05 Nov 2018
The theatrical skills of Italy’s politicians have been displayed on countless occasions during the country’s often-turbulent history. Membership of the eurozone has simply complicated this already volatile political landscape. But the current drama involving the government’s planned budget, unveiled at the end of September and subsequently rejected by the European Commission on Tuesday (October 23), threatens to turn into a crisis that could engulf the eurozone.
The ball appears to now be firmly in Rome’s court as the European Commission scolded Italy by rejecting its budget submission; asking them to resubmit their homework in three weeks’ time.
For now, however, Italy’s coalition leaders seem eager to take on Brussels as Rome insists it has no Plan B and the Commission cannot force a revision. Speaking at the Eurasian Economic Forum in Verona on October 25, Deputy Premier & Interior Minister Matteo Salvini said: "The budget will give stability and tranquillity to Italy, we do not need outside help".
Julien Rolland, European rates portfolio manager at Aviva Investors, believes political calculations are influencing this rhetoric. “The Italian government wants to reshape the continental political landscape ahead of EU parliamentary elections next year, increasing the number of populist representatives to a level that can influence the EU’s economic policies.”
Salvini, the leader of Lega, may also be seeking to engineer a crisis with the EU as a reason to call another election in Italy, adds Rolland. Support for Lega has soared since the election, from 17 per cent to well over 30 per cent in most polls, making it Italy’s most popular party.
Unsurprised by this latest development, Stewart Robertson, senior UK and European economist at Aviva Investors, explains that the governing coalition’s expensive electoral promises have slammed into the EU’s conventions of fiscal prudence. “Financial markets are understandably worried that the result could be messy, and the latest news from Brussels merely heightens that feeling”, says Robertson.
The strictures of EU membership demand that member countries comply with fiscal guidelines, which include a gradual reduction in deficits, and a stabilisation – and eventual decline – in public debt-to-GDP ratios. Italy was on such a virtuous path of fiscal consolidation prior to the March election, but the vote propelled the unlikely coalition bedfellows of the anti-establishment Five Star Movement and the anti-immigration and Eurosceptic party Lega into power.
“Both parties have long been highly critical of many aspects of the EU and made spending pledges during the electoral campaign that, if implemented, would lead Italy on a path away from the EU’s fiscal targets,” adds Robertson.
One possible outcome is that Brussels will open an excessive deficit procedure against Rome, potentially as soon as November, a process that could ultimately lead to financial sanctions. However, if past euro zone crises are anything go by we should not underestimate the levels of brinkmanship capable on either side; behind the theatrics, some detailed revision to line items could see both parties save face and come to a compromise – albeit delaying an inevitable clash further down the line.
The ratio of public debt-to-GDP in Italy, at around 132 per cent, is already among the highest in Europe. Any deviation from fiscal restraint could swiftly lead to significant problems, as recent developments in bond markets are already demonstrating.
Italian 10-year government bond yields moved out from 1.8 per cent in April to 3.70 per cent on October 19, after the government’s budget plans were revealed, before easing back to below 3.4 per cent on October 29. Meanwhile, in the space of a month, the spread between Italian government bonds and German bunds widened from 243 basis points to 322 basis points between September 24 and October 24, before falling back to just below 300 at the time of writing (October 29).
The previous government had planned to reduce Italy’s budget deficit to well below 1.6 per cent of GDP this year and to 0.8 per cent in 2019. The new regime’s plans to ramp up spending would leave the budget deficit at 2.4 per cent in 2019, with targets for 2020 and 2021 of 2.1 per cent and 1.8 per cent respectively.
The initial 2019 budget proposed cancelling a VAT rate hike that would have reduced the deficit next year to about 1.2 per cent of GDP. The administration also plans to introduce a minimum guaranteed income; cancel part of the 2011 pension reform; and introduce the first phase of a flat income tax. Deficit spending will total €22 billion in 2019, with the budget including €15 billion in cuts and extra revenue to help cover €37 billion in total additional spending.
Perhaps most worrying of all the budget targets are based on overly-optimistic growth assumptions. The government anticipates the economy will expand by around 1.5 per cent per annum over the three years covering 2019 to 2021, accelerating from the 1.2 per cent expansion it is forecasting this year. This view is at odds with other forecasters, who are projecting much lower growth. The IMF, for example, expects annual growth to average less than one per cent over the 2019-21 period.
Geoffroy Lenoir, head of euro sovereign rates at Aviva Investors, does not believe the government’s spending plans will provide a significant boost to growth either. “The government has yet to fully detail its programme so it is difficult to gauge the overall impact,” he says. “But while implementing the minimum guaranteed income could boost consumer spending, some of the other measures could have a negative impact on growth. Any slowdown in the global economy would also weigh on Italy.”
Lenoir had expected total government debt to decline over the next three years, but the budget’s “ambitious forecasts in term of growth and the cost of servicing that debt means that is now in doubt”. All eyes will now be on the contents of the revised budget in hope of improvements.
While Italy and the EU are at loggerheads, Lenoir believes investor sentiment will ultimately have more sway in influencing the Italian government than Brussels. “A prolonged spike in yields to over four per cent and a loss of investor confidence is the one development likely to change the political mood,” he says. “In that scenario, the economy would enter a vicious tailspin as higher borrowing costs force up the deficit and the country’s debt burden.”
Growing fears over debt have led to speculation Italy could lose its investment grade status from major credit rating agencies. Lenoir, however, believes this is unlikely – in the short-term at least.
“The agencies will look at the impact of the budget on Italy’s medium- to long-term prospects and it will be sometime before the effect becomes clear. A downgrade to sub-investment grade would see Italy leaving certain benchmarks and would raise questions about financing and liquidity. Given the size of the Italian economy and its debt, that would have enormous consequences for the eurozone and global economies so a downgrade will not be taken lightly,” he says.
Although Moody's downgraded Italy’s sovereign debt rating to one notch above junk status on October 22 due to concerns over the budget, they have kept their overall outlook stable which appears to support Lenoir’s view. Similarly, S&P cut Italy’s overall outlook to ‘negative’ but kept its credit rating as BBB.
The situation so far has been well contained, with the spike in Italian yields having little impact on other peripheral euro zone countries, with the possible exception of Greece. And while Italy does not need any funding until December, its requirements next year are projected to increase by around €30 billion. The European Central Bank’s support programme for Italy is expected to fall from around €70 billion (net purchases of around €55 billion plus reinvestment of around €15 billion) to around €30 billion over the year, at the same time as its deficit will widen.
The government’s reliance on domestic buyers is a concern, adds Rolland. Something that will only change if foreign investors start to gain confidence in Italy’s economic and political prospects. None of the theatrics displayed so far bode well. This latest Italian drama is fraught with danger and there could well be more than one act left yet.
Julien Rolland - Portfolio Manager, Rates
Stewart Robertson - Senior Economist (UK & Europe)