Italy faces fiscal moment of truth with December referendum

It is difficult to exaggerate the importance of Italy’s forthcoming referendum, not only for the Italian economic outlook, but also for that of the eurozone as a whole.

{mosads}If Prime Minister Matteo Renzi wins that constitutional reform referendum on Dec. 4, Italy could probably keep muddling along with its very troubled and highly indebted economy. If, however, as seems more likely, Renzi loses that referendum, Italy could be in for a prolonged period of political and economic uncertainty.

Such an outcome could throw into question the country’s continued euro membership and could raise basic questions as to the eurozone chances for survival in its present form.

Ostensibly, the referendum is about whether or not the power of the Italian Senate should be severely curbed in order to make the country more governable. However, by making the cardinal mistake of repeatedly saying that he would resign if he lost that referendum, Renzi has converted that referendum into a vote of no confidence on his leadership.

By so doing, he has managed to unite a divided opposition to bring him down and he has also sown division amongst members of his own party as to whether he should continue to be the party’s leader.

A “no” vote in the referendum would almost certainly mark the end of Renzi’s tenure as prime minister. It would also very likely result in the installation of a caretaker government of technocrats to manage the country until early parliamentary elections could be arranged.

Such a prospect is bound to unsettle both foreign and domestic investors, since it would raise the possibility of the populist Five Star Movement’s eventual rise to power. That party, which is firmly against Italy’s continued euro membership, has now drawn even with Renzi’s Democratic Party in the polls.

Beyond Italy’s borders, a “no” vote in the Italian referendum is bound to put wind in the sails of other European populist movement. In particular, coming so soon after the Brexit vote, when Britain voted to leave the European Union, and Donald Trump’s triumph in the U.S. presidential election, an Italian “no” vote would raise the National Front’s Marine Le Pen’s chances in next April’s French presidential election.

The last thing that the Italian economy now needs is a prolonged period of domestic political uncertainty that would threaten to stall the country’s economic reform effort.

Without deep economic reform, there is little prospect that Italy will be able to revitalize its sclerotic economy, which has continually underperformed the other major eurozone members’ economies. As an indication of this poor performance, Italy’s economy today is still some 6 percent below its 2008 pre-crisis peak level, while its youth unemployment rate remains in excess of 35 percent.

Unless Italy soon gets itself onto a more favorable economic growth path, there is the real risk that it will experience both a serious banking crisis and a renewed sovereign debt crisis.

This would especially be the case once global liquidity conditions are not as favorable as they are today. With nonperforming loans amounting to as much as 18 percent of its banking system’s balance sheet, Italy has the weakest banking system in the eurozone. Similarly, with a public debt to gross domestic product (GDP) ratio in excess of 130 percent, only Greece has a higher debt ratio among the eurozone’s 17 member countries.

Sadly, an Italian financial crisis would threaten the very foundations of the eurozone.

Unlike was the case in Greece, the Italian economy is simply too big to save with repeated European and International Monetary Fund (IMF) bailout packages.

Similarly, with sovereign debt totaling around $2.5 trillion, making the country the world’s third largest sovereign debt market, it would seem inconceivable that an Italian credit event would not have major spillover effects to the rest of the global economy and that it would not trigger contagion to the rest of the European economic periphery.

Hopefully, on Dec. 4, the Italian electorate will behave responsibly and vote “yes” to Renzi’s reforms, thereby avoiding the risk of triggering an early Italian economic and financial risk.

However, judging by the populist wave in both the recent Brexit referendum and the U.S. presidential election, I am not holding my breath for an Italian “yes” vote.

Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

The views expressed by contributors are their own and not the views of The Hill.