European Central Bank to Expand Bond-Buying as Itexit Risks Mount

© Sputnik / Natalia Seliverstova / Go to the mediabankWorld cities. Rome
World cities. Rome - Sputnik International
Italy is holding a referendum on Prime-Minister Matteo Renzi-proposed constitutional reform on December 4, which is seen as possibly paving way to the nation to leave the EU. In response, the European Central Bank (ECB) is preparing to address the possible consequences with its monetary stimulus measures.

Italian Prime Minister Matteo Renzi leads a news conference to mark his 1000 days in government in Rome, Italy, November 18, 2016 - Sputnik International
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Kristian Rouz – A referendum on constitutional reform in Italy, proposed by the nation’s Prime Minister Matteo Renzi, bears substantial risks to the entire European banking system, as anegative vote would likely entail a snap election and the rise of the populist Five Star Movement that upholds the ‘Itexit’ idea.

The European Central Bank (ECB) said their response to a possible voter rejection of the Renzi-proposed reform would be to buy increased amounts of Italian bonds in order to support their value and keep yields subdued.

Italy’s Five Star Movement, founded by the Italian comedian Beppe Grillo, bears significant similarities in their agenda to Britain’s UKIP and the US President-elect Donald Trump. The Five Star Movement is based on the principles of anti-establishment Euroscepticism and protectionism, and is likely to win a snap election entailing Renzi’s failure at the referendum on December 4. An electoral victory of the Five Star Movement would likely mean Italy’s separation from the European Union – Itexit.

Italian banks posted gains in stock trading on Tuesday, and the more volatile stocks are poised for further appreciation, while Italian bonds are becoming a less attractive investment asset ahead of the vote on Sunday. A negative vote on Renzi’s proposals would mean greater uncertainty for the Italian assets, and the value of bonds is particularly vulnerable as Italy’s debt-to-GDP ratio exceeds 132pc.

“Political uncertainties will likely keep investors away from the Italian assets and partly from the euro,” Ipek Ozkardeskaya of London Capital Group wrote in a note. “Italian referendum risks should counterweight the French-backed optimism earlier this week and push the euro buyers on the sidelines. The overall risk-aversion could lead the euro lower into the weekend.”

A man walks in front of the Monte dei Paschi bank in Siena, Italy, January 29, 2016. - Sputnik International
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The ECB is weighing an ad-hoc expansion in its bond-buying in response to a possible rejection of Renzi’s reforms, even though the regulator has recently been considering wrapping up its monetary stimulus. In order to balance the risks stemming from the likelier possibility of Itexit, the ECB could absorb a greater amount of Italian bonds within its 80 bln-euro bond-buying program. Such a move would allow to prevent sharp increases in bond yields across the Eurozone and declines in the euro’s FX rate.

Opinion polling in Italy suggests the ‘No’ vote has a greater popular support.

"If you have a crisis in the Italian banking sector … not only that could spread across Europe but also the solution that Renzi may come up with to just break the rules and bailout the banks, in which case he would be massively undermining (the) banking union," Megan Greene of Manulife Asset Management said.

The Five Star Movement has declared as one of its goals conducting an Itexit referendum after they form the cabinet, which is very likely should the “No” vote prevail this Sunday. Italy has long been struggling to charter feasible economic policies within the Eurozone, as the ECB’s austerity and relatively strong euro have weighed on the Italian growth. Meanwhile, the structural implications of Italy’s economy suggest a weaker national currency and higher inflation would ensure higher GDP growth over the medium-to-long-term. In order to do that, Italy would have to leave the euro area.

“Any credible noise about euro exit would induce capital flight and severe market turmoil, so that market pressure might force parties that campaigned for euro exit to quickly revise their plans,” economists Gianluca Salford and Marco Protopapa wrote.

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The euro has declined by 3pc in November, whilst yields on Italian bonds have advanced to above 2pc first time since the speculation of Greece leaving the euro had affected the markets of the entire Southern Europe in mid-2015.

The ECB said their urgent buyout of Italian bonds after the referendum would be limited to days or weeks just in order to offset the immediate shocks to the markets. The monetary easing, practiced by the ECB, is aimed at propelling growth and inflation in the entire euro area, whilst it is not designed to fight economic turmoil in individual member countries.

"The Governing Council understands that there is some space to help Italy, which will be used, if needed. The asset purchase program has built-in flexibility," an anonymous ECB source told Reuters. "The key is that the ECB has to be convinced the volatility can be overcome by using this flexibility."

Meanwhile, the Italian authorities have referred to market concerns of the upcoming referendum as exaggerated. Paolo Gentiloni, Italy’s foreign minister, said that “in any case we will have a weaker and more unstable country, but not a threat for the European economy.”

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