By Simon Nixon
After the Brexit vote and the election of Donald Trump, the only thing anyone can say for certain is that nobody
knows anything. A defeat for Prime Minister Matteo Renzi in this weekend's Italian constitutional referendum could well
be the spark that reignites the eurozone crisis, reviving doubts about the survival of the single currency. But neither
Brexit nor Mr. Trump's victory has so far led to the turmoil that many predicted, even though both caught markets by
In contrast, a "no" vote in Italy on Sunday would come as no surprise at all. This referendum has been on
investors' radar all year and polls have consistently indicated that Mr. Renzi is heading for defeat. Nor are Italy's
banking problems, which are the root of the market's anxiety, in any way new: Investors know very well where the
problems are and what it would take to fix them.
Investors are clearly not convinced by the argument that the referendum is merely a technical issue with no bearing
on Italy's membership of the European Union. Italian government bond yields have jumped, the 10-year bond now trading at
a spread of 1.7 percentage points above German bonds, and bank shares are trading at a fraction of book value. Bankers
say that investment has stalled, while capital outflows--as reflected by the Bank of Italy's balance sheet--have reached
their highest level since 2011.
If the European Central Bank wasn't buying government bonds as part of its quantitative easing program, Italy would
surely be already facing a full-blown crisis. But what more can the ECB do if the referendum outcome leads to further
volatility? The short answer is that in the short-term, not much.
The ECB Governing Council will meet for a regular policy-setting session just days after the vote, giving it an
opportunity to pour some oil on troubled waters. But the ECB's ability to help Italy is constrained by its mandate,
which requires it to set monetary policy to achieve its inflation target for the whole eurozone, not to target financial
conditions in one country. That said, in the event of "no" vote, the ECB is more likely to extend its QE program next
The ECB is also likely to want to reassure markets that it still has plenty of firepower to fight future crises.
That will require it to spell out how it can increase the pool of assets eligible for its QE program. As things stand,
that pool is limited by the ECB's self-imposed rules, which require it to buy government bonds strictly in proportion to
each country's ECB shareholding and only in quantities that neither guarantee a loss, nor give the ECB the power to
block a debt restructuring.
Relaxing any of these constraints is politically toxic: at a recent informal meeting of the Governing Council there
was no clear majority for any option. Even so, the most likely outcome is some action to loosen all three constraints,
says someone familiar with the discussion.
If the ECB's regular QE program can't stop Italian bond yields from soaring to levels that threaten financial
stability, then it will come under pressure to do "whatever it takes."
That would mean activating the tool that it created at the height of the eurozone crisis in 2014 but which has
never been used: Outright Monetary Transactions. This would allow the ECB to buy much larger quantities of Italian
bonds, but only once the Italian government had agreed to a rescue program with the European Stability Mechanism, the
eurozone's bailout fund. This, of course, would only be possible if and when Italy has a stable government able to agree
to and implement the conditions.
There is little doubt what the first condition of any ESM program would be: a full cleanup of the banking system.
Had Rome done this years ago, no one would be worrying about the referendum now.
That it hasn't done so reflects a lack of political will: a reluctance to impose losses on bank shareholders, many
of which are politically well-connected local charitable foundations; on borrowers, many of which are politically well-
connected small and medium-size businesses; and on bondholders, many of which are ordinary savers who were persuaded to
switch low-yielding deposits into higher-earning bonds without being told of the risks.
The costs of fixing Italy's banking system aren't large: eight banks require an estimated EUR40 billion ($50
billion) of capital, equivalent to just 2% of GDP. There is even a deal on the table, agreed to with Brussels, that
would allow the government to inject much of this money, thereby limiting bondholder bail-ins to junior debtholders,
with compensation allowed for retail investors who were victims of mis-selling.
But will the political will that has so far been lacking somehow manifest itself in the messy aftermath of a
referendum "no" vote? Or will market pressure be needed to force Rome's hand? And what impact will a banking cleanup
have on the Italian political landscape? No one knows anything.
Write to Simon Nixon at email@example.com
(END) Dow Jones Newswires
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