Remember how the Italian banking crisis threatened to bring down the eurozone financial system over the summer?
Fast forward four months and we’re at it again. This time it’s not the Italian lenders that’re the main concern, but rather how they and the wider European political system will be impacted if Italians vote “no” in Sunday’s referendum.
While the ballot is on proposed constitutional reforms, it is generally being seen in the country as a vote of confidence in Prime Minister Matteo Renzi, with the risk that a victory for “no” will lead to his resignation and the dissolution of Italy’s government.
“Ever since the Brexit vote, we have viewed a potential political crisis in Italy as the top event risk in Europe for 2017. Unlike Brexit, which poses a severe risk to the U.K. but not to the eurozone, Italian problems could theoretically spark a systemic crisis in the eurozone,” said Holger Schmieding, chief economist at Berenberg, in a note.
Furthermore, “a protracted period of political uncertainty after a ‘no’ vote could exacerbate the Italian banking issues, unsettle the Italian bond market and weigh on business and consumer confidence,” he added.
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Italian banks have already suffered greatly in 2016 due to nonperforming loans, ultralow interest rates and slow economic growth. The FTSE Italia All-Share Banks Sector Index IT8300, -0.63% is down 50% this year and has lost 11% in the past month alone.
The poster child of the Italian banking crisis Banca Monte dei Paschi di Siena SpA BMPS, +0.19% has wiped out 84% of its market value in 2016 on fears the lender — Italy’s oldest — would become insolvent because of its high levels of bad loans.
The financial woes have also weighed on the broader Italian stock market this year, with the FTSE MIB index I945, -0.21% down 22% year-to-date. Meanwhile, the borrowing costs on 10-year Italian government bonds TMBMKIT-10Y, +1.00% have jumped back above 2% for the first time since the summer of 2015.
Market is ‘too complacent’
But even with those moves, markets aren’t truly prepared for a “no” outcome, according to analysts at Deutsche Bank. In a note dated Nov. 28, they said “there is a risk that the market is too complacent” and that investors are “underestimating the probability of a significant negative reaction” in the case voters reject the reform proposal.
They also expect Renzi to resign if he loses the referendum, leaving others to deal with the aftermath.
“If we are correct markets will have to deal with a ‘no’ and the risk of a government vacuum. Markets could react negatively, with significant stress on the banking sector,” they said.
Analysts have also pointed to a potential selloff in the euro EURUSD, +0.2644% if voters reject the reform proposal, although the shared currency already has shed a lot of value in the run-up to the ballot. On Wednesday, it was down 3.2% against the dollar for the month at $ 1.0639.
“Political uncertainties will likely keep investors away from the Italian assets and partly from the euro,” said Ipek Ozkardeskaya, senior market analyst at London Capital Group, in a note.
“Italian referendum risks should counterweight the French-backed optimism earlier this week and push the euro buyers on the sidelines. The overall risk-aversion could lead the euro lower into the weekend,” she added.
Little chance of ‘yes’ vote
Both Schmieding from Berenberg and Deutsche Bank put a 60% probability that Italians will vote against the reforms.
At J.P. Morgan, economists see only a 30% chance Renzi can get enough backing for a “yes” vote. That means a potential “no” outcome should come as no surprise to investors and therefore do little harm to financial markets.
“In contrast to the U.K.’s EU referendum, or the U.S. elections, where the results were a surprise, the markets are likely to be much better prepared for a negative outcome this time around,” said Mislav Matejka, J.P. Morgan’s chief European equity strategist, in a note.
Italian banks could, however, suffer an initial knee-jerk selloff, he added, but the recent slump means most of the bad news are already reflected in the price.
“Eurozone banks remain cheaper than typical, despite better performance since summer, and ECB is likely to step in to contain any spread widening. We view the weakness as a buying opportunity and within periphery we continue to prefer Spain over Italy this year,” he added.
The European Central Bank meets on Dec. 8 and is widely expected to extend its bond-buying program. The bank is also ready to temporarily step up its purchases of Italian debt if Sunday’s referendum result prompts an increase in the country’s bond yields, according to Reuters.