Renzi’s Italian Fate Also Overshadows Draghi’s Route for QE

  • Italian vote could impact markets and euro-area growth outlook
  • ECB faces decision on future of bond-buying plan this week

Nomura's Gaynor: Likely QE Program Will Be Extended

Matteo Renzi might not be the only person this week to have his plans thrown up in the air by the Italian electorate.

His countryman Mario Draghi, president of the European Central Bank, will now have to take into account the scale of Renzi’s defeat in Sunday’s constitutional referendum -- and resignation as prime minister -- as the ECB evaluates its quantitative-easing program. The result has the potential to stoke market turmoil, widen bond spreads and depress the growth outlook, and so throw a spanner in the works of a finely calibrated monetary mechanism.

Draghi’s Governing Council is considering whether to adjust and extend QE so that it can keep going in tight bond markets as long as needed to achieve its inflation goal, with a decision due Thursday. The task of sustaining the recovery would have been easier had the euro area’s third-largest economy been able to give itself a boost in the shape of an accelerated reform program; now the ECB may instead have to return to firefighting duties in financial markets.

“Italy has missed a splendid opportunity to reform its political system and streamline its public administration,” said Holger Schmieding, chief economist at Berenberg Bank in London. “The heightened uncertainty strengthens the case for the ECB to announce this Thursday an extension of its full asset-purchase program of 80 billion euros per month beyond March 2017.”

QE Support

A spokesman for the ECB declined to comment, though Governing Council member Ewald Nowotny warned against drawing premature conclusions.

“The European Central Bank has the task of making monetary policy for the entire euro area, not for a single country,” he told reporters in Vienna, adding that Italian government bond yields have risen, but their level is not “alarming.”

The yield on Italian 10-year bonds was up 13 basis points at 2.035 percent at 1:14 p.m. Rome time. The euro slid as much as 1.5 percent before recovering to trade 0.4 percent higher at $1.0703.

Structural adjustments intended to boost the region’s growth potential are seen by the central bank as a vital counterpart to monetary support, and Italy, with stagnant productivity and a banking sector saddled with soured loans, is a chief candidate for reform. The ECB may now find itself having to support the economy more, or for longer.

According to a Bloomberg survey of economists before the vote, Draghi will announce an extension of asset purchases on Thursday at the current pace. Most respondents also said that the scenario of slowly accelerating inflation and a moderate but steady recovery will give him room to start tapering by late 2017.

The scale of Renzi’s loss may now endanger that scenario. The vote caps a year of political upheavals in the European Union, including the decision by the U.K. six months ago to leave the bloc. As then, ECB officials are likely to stress their ability to manage liquidity shortages in the bloc’s financial system while playing down the need for any larger interventions, such as a repeat of the 2011 expansion of the central bank’s first government bond-buying program to rein in soaring Italian yields.

“The referendum in Italy yesterday may be deemed as another source of uncertainty,” ECB Governing Council member Francois Villeroy de Galhau said in a speech on Monday in Tokyo. “However it cannot be compared to the British referendum: Italian people have been called to the polls to vote on an internal constitutional matter, and not about Italy’s long-standing EU membership. We will nevertheless look closely at its consequences.”

In June, in the aftermath of the Brexit vote, central banks around the world including the ECB offered the financial system fresh funds, and some even intervened in currency markets, to prevent investor unease spiraling out of control. Then, global markets mostly calmed after some initial volatility.

“Political uncertainty is dominant,” ECB President Mario Draghi said in an interview with El Pais published last week. “So far we’ve seen that in the short-term the response to these uncertainties has been more muted than people expected.”

Economic Projections

While the ECB may be on top of any initial turmoil, it can do less about the hit to longer-term growth expectations that political paralysis in Italy may bring. The economy there has barely grown since entering the euro, and output per head is below the level before the single currency was introduced. The Italian statistics agency Istat forecast in November an expansion of 0.8 percent in 2016 and 0.9 percent next year.

If Italy’s growth is hobbled further, that bodes ill for the ECB’s own outlook for the euro area. Fresh forecasts are due to be presented at the policy meeting that culminates on Dec. 8, and which will serve as the basis for the decision on QE.

The referendum also has the prospect to deepen the crisis in Italy’s banking sector, which under the weight of around 360 billion euros in non-performing loans and weak profitability has seen an investor sell-off this year. That outcome also falls at the ECB’s door, as the central bank is responsible for euro-area banking supervision, and, if needed, triggering resolution proceedings.

Monte Paschi

Bondholders of the country’s third-largest lender, Banca Monte dei Paschi di Siena SpA, last week agreed to swap more than 1 billion euros ($1.1 billion) of subordinated notes for shares, making it easier for the bank to complete a vital 5 billion-euro capital increase by the end of the year. That, too, may now be at risk. Monte Paschi shares slid as much as 7.5 percent.

“Renzi had brought some hope that Italy would finally be embarking on a path of real economic reforms, but these hopes have now been dashed,” Jan von Gerich, global fixed income strategist at Nordea Bank in Helsinki, said in a note to clients. If Draghi doesn’t seem willing to use the bond-buying program now to contain Italian yields if needed, “it would dent confidence in the central bank’s ability to control the bond markets,” he said.

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