Italy Politics June 2019

Italy

Italy: Risk of unprecedented fine and resurging financial turmoil elevated

June 25, 2019

The European Commission could launch an excessive deficit procedure against Italy in the next few months for breaking spending and borrowing rules, unless convincing measures are swiftly adopted. Such a course of events would most likely renew financial market turmoil, which would push up bond yields and thus further raise the financing costs of the country’s mountainous public debt; at the end of May, Italy’s bond yields spiked on rising fiscal tensions with EU institutions, demonstrating once again that financial markets remain extremely sensitive to developments in the Italian political and economic landscape. Tighter financing conditions and weaker investor confidence would inevitably further hit the limping Italian economy, as already occurred in the second half of last year.

In a letter sent to the EU leaders on 20 June, the Italian government said it expects the 2019 deficit to come in at 2.1% of GDP, below the 2.5% of GDP projected by the EC. The EC tabled a disciplinary procedure against Italy over its failure to comply with the debt reduction benchmark in 2018 and on expectations that the country will not comply with the debt reduction benchmark either in 2019 or in 2020. Higher-than-expected revenues, minor spending cuts and some savings from the government’s two key measures—the citizen’s income and the lowering of the retirement age—should, according to Italy’s government, help reduce the divergence between the government’s forecasts and those of the EC. Nevertheless, also due to the temporary nature of the proposed fiscal measures, it seems unlikely this will satisfy the Eurozone finance ministers, who are scheduled to meet on 9 July to decide whether to support an excessive deficit procedure. On 5 June, the European Commission stated that the opening of an excessive deficit procedure against Italy was “warranted”, due to the country’s high debt load and lack of a credible plan to address it.

Although the government stated it will stick to EU rules, it seems probable the Commission will take further disciplinary steps, which increases the possibility of an unprecedented fine. Under EU rules, no country should have a budget deficit higher than 3% of GDP or public debt above 60% of GDP, and countries with large public debts should gradually attempt to reduce their debt burden. Italy, meanwhile, had a public debt of over 132% of GDP in 2018 and is planning to deliver major tax cuts in 2020 budget which will further strain government finances and spike the public-debt-to-GDP ratio. The excessive deficit procedure could theoretically result in a fine of around EUR 3.5 billion (or 0.2% of GDP), in the form of an interest-free deposit. However, that would be the final step of a long and complicated process, which could last several months, during which the government would be given the possibility to take corrective actions. Italy and the EC could thus settle for a compromise and close the procedure, in a déjà vu of what happened at the end of last year. That said, as things currently stand, and despite some recent budget reprieve hopes which sent Italy’s government borrowing costs close to one-year lows on 24 June, the government could stand up to the EU institutions and go ahead with its major tax cuts plans.

Speculating on the most likely outcome of the ongoing confrontation, Nicola Nobile, an economist at Oxford Economics, noted:

“If last year’s developments are anything to go by, the government should act to avoid turmoil in the financial markets, which contributed to the recession in H2 2018. However, we doubt the government, whose centre of power has shifted towards La Lega since the European elections, will take this approach. We therefore expect political and fiscal uncertainty to remain high over the coming months, with financial markets likely to react negatively.”

FocusEconomics Consensus Forecast panelists see GDP growing 0.1% in 2019, which is unchanged from last month’s forecast. In 2020, the panel expects the economy to grow 0.6%.


Author: Massimo Bassetti, Economist

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