Italy (Five Star Movement, etc.). These movements may eventually lead to a stop or slow down of the reform process introduced by the current Italian Government of prime minister Matteo Renzi.

Those who will vote “NO” to the Italian Constitutional Referendum of December 4th claim that the “Yes” vote will be dangerous for the Italian democracy since it would lead to concentration of power in the current government led by Matteo Renzi (Italian still have deep memory of Mussolini’s regime) and it would not significantly reduce the costs of political establishment or improve the efficiency of its legislative process.

Those that will vote “Yes” to the Referendum instead claim that a “No” vote victory might lead to the country political instability and to a serious stop to the reform process.

One thing is sure, the resolution of the current Italian banking crisis and the need to progress in the implementation of a set of reforms aimed to improving the modernization of the country are mandatory steps in order to assure the future sustainability, growth, competitiveness, and prosperity of the Country, regardless of the victory of the “Yes” or “No” vote in the Italian Constitutional Referendum of December 4th.

But if one takes a closer look at the “Big Picture” of what this referendum might really lead to and to what impact this referendum might have on the future of the Italian economy, its fragile banking industry, and political and financial stability and governance, other elements should be taken into consideration as well to understand the context.

Italian banks are in the middle of a difficult process in order to get rid of their non-performing loans through the securitization process (securitization vehicle – “SPV”) in order to cleaning up their balance sheets and to complete the recapitalizations required by the supervisory authorities (i.e. European Supervisory Review and Evaluation Process – SREP).

Given the current market value of these non-performing bank assets, in spite of the State guarantees granted on some tranches of the securitizations (paid at market prices) , there is still a “pricing gap” which is negatively affecting the alignment between banks supply (sale) of NPLs and market demand for these distressed assets.

In order to close the “pricing gap” between supply of NPLs and demand of NPLs, the Italian Government aims to complete the implementation of critical reforms that should speed up and make more efficient the NPL collection process, the execution of foreclosures, the introduction of a more efficient bankruptcy regulation, the improvement of collateral management practices and so on, which ultimately should lead banks in the future to reduced write-downs and allowances for bad loans (NPL) and Unlikely-to-Pay loans. Many observers advocate the need to extend the new rules aimed at speeding up the collection of NPLs loans also to the existing loan contracts and not only to the new loans.

Furthermore, since a number of Italian banks, as well as, many European banks share a number of common structural problems related to low profitability, outdated business models, high levels of Gross NPLs (that is approximately €1 trillion) but also severe operational risks related for example to legal risk (i.e. billions of euros of lawsuits due to mis-selling and deceptive business practices), there is probably a urge by policy makers to make these costs more sustainable for banks otherwise, sooner or later, there might be a risk of a tough shareholders’ revolt (i.e. due to the impact of the high risk-based capital requirements, low dividends, and low capital gains).

Thus, European leaders probably might have a great incentive to cooperate in order to make capital requirements more sustainable in order to spur growth of the European economies but also to make banks’ profitability more sustainable.

In case there will be the application of the “Bail-In” rule in the resolution of the MPS crisis, it would be a sensible solution at least to exempt retail investors from the application of this clause. The retail investors are currently dealing with the tough decision of accepting or not the voluntary debt-to-equity swap (if applicable according to the MIFID rule). The “Bail-in” rule imposes losses on bank’s liabilities on shareholders, bondholders, and depositors with holdings above €100.000. It is certainly important that the European Bank Resolution Fund (Single Resolution Fund – SRF) will be strengthened in the future in order to improve the banking system resilience to systemic shock and potential bank failures.

At this moment, (December 2nd, 2016), no one can accurately predict what the result of the Italian Referendum on December 4th will be, but whatever will be the outcome of the Italian Referendum it is critical that the Country will continue on its path to modernization, social inclusion, and economic growth, and hopefully that a more integrated Euro zone will allow to improve its resilience to systemic risks, its sense of community, and it may lead in the future to a more balanced and harmonized economic path to long-term prosperity and solidarity among the member States. Europe and the rest of the world have to cherish and preserve the   value and inspiration of “sustainable capitalism.”