The eurozone banking system has been the weakest link in the global financial system for several years now.
US banks are cleaned up and raring to go. British banks are getting there.
But in Europe, the banks are still a mess. The trouble is, when you don’t run your own currency and you don’t have control over your own policies on state aid – in effect, when you lack economic sovereignty – there’s no easy way to bail out a bankrupt bank.
So for Europe, the whole post-crisis era has been a long case of “extend and pretend”, punctuated by periodic crises.
Now markets are worried that Italy might be the crisis that breaks the eurozone’s back…
The Italian referendum: what’s at stake?
The Italian stockmarket slid yesterday, as investors started to fret about the referendum on Sunday.
We’re following the pre-“voter event” playbook quite nicely just now. Markets are positioning themselves for the outcome that they think will definitely happen, according to the most recent polls.
The difference between this referendum and the Brexit and Donald Trump votes is that markets are assuming that the vote will go against the establishment, rather than for it.
To summarise, the Italian referendum is on a series of constitutional reforms aimed at making it easier to get things done. The aim, notes Bloomberg, is to reform the Senate from so that it can no longer “block legislation indefinitely, gets consulted on fewer matters, and loses its power to topple the executive by calling a vote of no confidence in the government.”
Some argue that the reforms give the prime minister too much power. Others would look at the fact that Italy has had 63 governments since the end of World War II and perhaps accept that some sort of reform to end this paralysis would be a good idea.
As an outsider, it looks to me like Italian politics probably has too many powerful vested interests that are able to stymie the system from within, and that these reforms would be a step in the right direction.
But I’m well aware that outsiders often miss important nuances, and I’m also not keen on any individual in government getting too much power. So if we have any Italian readers with strong feelings on the topic, feel free to put them in the comments below.
The big issues: the euro, and the Italian banking sector
All that said, the referendum isn’t really just about constitutional reform. It’s about voters having the opportunity to slap the establishment in the face again. And polls suggest that they’ll take it.
If the voters vote “no”, then prime minister Matteo Renzi has said that he’ll resign (he’s opted for the “passive-aggressive” school of political tactics). If he steps down, then Italy will more than likely be plunged into political chaos.
I realise that even the least cynical among you are thinking that “political chaos” and “Italy” go together like “love and marriage” or “Marmite and Brexit”. It’s practically the natural order rather than some market-shattering exception to the rule.
Yet there are a couple of trickier-than-usual issues involved here. And that’s what has the markets worried.
The first worry is the Five Star Movement. It’s Italy’s populist party. If Renzi steps down, and an election is eventually triggered, then the Five Star Movement is the one that is most likely to benefit. It isn’t 100% sure what it feels about the euro, but it’s (currently) inclined to give the voters a referendum on ongoing membership.
Reports The Independent: “Five Star’s Luigi Di Maio, vice president of the lower house, said that if the party achieves power, it would push for an advisory referendum on euro membership.” In an interview with Italian newspaper La Repubblica, he said that he’d like to see “a euro at two speeds or a national currency.”
So there’s that to think about.
The second and more immediate worry is the state of the Italian banking sector. Even by eurozone standards, Italy’s economic performance has been consistently awful for the last two decades or so. Partly as a result of that, Italy’s banks are sitting on a big pile of bad debt.
The government is still trying to figure out a way of recapitalising them that doesn’t break the eurozone’s rules on state aid, and that doesn’t screw over the millions of small bondholders who have loaded up on bank debt in the belief that it was safe.
Renzi is determined to sort it out, and if the vote goes his way, relieved eurozone officials will probably give him the wiggle-room he needs to fudge the issue.
If he doesn’t though, says Ambrose Evans-Pritchard in The Daily Telegraph, we could be looking at another Greece-style bailout by the European Stability Mechanism. That would be an embarrassment for Italy, and only add to the risk that the country eventually votes to leave the eurozone.
What you should really be worried about
It all sounds very worrying. Various US hedge funds are now getting all excited about the breakup of the euro again.
My view? Don’t bet on it. Not yet.
First things first, Sunday is the first step in a really long process. In the long run, I believe that the euro is doomed. The internal contradictions are too great, and the chances of Europe embracing a full-blown political union still seem small.
But that’s the long run. The shorter run – which could potentially be measured in years – is, in this case, more important to investors. And we’ll have plenty more warnings before Italy actually ditches the euro.
Renzi has to lose. Then he has to step down. Then there has to be an election. Then Five Star has to win. Then it has to decide whether it even really wants to leave the euro. Then it has to call a referendum (and Italy’s constitution has a whole series of obstacles to doing that – its constitution apparently “bans the abrogation of international treaties via a popular vote”, according to The Independent). Then the population has to vote to reject the euro. Then the people in power have to accept that vote.
That’d take an awfully long time. I’m not dismissing the possibility and I’m not downplaying the risks. I’m just saying that – oddly enough – there aren’t a lot of unknowns here. And the market is already pricing in quite an aggressive ‘no’ outcome.
For me, this is a “sell the lead-up, buy the result” referendum. Even if it’s a “no”, I suspect the fallout will be less grim than everyone imagines right now.
As I’ve said many times in the past, the real crunch point for the euro will only come when a eurozone country votes in a genuinely euro-sceptic political party. We’re not there yet, and even a “no” vote in the Italian referendum represents only a tiny nudge in that direction.
However. I don’t want to be too sanguine about this. Because 2017 holds a whole series of elections in the eurozone that could send this thing spinning out of control. We’ll be looking at them in next Friday’s (9 December) special forecasts issue of MoneyWeek magazine. This is one issue that you won’t want to miss.
2016 has been an incredible year, and the spillover effects from all of the upheaval we’ve seen this year promise to continue into 2017. We’ll be outlining all of the threats and all of the opportunities on offer, and giving you our view on what the biggest investment stories of next year will be – and how to profit from them.
This is the ideal issue to start your MoneyWeek subscription – sign up now to make sure you get it.