Since the European sovereign debt crisis, critics of the euro have asked how long the single currency can continue when the economies which use it are on such divergent trajectories. Now, after a third Greek bailout, a Brexit vote and Donald Trump’s presidential win breathing hope into eurosceptic parties across Europe, their prophesy may be vindicated. When Italy goes to the polls this Sunday for a referendum on constitutional reform, some believe that a No vote could threaten the euro’s future.

Proposed by Prime Minister Matteo Renzi, the vote would end the “perfect bicameralism” at the heart of Italian politics, which he thinks has prevented his government from implementing necessary economic reform because of obstruction by the Senate, which shares power with the lower house. A Yes vote would also draw powers from the regions to the central government.

A number of polls from October put No on 52 per cent – a result Renzi has himself helped to bring about by promising to resign as Prime Minister if he loses, effectively turning it into a vote of confidence in his premiership and Italy’s membership of the euro.

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If his government falls, the fear is that the country’s anti-capitalist, anti-austerity, eurosceptic opposition, the Five Star Movement (M5S), would capitalise on recent electoral successes in Rome and Turin and win the snap election. Worse still, a recently passed law designed to reduce political gridlock in the lower chamber, known as “Italicum”, could grant M5S a majority of seats even without a majority of votes. M5S has called for an advisory referendum on Italy’s membership of the single currency, which it could then push for.

Snap reaction

After a year of seismic shocks to the status quo, markets are nervous that Renzi will lose, but the short-term impact is unlikely to be as crippling for Italy’s economy as many seem to expect.

“The country is used to political instability, implying a likely small impact on business and consumer confidence,” said Danske Bank in a note last week. And even if Renzi were to resign, the other parties in the governing coalition would likely choose a replacement to form a caretaker government within the 70-day window ahead of a scheduled election next year. Capital Economics predicts a fall in Italian equity prices and a rise in bond yields immediately after a No vote (10 year debt is currently yielding 2 per cent). But “as it became clear that little would change, they might soon recover.”

"Le sofferenze"

Italy’s beleaguered banks, which have halved in value this year, have borne the brunt of markets’ pre-referendum anxiety. UniCredit and Banca Popolare di Milano fell more than 4 per cent in yesterday’s session. Monte dei Paschi di Siena – the only one out of 51 European banks to have all its capital wiped out during an ECB stress test earlier this year – shed a massive 13.8 per cent of its value yesterday, as it began its efforts to recpaitalise with a €4.3bn (£3.7bn) debt-to-equity conversion, ahead of an ambitious €5bn capital raise. It has lost 86.6 per cent over the last year.

A No vote could make such capital raising much harder for Italy’s banks, Lorenzo Codogno, former chief economist at the Italian treasury told the FT. If they fail, the risk to the Eurozone could be huge.

Europe was slow in general to get its banks to recapitalise their balance sheets and reduce the proportion of their risk-weighted assets after the financial crisis, but many of the loans issued by Italian banks both to individuals and companies are now worth far less than they were when they were issued. The IMF reckons that non-performing loans (NPLs) have tripled in Italy since the crisis, and were worth €360bn at the end of last year. More than half are thought to be bad loans, known locally as “sofferenze” or “the suffering”.

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The country’s economic growth was anaemic long before the financial crisis, and the IMF has estimated that it won’t return to pre-crisis levels before 2025. Productivity and private consumption in Italy lag behind other euro-area countries, and investment growth is almost non-existent.

Euro anguish

Why should Europe be worried? Italy’s NPLs make up roughly 40 per cent of the Eurozone’s total. Many of them are uncollateralised, meaning that no asset, like a house for example, is recoverable if borrowers default. Worse, the banks are refusing to write down these dud loans to their real value, because this could make them insolvent, so few buyers are interested.

The Italian authorities have moved to speed up insolvency proceedings and institute better corporate governance. A new reform forces Italy’s ten largest co-operative lenders to become joint-stock companies by the end of this year.

But Renzi has been reluctant to let any of them fail. This is because retail investors in Italy own an unusual amount of bank bonds (€200bn), and there is little political appetite to sacrifice the savings of ordinary people by allowing banks to go bankrupt. But a Yes vote on Sunday would encourage investors to recapitalise the banks, the government has reasoned.

Others disagree. The University of Bologna’s Gianfranco Pasquino and Andrea Capussela, an author, argue that curtailing the Senate’s powers would speed up lawmaking in the country, but not address the defective implementation of legislation, the inefficiency of the public administration, the length of judicial proceedings, and the weakness of its rule of law, which make real reform difficult.

Moreover, an M5S referendum on Italy’s euro membership could be declared unconstitutional anyway, because popular votes in Italy cannot dissolve international treaties.

A systemic banking crisis, on the other hand, could be much more destructive, especially if confidence in the ECB and the Eurozone’s leaders began to founder, a severe recession materialised and markets questioned the viability of the euro and the EU as a whole, according to MSCI’s Carlo Acerbi. European financials could lose a third of their value, with the yield on six month Italian bonds rising by almost the same amount. “A diversified, global multi-asset portfolio could lose nearly 9 per cent.”