The run-up to the Italian budget has been dominated by uncertainty: the two parties forming the recently established government, the anti-establishment 5-Star Movement and the far-right League party, want to deliver their electoral campaign promises of tax cuts and increased public spending, despite the country’s mammoth debt pile, and flout European Union (EU) deficit limits.
However, in recent days, news reports have suggested that the Italian government coalition members are about to reach a compromise on the nation’s budget deficit. As the deadline for the government’s fiscal targets looms, here are the key considerations that financial markets should pay attention to:
The Italian government must present its deficit and debt targets by Thursday, 27 September. Like all other eurozone countries, Italy will submit a draft budgetary plan for next year to the European Commission by 15 October (even though last year the government sent the budget on 17 October). The European Commission will then have two weeks to issue a non-binding opinion on the budget, with a final vote by the national parliament expected by the end of the year. The European Commission could choose to reject the Italian budget – a power it has never used so far – if it does not conform to the EU rules. Under these rules, no member country should have a deficit larger than 3% of GDP – and member countries are required to set targets every year to show they are moving in the right direction in terms of debt sustainability. If a rule is breached, the EU can initiate an excessive deficit procedure (EDP) against the member state at fault, which can lead to sanctions. But that is unlikely to happen at this stage.
At 132% of GDP, Italy has the biggest public debt pile in the eurozone after Greece. What’s more, recent developments could put the country’s debt mountain on an unsustainable course: economic growth has slowed this year and funding costs have increased in recent months in response to domestic political uncertainty. The latter is still weighing on the budget process: a three-way division has emerged within the government as the country’s economy minister Giovanni Tria tries to juggle the League’s demands for a flat tax and the 5-Star Movement’s proposed universal basic-income guarantee alongside the EU deficit limits. However, Tria has reassured European institutions and financial markets by endorsing an orthodox approach to the budget, which respects the EU’s fiscal rules, rather than accommodating the ruling parties’ aforementioned flagship policies and blowing the country’s deficit (they are jointly worth €80-100bn, or 5-6% of GDP). This week the Italian media reported that Tria would allow a budget deficit of 1.9%, suggesting the 5-Star Movement’s leader Luidi Di Maio has backtracked from an earlier suggestion that France’s deficit of 2.8% should be copied. Indeed, the country’s deficit targets will probably include some diluted versions of both parties’ promised policies – even though, less than 48 hours before the deadline for the country’s fiscal targets, Di Maio threatened to withdraw support for the budget if it does not include the full funding for the 5-Star’s planned universal basic-income guarantee1.
In the end, the government is likely to respect the fiscal rules stipulated by the EU. After all, to raise funding for its spending plans, it will need to have financial markets on its side. As such, the budget deficit may show a fiscal deficit of 1.6-2% of GDP for 2019 – that’s higher than the target of 0.8% of GDP set for 2019 by the previous administration, but roughly in line with this year’s expected outcome – and it’s likely to be accepted by Brussels, reluctantly.
There are risks of a policy accident. If the coalition government fails to reach a compromise on the budget and a government crisis ensues, the stringent EU fiscal rules could serve as a convenient explanation for its demise.
Although there have been conflicting statements from the coalition in recent months, our base case is that a compromise will emerge – but there will be some bumps in the road to budgetary approval – and the coalition government will remain intact, for now. However, tensions are likely to re-intensify ahead of the European Parliamentary elections in May next year.
For now, the budget is likely to be another missed opportunity, focusing on whatever small achievement has been made by way of higher spending or lower taxes. Disappointingly, there will be little emphasis on the much-needed structural reforms, which are essential to boosting the country’s depressed potential growth and thereby ensuring debt sustainability in the longer term.