DEUTSCHE BANK: Everybody is missing the biggest risk in Italy

The UK isn't the only country to hold a make-or-break referendum this year.

After Brits go to the polls in June to vote on EU membership, Italians will have a say on reforms to its Senate, the upper house of parliament, in October.

If approved, the reforms could improve the stability of Italy's political set up and allow prime minister Matteo Renzi to push through laws aimed at improving the country's economic competitiveness.

If denied, Renzi's government will fall, plunging Italy back into the type of political chaos last seen after the ousting of former Prime Minister Silvio Berlusconi, according to Deutsche Bank.

"If the referendum is rejected, we would expect the fall of Renzi's government. Forming a stable government majority either before or after a new election could become extremely challenging even by Italian standards," Deutsche Bank analysts led by Marco Stringa said in a note to clients.

A political mess can quickly turn into a financial and economic mess. And Italy cannot afford that at the moment.

It has crushingly low labour productivity:

An economy that regularly performs more poorly than analysts expect:

And a 20-year history of underperforming its European peers:

Add to that a large measure of political risk and it's possible that Italy's high sovereign debt will begin to worry investors and markets again towards the end of the year.

Here's Stringa (emphasis ours):

Italy's political risk right now does not appear on the radar of markets.

The story may change over the next months. The October referendum on the Senate reform is crucial. Italy's institutional framework combined with the fragmented political spectrum has often created a toxic mix: implementing reforms has been as much a problem as passing them in the Parliament.

While it's not a done deal that the government would fall if the referendum fails, it's the most likely outcome. Italian sovereign debt yields, which have been kept low by loose monetary policy from the European Central Bank, would come under pressure again as investors price the bonds according to the new political risks:

This scenario could compromise Italy's ability to reform until market pressure materialises again.

Growth would likely remain unsatisfactory and the country would become vulnerable to shocks above all when the ECB QE programme terminates. Hence, the Senate reform is essential for the short-term and the medium-term stability of Italy.