Italy’s referendum decision adds up to a worst case scenario for the euro

‘It is no exaggeration to say the euro could be facing extinction by the end of 2017’

PUBLISHED : Monday, 05 December, 2016, 1:39pm
UPDATED : Tuesday, 03 July, 2018, 7:59pm

The euro is facing the biggest threat to its existence

Year-end is normally the time when investors are looking to wind down positions and book profits, especially after a bumper 2016 when stock markets have hit all-time highs and bond yields hit rock bottom lows. But investors are in for a shock as their world is about to be turned upside down. The euro will be in the thick of it as Europe faces up to grave new uncertainties.

Watch: Italy’s PM Renzi quits after crushing referendum defeat

Italy’s failed referendum vote over proposed constitutional reforms has sent profound shock waves through global markets. The euro has had some near misses in the past, but this time the currency could be facing its biggest existential threat. It is no exaggeration to say the euro could be facing extinction by the end of 2017.

In the next few months it could be all change on the political landscape, with the risk of Europe’s traditional, europhile centre-ground being swept aside

Global investors can ill-afford to be complacent as the ramifications will be huge, possibly hurling the world into a bigger catastrophe than the 2008 US subprime crisis with all its ensuing toxic fallout. Italy’s no-vote might not only mark the beginning of the end for the euro, but could also set the world down a new trail of doom, gloom and economic destruction.

Italy is only the tip of the iceberg. The emergence of more volatile political pressures in Europe, a failing euro zone recovery and spectre of the European Central Bank losing its grip on prudential monetary control are adding up to a lethal cocktail of risk for the euro zone and the single currency ahead.

The euro was already on a slippery slope against the resurgent US dollar, so the weekend’s news will accelerate the currency’s slide towards the edge of the parity precipice. European stocks and bonds are set to suffer as confidence in the euro collapses. The contagion will spread.

Without a doubt, Italy’s no vote is a big shock to global confidence. Even though a negative result had been expected, no amount of forward planning could prepare the markets for an event of such magnitude. Italian Prime Minister Matteo Renzi’s resignation risks plunging the country into new elections and another political crisis, setting the stage for the anti-establishment, euro sceptic Five Star Movement to sweep into power.

If so, it marks a dark omen for global markets as credit default risks will rocket. It is not just fears of a possible crash among Italy’s hard-pressed banking sector, but also what happens to Italy’s mammoth government bond market – arguably the third largest in the world. With the nation’s public debt mountain running at an eye-watering 160 per cent of GDP it is no doubt causing nightmares for EU policymakers and ECB officials.

If investors thought the Greek debt crisis was bad enough, a collapse in Italian bond market confidence could presage a bloodbath for Europe’s high-yield bond markets. It is no surprise that Italy’s benchmark 10-year government yield spread over safe haven Germany jumped sharply in recent weeks. If the crisis deepens and panic selling takes over the market could set its sights on the record 775 basis point peak recorded during 1992’s ERM crisis.

It would be too much for the ECB’s resources to handle and speculators would have a field day testing the ECB’s resources to fend off a full-scale assault against the euro zone’s most vulnerable debt markets. Risk assets in Italy, Greece, Spain and Portugal would all be in the firing line.

Italy marks a dangerous watershed for Europe. In the next few months it could be all change on the political landscape, with the risk of Europe’s traditional, europhile centre-ground being swept aside by the rising tide of pro-nationalistic, anti-Brussels, anti-austerity populism sweeping across the continent.

Upcoming national elections in Germany, France, Netherlands and others could see sweeping changes to Europe’s status quo. Voters are fed up with austerity, low growth and high unemployment and want a change. Fired up by Britain’s Brexit vote, it would only take one Eurexit leaver to bring the whole house of cards down.

It is almost incidental that the ECB votes this week to extend quantitative easing by a further six months. Once broken, no amount of ECB easing will succeed in putting the euro zone humpty-dumpty back together again.

The biggest worry is the ECB is getting itself into an even bigger toxic monetary muddle over QE and open market operations. Thanks to QE and super-stimulus the ECB’s balance sheet is ballooning to unsustainable size and complexity.

Once markets start to question the ECB’s credibility it will be game-over for the euro.

David Brown is chief executive of New View Economics