Italy grabs the EU by the… budget…

The Italian coalition government has entered into open rebellion with the European Union by presenting a draft budget that incorporates a massive increase in its spending, in direct violation of the Growth and Stability Pact and its own commitment to it.

As the European commission has stated, the draft budget “is not in line with the commitments presented by Italy in its Stability Programme of April 2018”.   In July of this year, the Italian Government accepted and agreed to accept and abide by the recommendations of the European Council of ministers, to which it belongs

Let’s clarify where Italy stands at this juncture and why its draft budget represents a threat to its own economic stability.  Moreover, this action also risks violating the European Union’s “bonds of trust” in the words of Mr. Dombrovskis Head of the European Commission’s Financial Stability, Financial Services and Capital Markets Union.

Last year, Italy recorded a primary budget surplus (excluding debt servicing) which stood at a commendable 1.5% of its gross domestic product (GDP). Yet its overall deficit stood at 2.3% of GDP in 2017 due to the large cost of debt servicing. With an overall debt/GDP ratio of 131.2% in 2017, interest payment stood at 65,5bn euros last year, 3,8% of GDP. The burden of public debt is indeed a permanent

The EU Commission is considering the Italian draft budget with regard to the rules of the Preventive leg of the Growth and Stability Pact (GDP):

• The expected structural adjustment (i.e reduction of the deficit, regardless of the economic cycle) of 0,6% of GDP in the Preventive leg of the GSP, will now be an 0,8% of GDP outright expansion.   
• In nominal term, the fiscal deviation from the GSP is of an unprecedented amount: the fiscal expansion announced in the draft budget is of 1% of GDP, this would be a 25 bn euros extra spending, according to the Commission.
• Furthermore, the implied reduction of the debt/GDP ratio is based on overly optimistic assumptions, starting with growth. The Commission does not believe, that this budget would help contain or better reduce the (Italy’s) overall country’s debt.
• The EU commission reminds all governments that these rules have been commonly agreed and sealed in a treaty that they are committed to uphold.
• Of course, there are margins for manoeuver as governments are free to choose their budgetary path to meet these targets:
  • If a member state were experiencing a severe economic downturn,
  • If a member-state were to introduce major structural reforms, overall structural spending effort could be reduced, extended over time (i.e, between 0,2% – 0,3% of GDP instead of the expected 0,6%).  The Italian coalition has on the contrary vowed to redesign the retirement system, in effect allowing many to retire at 60 or a bit less that the expected 67, after the last leg of the previous law is introduced in 2019.  
• Finally in its statement, the European Commission reminds Italy that the country benefited from “substantial support through EU-backed financing in recent years” (…).  “The second biggest beneficiary under the Junker plan” Italy has received important support in financing investments, supporting SME’s competitiveness, assistance for “security threats, refugee crisis and earthquakes”, states the report.

From the Italian government’s perspective:

• The draft budget plan aims at supporting the economic activity and therefore will foster greater employment creation, leading to increased revenues, investments and spending, and in the end reduce the overall deficit and debt.  In essence Italy will grow its way out of its deficit.
• Italy also argued that other countries – France among others, Spain, Portugal – were allowed some leeway and did not respect the GSP, without incurring any actual financial penalty.
• It cannot be denied that holding a primary surplus over a long period of time, can be economically painful too, and provide an excessive burden on the overall economy. Greece is recording large primary budget surpluses to tackle the burden of its debt.

One cannot ignore that the draft budget is also a political message openly defying the European Commission, and institutions, and enabling the coalition in government to hold its promises and eventually reject to external forces the responsibility for Italy’s difficulties. Contrary to the 2011 years, the share of foreign ownership of the Italian debt has fallen dramatically, to around 25%.

What’s next?

If the Italian government maintains its draft budget, the Commission will issue a statement and recommend the European Council of ministers to issue some stricter recommendations, or even consider some financial sanctions. The Italian government is most likely to be seeking a confrontation/negotiation at the political level, rather than with the Commission.   The country may use this conflict to negotiate concessions, for example, excluding the debt held by the ECB from the calculation of its own debt (which represents about 230 bn euros, almost 12% of its GDP), excluding some large public investment spending from the deficit calculation etc. and avoiding sanctions.

Such tactics incur some major risks however:

• Markets may also render judgment on this development by widening the spread between Italian and German (Euro) bond spreads.   With the Italian bond (BTP)/Bund already over 300bp, many analysts consider that a move to 400 basis point spread with the German bund, would negatively impact Italian banks and corporates, as investors shy away from the credit exposure.  
• Italy could alienate “northern” European member states, which would complicate matters in the event Italy might need additional help later on (through the European Stability Mechanism ESM).   It could also lead more fundamental questions about members’ allegiance to the EU and its treaties.

What a waste!

This confrontation is a lot of wasted energy just when economic efforts were starting to payoff. On the public debt front – when Italy had to save some of its banks – the overall debt/GDP ratio had peaked in 2016 at 132% of GDP and was slightly lower in 2017 at 131.7% of GDP.  With a continuous primary budget surplus, the debt/GDP ratio would have started to decline quite significantly, as real rates have peaked and nominal rate had begun to fall, providing the government with some rising margin for manoeuver. The expected end of the net ECB bond purchase programme by the end of the year, may make matter worse.

Possible outcomes in the coming weeks:

• The Italian government could revise its draft budget to meet the Commission recommendations, though the gap remains wide and only see a small probability of this happening.
• The European Council may be willing to enter into a larger set of negotiations, seeking compromise. But the larger the compromise the greater the risk any deal exacerbates discontent arises among Europeans particularly the “German/Scandies” who fear they will eventually foot the bill. Just months ahead of the European parliamentary election, it seems that the “anti-EU camp” would just be reinforced.
• ECB president Mario Draghi used a strong tone towards the Italian government recommending to “(…) reduce the tone and don’t question the constitutional existential framework of the euro”.

In the meantime, the euro is faltering – fast approaching the 1.1203 5 year resistance level vs USD –  and the bond market spreads of peripheral euro area countries start to widen, albeit more moderately, against the German bund. Following rating downgrade of Italian public debt and other institutions by Moody’s (to Baa3 level with stable outlook). With the threat of major crisis ahead, we feel that the Italian coalition is confident it can draw a compromise from its European partners and claim victory ahead of the European Parliament election next spring. If that were the case, markets would probably rally in the very short run. But the expected deterioration of Italy’s public finances while headwinds strengthen, due to a deteriorating global environment, may just offer a short term reprieve.

In the longer run, the rise in the populist movements in Europe ahead, does not bode well for any definite fix or “reasonable” compromise.

Valérie PLAGNOL

October 26 2018