Skype: Signal2forex / Whatsapp: +79065178835
0$0.00

No products in the cart.

What’s Next for Italy’s Budget?

Executive Summary

Since our most recent special report on Italy, Italian policymakers have continued full steam ahead with their plans to ease fiscal policy next year through a combination of tax cuts and increased spending. Over the past eight weeks, there have been multiple back and forth exchanges between Italian and EU policymakers on the structure and budget impact of these policies. Italy has gradually made some modest concessions, but through each iteration Italy has stuck to its initial deficit target of 2.4% in 2019. Thus far, EU officials have remained unsatisfied. In a report issued on November 21, the European Commission took another step toward an excessive deficit procedure (EDP) against Italy. In short, the report showed that EU officials remain concerned about the fiscal outlook in Italy, and that they are exhibiting a willingness, at least for now, to use all of the tools at their disposal to enforce fiscal discipline.

So what happens next? It is possible that the European Commission could formally launch the EDP against Italy next week, though sometime in the second half of January/first half of February appears more likely. What would an EDP entail? After the process officially begins, Italy would have either three or six months to correct its fiscal excesses, with the three-month window reserved for particularly serious violations. Assuming Italy were to get the six-month window, this timeline implies the process could come to a head sometime in mid-2019. Were Italy to continue to defy Brussels after this time has elapsed, the country could be subject to a penalty of 0.2% of its GDP (about €3.5 billion), with growing penalties over time possible in the face of continued defiance by Rome. In this report, we update our readers on developments in Italy, lay out next steps and provide three potential scenarios for how things play out. In our view, the most likely outcome is that an eventual compromise will be reached before financial penalties are imposed on Italy, though it could take several months before a resolution is realized.

Italy’s Budget Remains in Focus

Since our most recent special report on Italy, Italian policymakers have continued full steam ahead with their plans to ease fiscal policy next year through a combination of tax cuts and increased spending. Over the past eight weeks, there have been multiple back and forth exchanges between Italian and EU policymakers on the structure and budget impact of these policies. Italian bond yield spreads have remained elevated over that period (Figure 1), while real GDP growth in Q3 was disappointingly slow (Figure 2). Italy has gradually made some modest concessions, such as a backup plan that involves a public asset sale should next year’s target not be met. Through each iteration, however, Italy has stuck to its initial deficit target of 2.4% in 2019, well above the 0.8% target for 2019 proposed by the previous government back in April.

– advertisement –


Thus far, EU officials have remained unsatisfied. In a report issued on November 21, the European Commission took another step toward an EDP against Italy. In short, the report showed that EU officials remain concerned about the fiscal outlook in Italy, and that they are exhibiting a willingness, at least for now, to use all the tools at their disposal to enforce fiscal discipline. Why this tough approach for Italy in particular? For example, a deficit of 2.4% of GDP next year in Italy would still be smaller than some other countries. France, for instance, is targeting a deficit of 2.8%.

The reasons are multi-faceted and nuanced, but Italy faces three fundamental fiscal headwinds. First, Italy has the second-largest debt-to-GDP ratio in the EU, behind only Greece. At 133% of GDP, Italy’s sovereign debt load is much larger than France’s or Germany’s (Figure 3). This previously accumulated debt gives Italy less leeway for additional deficit-financed stimulus if Italian authorities are to bring the debt-to-GDP ratio down over time. Second, Italy spends a much larger share on interest expense. At 3.6% of GDP, Italy’s interest expense is double France’s and quadruple Germany’s (Figure 4). Finally, the projected directional trend in Italy’s finances is set to move in the wrong direction under the proposed budget. In Italy’s draft budgetary plan, the structural budget deficit is projected to go from 0.9% of potential GDP in 2018 to 1.7% of potential GDP in 2019. By contrast, France projects a structural budget deficit of 2.0% of GDP, but this number is on an improving trend compared to previous years. In short, the EU appears wary of allowing a major economy with a large debt level and interest expense to reverse direction on its deficit target, even if that target remains within the 3% rule.

So what happens next? Next, EU government representatives on the European Council have to sign off on the European Commission’s report recommending an EDP, which appears likely very soon. From there, it is possible that the European Commission could formally launch the EDP against Italy as early as next week, though sometime in the second half of January/first half of February appears more likely. What would an EDP entail? After the process officially begins, Italy would have either three or six months to correct its fiscal excesses, with the three-month window reserved for particularly serious violations. Assuming Italy were to get the six-month window, this timeline implies the process could come to a head sometime in mid-2019. Were Italy to continue to defy Brussels after this time has elapsed, the country could be subject to a penalty of 0.2% of its GDP (about €3.5 billion), with growing penalties possible over time in the face of continued defiance by Rome. We lay out below three scenarios that portray how the ongoing Italian-EU budget relations could play out in the coming months.

Scenario One: Dragging Their Feet to an Eventual Compromise

In scenario one, the process continues to drag on as it has for the past few months. Officials in Brussels continue to slowly turn up the heat on Rome, while Italian policymakers remain defiant. Behind the scenes, however, the dialogue between the two sides continues. Eventually, perhaps even as late as after the EU Parliamentary elections in May 2019, the two sides reach an acceptable compromise. Both sides have incentives to avoid the worst-case-scenario. On Italy’s side, financial markets can keep the pressure on Italian policymakers. An increase in sovereign bond yields would pressure the government’s interest expense, while also raising benchmark borrowing rates throughout the Italian economy. Falling bond prices would pressure Italian banks and retail investors and likely dent the Italian stock market, unwelcome developments for the government coalition in power. From the EU side, one has to wonder just how far policymakers are willing to directly intervene in Italy’s sovereign budget. Unlike Greece in years past, Italy is not in any need of direct support at this point in time, and perhaps more fundamentally, Italy is much larger. Italy is one of the world’s ten largest economies with a sovereign debt market of about €2 trillion.

The EU report from Nov. 21 discussed earlier seemed to take particular issue with measures to lower the retirement age, as this could reduce the supply of labor and hamper potential economic growth. Proposals to increase public investment, in contrast, appeared to be given more leeway, at least in our reading of the report. Perhaps a potential compromise exists whereby some transfer payment stimulus is scrapped, but other investment-inducing policies (via the tax code and/or direct public investment) are allowed to remain more or less intact. Over the past week or so, Italian leaders have hinted they might adjust the 2.4% target for 2019, perhaps signaling some additional flexibility is in the offing. While the situation clearly remains very fluid and more back and forth is likely, this a tentative first sign that a compromise might be reached over time.

Under this scenario, Italian bond yields would likely wax and wane roughly within their recent range over German bond yields. Once a compromised is reached, spreads would likely compress, though probably not fully retracing back to the levels seen before the election. The euro would probably muddle through relatively close to current levels until a compromise was reached, at which point it would likely start to move higher versus the dollar.

Scenario Two: Unable to Meet Its Promises, Italy’s Government Collapses

Although Italian policymakers have not done enough to appease the budget hawks in Brussels, it is becoming clearer that the soaring rhetoric and outsized fiscal promises made on the campaign trail in Italy are unlikely to become a reality in full. Even if Italy’s draft budget plan were accepted as is, allocating the finite stimulus across so many competing priorities (tax cuts, increased public investment, a lower retirement age, a “citizens income,” etc.) wo