Analysis

The 'no' victory could mark the beginning of a period of uncertainty and instability (see ITALY: Referendum 'no' vote could trigger crisis - October 24, 2016).

Political implications

Immediate elections are impossible because the electoral law, known as the 'Italicum', applies only to the Chamber of Deputies and is not compatible with the perfect bicameralism of the parliament. The previous electoral law has been judged unconstitutional by the constitutional court, so there is currently no adequate law for electing the Italian parliament (see ITALY: Renzi will face critical tests before year-end - August 12, 2016).

This leaves two options: Renzi could accept a second mandate or an independent technocratic candidate could be asked to form a government.

The former is very unlikely, as Renzi ruled out this option after his defeat, while the latter has strong limitations with respect to the duration and extent of the mandate and would require the full support of all major parties to share the burden of the difficult choices to be made.

It is possible that, glued together by desperation, the mainstream parties will push through the necessary structural reforms, avoid early elections and prepare for the regular 2018 vote hoping that, in the meantime, the economy improves and voters reward their efforts.

However, this may be over-optimistic and the role of the populist Five Star Movement (M5S), the second-largest party in parliament, adds a peculiar element of uncertainty (see ITALY: M5S strength could tip referendum outcome - October 11, 2016).

It is therefore unlikely that Italy could thrive with a technocratic government. Instead, the most likely scenario is a caretaker government that lasts just long enough to approve the new electoral law and negotiate a truce with the EU on issues such as the migrant crisis or public finance consolidation until new elections are called.

In this scenario, new elections could be held in June 2017. The outcome is highly uncertain, with unknown factors including the form the new electoral law will take, whether Renzi's Democratic Party (PD) will split, whether Northern League leader Matteo Salvini will be the centre-right candidate and whether the M5S will remain uncompromising or accept an alliance to govern the country in case of victory.

Electoral law

The Italicum came into force on July 1 and was not affected by the referendum. However, it was specifically designed for the parliament as reformed by the referendum: it applies only to the Chamber of Deputies and aims at having a clear winner immediately after polls close.

It is based on a two-round system where parties, rather than coalitions of parties, run against each other. The majority bonus guarantees that the winning party gets at least 54% of the seats.

The constitutional court is evaluating the constitutionality of the Italicum. Moreover, Renzi had promised to change it after the referendum to ensure the support from personalities such as former President Giorgio Napolitano, who approved of the constitutional reform but criticised the strong majoritarian bias of the Italicum and the potential disequilibrium between the executive and legislative powers that it could cause when applied in combination with the constitutional reform.

A completely new electoral law for the Chamber of Deputies and the Senate has to be devised but it is not clear which parliamentary majority will shape and sign it.

Economic consequences

The ECB's protective umbrella is still wide open, but the Monte dei Paschi di Siena (MPS) recapitalisation plan perfectly overlapped with the referendum: on December 2, the voluntary debt-equity swap closed, with 1 billion euros (1.07 billion dollars) of subordinate bonds accepting the conversion to new equity; over the course of today, it will become clear how many new institutional investors will participate in the 5-billion-euro capital increase (see EURO-AREA: Pressures push banks towards a cliff-edge - December 2, 2016).

The risk of a failure of the MPS recapitalisation plan should not be underestimated. The amount (5 billion euros is equivalent to 0.3% of GDP) is relatively small for a country such as Italy, but the MPS is the third-largest Italian bank and, with the EU's new banking union resolution rules, the bail-in of (at least) subordinated bondholders is unavoidable before a government can intervene to nationalise and save the defaulting bank.

Among the subordinated bondholders are thousands of retail investors.

In order to avoid a fully fledged banking crisis, a strong government is necessary to supervise the MPS restructuring process.

A successful MPS restructuring should help other banks having to recapitalise in the next few months. Among them is Unicredit, the only Italian banking group that is classified as systemically relevant by the ECB. Estimates suggest that it will need a capital increase of up to 13 billion euros.

Even if a new strategy for dealing with the banking crisis is devised, the ailing Italian economy is unlikely to benefit in the next few quarters.

A lower GDP growth rate caused by political uncertainty, a higher bond spread and stricter credit conditions will further complicate negotiations with Brussels, as they will make it more difficult for the Italian government to meet its public finance targets.

Moreover, even if the targets were reached, Italy would be at risk of non-compliance with EU rules. Introducing new austerity measures might deal a fatal blow to an already anaemic recovery.

The spread of Italian over German bonds is an additional cause for concern: although the ECB has sufficient ammunition to fend off a speculative attack against a member state, a general loss of confidence, causing domestic investors to flee the country, would have serious ramifications.

In those cases, the ECB's action must be inside a financial assistance programme in order to be effective and credible. The implications of such a programme are a temporary loss of (fiscal) sovereignty for the country and, possibly, a debt-restructuring plan.