Markets Weather Italy Referendum Result, but Banks Are Vulnerable

Italy"s Renzi to resign following referendum defeat

Financial markets were stoic on Monday after Italian voters decisively rejected changes to their countrys Constitution intended to speed government decision-making and spur italys stagnant economy.

stocks in Europe and the United States rose, and the euro recovered from early losses a reaction that was muted in part because opinion polls had predicted the no vote, giving investors time to adjust their portfolios, and also because political instability in Rome is not exactly unusual.

But analysts said the potential for market turmoil remained if the vote resulted in a long period of government paralysis and delayed plans to fix Italys ailing banks, whose shares fell sharply on Monday.

It will be very much related to two factors, said Nicola Nobile, a senior European economist at Oxford Economics in Milan. What is going to happen to the banking system, and if were going to have a government soon.

The vote was another sign of popular resistance across Europe to changes that economists say are needed for the 19-country eurozone to overcome problems that have threatened its existence. Such overhauls are particularly urgent in Italy, which has had no lasting growth for a decade and is the second-most-indebted country in the eurozone after Greece.

The European Central Banks Governing Council, which is scheduled to meet on Thursday, is expected to extend its purchases of eurozone government bonds to hold down borrowing rates. But analysts say that central bank measures cannot keep the currency bloc together indefinitely if its members are unwilling to take steps that are essential to growth.

The political uncertainty caused by the vote will postpone plans to rebuild Italian banks and to help them deal with problem loans, which account for nearly a fifth of total debt and are a serious drag on the economy.

Though market interest rates, or yields, on government bonds rose across Europe indicating that investors now consider the region to be a riskier place to put their money the increase was highest in Italy, a sign of the heightened uncertainty over the countrys prospects. American Treasuries followed European bonds lower, sending yields up.

After the vote, the euro initially fell as much as 1.5 percent against the dollar in Asian trading, but it recovered by the morning in Europe and even gained ground compared with last week. Major European and United States stock markets were all slightly higher as well.

The most immediate concern for investors is probably the Italian banking system. Prime Minister Matteo Renzi said he would resign, postponing, if not derailing, plans to restructure Monte dei Paschi di Siena, Italys most troubled bank and a linchpin of the financial system.

Political instability will make it even more difficult than it already was for Monte dei Paschi to raise the 5 billion euros, or $5.3 billion, it needs to clean up its portfolio of bad loans. Mr. Renzis government had been trying to encourage reluctant investors to put up the money.

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Right-wing parties have been achieving electoral success in a growing number of nations.

In the worst-case scenario, the bank would not be able to raise the money and there would be a so-called bail-in of the lender in which shareholders, bondholders and depositors would bear the losses.

That would be quite painful for the banking system, Mr. Nobile said. The negative reaction would not just be with Monte dei Paschi.

Shares in Monte dei Paschi were down 3.5 percent in afternoon trading while the shares of UniCredit, Italys biggest bank, fell 6 percent before paring some of the losses.

UniCredit has scheduled an investor presentation for next week and had been expected to outline plans to raise more capital. The timing of the presentation now looks unfortunate.

Problems at Italian banks could spread across the eurozone. Large banks around the Continent continually lend money to one another, which allows problems at one institution to spread quickly.

European banks have lent 385 billion to Italian banks, or slightly less than 2 percent of total credit, according to analysts at Credit Suisse. BNP Paribas of France is the most vulnerable, with just under 10 percent of its outstanding loans in Italy. Commerzbank and Deutsche Bank in Germany have about 3 percent of their credit portfolios in Italy, according to Credit Suisse, which said the sums are not large enough to undermine the eurozone banking system.

However, history shows that the extent of banks exposure to one another does not usually become clear until a large lender gets in trouble.

In the worst case, Italy could again be at the center of a crisis like the one that nearly destroyed the eurozone in 2011. The vote could set off a political chain reaction leading to a government headed by the populist Five Star Movement.

The risk in Italy is that a Five Star party-led government is coming next, and it will move to pull Italy out of the E.U., Carl Weinberg, chief economist at High Frequency Economics in Valhalla, N.Y., wrote in a note to clients on Monday. That prospect undermines the creditworthiness proposition underlying Italian bonds.

There is danger of a vicious circle if the Italian economy sags. More businesses and consumers would have trouble paying their debts, and the number of problem loans could rise further. Bad loans are a dead weight on the Italian economy, because they prevent banks from providing credit needed for businesses to expand. And problems at Italian banks would become even more intractable.

Italys national debt is equal to 136 percent of gross domestic product. The government depends on investors willing to continue rolling over the debt at reasonable interest rates.

Investors have already been demanding a higher premium on Italian bonds. The yield on Italian 10-year government bonds has nearly doubled since August, to around 2 percent. That is still far below the more than 7 percent reached in late 2011, during the darkest days of the eurozone financial crisis. But the increase is a sign that investors consider the bonds to be more risky.

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Source: http://www.nytimes.com/2016/12/05/business/italy-referendum-euro-markets.html