Skyline of Florence, Italy

Italy Politics October 2018

Italy: Coalition delivers spendthrift budget in defiance of European institutions

The Italian government approved an EU rules-breaking 2019 budget in mid-October, clashing swords with the European Commission (EC). The budget sent the country’s bond-yields to a four-year high, and spells further troubles for the Italian financial and banking sectors. Moody’s quickly downgraded Italy’s rating by one step on 18 October but also changed the outlook from “negative” to “stable”. The decision had the paradoxical effect of calming financial markets, which had expected the outlook to remain negative, and as the rating agency kept the country’s rating above the junk status. Financial market noise will likely remain elevated going forward as the government and the EC wrangle over the budget, while probably the economic effects of the document won’t be beneficial.

Notably, the government proposes to widen the fiscal deficit next year to 2.4% of GDP on the back of higher spending (around EUR 40 billion), breaking its earlier pledges to EU authorities that it would narrow the gap. Moreover, considering the government built the budget plan on a bullish 1.5% GDP growth forecast for 2019—one reason why Italy’s parliamentary budget office watchdog refused to validate the budget—the new fiscal deficit estimate could prove to be too optimistic. While the budget outlines a number of stimulus measures which should give a modest short-term stimulus to consumption, the redistributive nature of some of these measures means that the budget could actually reduce the economy’s growth potential, limiting any stimulus. At best, market analysts speculate that the budget will give a small short-lived boost to GDP growth.

The highlights of the budget include the introduction of a citizenship income, the partial reversal of a 2011 pension reform and the cancelling of a planned hike in the VAT—which was set to rise as of 1 January. In addition to the higher deficit, the budget provides vague details of increased revenue from a variety of sources, including curbing ministries expenditures, increasing various taxes on banks and insurance companies and elevating the fiscal burden on corporations. The overall economic effect of the budget is mixed. On a positive note, scrapping the increase in VAT rates will avoid a negative impact on consumer spending, already weakened by weak wage dynamics due to stagnating productivity growth. The effects of the citizen income, however, are more difficult to predict: On the one hand, additional social transfers—if not saved for a rainy day—could sustain private consumption; on the other hand, the basic income could discourage the unemployed to search for work and thus weigh on employment, an effect only minimally buffered by the introduction of cumbersome conditionalities. Moreover, the reduction in the retirement age will most likely translate into a decrease in employment. Coupled with the recent tightening of labor market rules, this could spell trouble for labor market dynamics.

The expansionary fiscal stance could also backfire due to the hefty public debt load. Despite the latest moderation, government bond yields are much higher than they were before the government was formed in early June. This makes the public budget more vulnerable and reduces room for maneuver in the event of another recession. Furthermore, higher interest rates weigh on banks’ balance sheets, which could in turn restrict credit extension due to higher funding costs. The expected tightening in the ECB monetary stance, putting further upward pressure on yields, could only make things worse.

Looking forward, the stage is set for a political showdown between the Italian government and the European Commission, which will likely keep financial markets jittery. The EC is expected to ask for modifications to the budget; however, the government has shown little appetite for meaningful changes thus far. If the EC and the Italian government do not meet eye-to-eye on the budget, the EC could launch a Significant Deficit Deviation Procedure. With the elections for the European Parliament scheduled for May, it is quite likely that the two coalition partners will stand their ground to drum up support. Aside from a confrontation with the EC, growing doubts about the sustainability of the country’s public debt load could lead to further market reactions. S&P Global Ratings is scheduled to review Italy’s ratings by the end of October, which will be another significant test for the budget; another downgrade, especially of a greater magnitude, would likely further deter investors.

FocusEconomics analysts expect the recovery to continue next year, although at a sluggish pace. Long-standing problems weigh on Italy’s outlook, most acutely: its huge public debt, sluggish productivity growth, and high taxes. Uncertainties surrounding the government’s stability and the direction of its economic program further cloud the outlook. FocusEconomics Consensus Forecast panelists see GDP growing 1.1% in 2019, which is unchanged from last month’s forecast. In 2020, the panel also expects the economy to grow 1.0%. Moreover, the panel projects the fiscal deficit to reach 2.4% of GDP in 2019, which represents a deterioration of 0.3 percentage points from last month’s forecast, and sees it remaining at the same level in 2020.

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