Italy’s constitutional referendum is fast approaching and financial markets are already jittery. While some observers have pointed out the risk of the Five Star Movement getting into power, or even of Italy leaving the euro, these are extremely unlikely scenarios, at least in the short term.
The outcome of the referendum may be more evenly balanced than people tend to acknowledge, i.e., a 50/50 split. In the event of a ‘Yes’ victory, which would be a surprise for financial markets, the 10-year BTP-Bund yield spread could narrow sharply. If ‘No’ triumphs, there would be a potential further widening, but the real risk stems from financial instability.
Ongoing problems in the banking sector, as yet modest economic expansion, and vulnerability in public finances, combined with political uncertainty, would produce a dangerous mix.

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