Is Italy about to face an excessive deficit procedure?

Trouble is brewing again in Italy. The success of the Lega party in the recent European elections means the prospect of fresh parliamentary elections cannot be ruled out. At the same time, the European Commission is recommending that an excessive deficit procedure be initiated against the Italian government. But it is the capital markets that have the greater leverage over Italy.

Italian politics has been in the headlines for all the wrong reasons again in recent weeks. Even before the European elections on 26 May, the capital markets were taking seriously the statements of Matteo Salvini, foreign minister and leader of the Lega party, and those close to him – particularly on the subject of pushing back against the EU’s debt rules. Fears of another row between Rome and Brussels about government debt and Italy’s budget deficit caused spreads on ten-year Italian government bonds over German government bonds to rise by just over 30 basis points between the middle of March and the date of the elections. Following the unexpectedly strong showing of the Lega party in the elections, the spread initially widened by a further 20 basis points in a fragile market already weakened by the trade conflict and concerns about the economy. In recent days the situation has been calmed somewhat – at least for a while – by conciliatory comments coming out of China and the prospect of monetary policy support from the Federal Reserve held out by Fed Chair Jerome Powell.

The Lega party secured 34.3 per cent of the popular vote in the election on 26 May. This was the best result in its history and put it way out in front of all the other parties. In contrast, the left-wing Five Star Movement led by Luigi di Maio managed only 17.1 per cent – half the share it won in the Italian parliamentary elections in March 2018. The balance of power within the coalition in Rome has thus shifted considerably, which could prompt the right-wing Lega to end the coalition. If there were an early Italian parliamentary election and voting went the same way as in the European elections, under Italian electoral law the Lega could secure a governing majority in a right-wing alliance with the much smaller Fratelli d’Italia (Brothers of Italy). This prospect is made more likely by the fact that initial opinion polls following the European election show that support for Salvini is still rising. In a coalition of this kind, the Lega party would be the dominant partner.

Polls show Lega to be the strongest party by some margin

Polls show Lega to be the strongest party by some margin
Source: pollofpolls.eu; 4 June 2019; Polling numbers for the four largest parties

The earliest possible date for fresh elections would be September. However, this clashes with the presentation of the 2020 budget in the Italian parliament, which is currently scheduled for 27 September. President Sergio Mattarella, who would have to call the new elections, needs a functioning government in order to get the budget passed. Were the country to go to the polls at the start of the month, it is highly unlikely that a new coalition government would be up and running in time. However, it is equally questionable whether the current coalition would be able to reach a consensus on the matter of the budget. After weeks of wrangling and the threat of resignation by non-party prime minister Giuseppe Conte, the coalition partners have recently moved closer together again. According to press reports, Luigi Di Maio and Matteo Salvini have discussed the possibility of breaking the EU deficit rule in a telephone conversation. The government remains committed to gestures of largesse, whether in the form of a new ‘citizen’s income’, pension reform or radical income tax cuts – but without any serious proposals on how this would be funded. At the same time, the coalition partners appear to be increasingly distancing themselves from the automatic increase in value added tax to raise an additional €23 billion that was agreed with the European Commission in connection with the dispute in November 2018. This is also moving them further away from Conte’s position, which is to insist that Italy should comply with the European Union’s debt rules. So even if the current coalition were to continue, the budget could become the make-or-break political issue in Italy.

The budget will be the make-or-break issue for Italian politics

The budget will be the make-or-break issue for Italian politics
Source: Union Investment, as at: 07 June 2019

European Commission recommends launching an excessive deficit procedure against Italy

So far, the European Commission has merely issued warnings but it is now recommending that disciplinary proceedings be launched against Italy in response to the excessively high level of government debt. Reports suggest that a letter to this effect has been sent to Rome. EU sources say the Commission concluded that the action taken by Italy’s government in 2018 to rein in debt was insufficient. The next step will be for the EU member states to examine the matter. Italy may end up being fined by Brussels to the tune of several billion euros.

Debt levels and interest burden rising

Debt levels and interest burden rising

In 2018, Italy’s debt had risen to 132 per cent of GDP, the second highest level in the EU after Greece (181 per cent). In absolute figures, Italy’s debt burden currently amounts to around €2.3 trillion. The EU’s rules on borrowing state that when debt exceeds 60 per cent, credible measures must be introduced to reduce it. This hasn’t happened in Italy, which means a further increase in the budget deficit is almost certainly on the cards and this is why the Commission has acted. From an investor’s perspective, the critical issue now is that the deterioration of Italy’s primary fiscal balance is increasingly calling the country’s ability to service its debt into question. Thanks to the zero interest rate policy of the European Central Bank (ECB), Italy is currently benefiting from a credit market that is still very favourable by historical standards. However, if investors demand significantly higher interest rates for future loans to the Italian state, this could lead to a downward spiral.

But the road from the initiation of an excessive deficit procedure to the imposition of a fine is a long one. Following a recommendation by the European Commission, a majority of Europe’s finance ministers have to vote in favour of opening proceedings. And the proceedings themselves can then take several years. The agreement of the majority of member states has to be obtained at each important stage of the process. And Italy can also avoid the fine by implementing the EU’s recommendations in its budget for 2020. It has to present its plans for this budget to the Commission by 15 October. Even if the Italian government stands its ground, a financial penalty is unlikely – at least if historical precedents are anything to go by. The EU has never yet imposed a fine of this kind. Action was eventually taken against Spain and Portugal in 2016 following years of deficit rule violations, but in the end the European Commission and finance ministers decided against imposing a fine. The reason given at that time was the precarious economic and social situation of both countries.

The Italian government thus has every reason to hope that it will escape without punishment. Confrontation with the EU is inevitable, following Italy’s breaking of all borrowing and deficit rules, and will in all likelihood end up in an excessive deficit procedure. Italy would have to reduce its structural budget deficit by 0.6 percent of GDP per year but the Commission’s latest forecasts indicate that the deficit will widen by 1.2 per cent of GDP in 2020. This doesn’t even include the latest tax cuts proposed by Matteo Salvini which would almost double the deficit. Almost three quarters of the currently expected gap could be plugged by increasing VAT. But the Rome government’s fear that this could tip the stagnating Italian economy into recession is entirely justified. And a fine would make the situation even worse.

Capital markets have greater leverage

While politicians appear to have their hands tied, to some extent at least, in terms of exerting pressure on the Italian government, the capital markets probably have the greatest leverage. A rigid and confrontational attitude is likely to lead to further interest rate hikes and widening spreads on Italian government bonds and thus have a knock-on effect in other segments of the Italian bond market. Given the current state of the economy, the government would have no economic policy levers at its disposal and would be forced to react to the higher interest rates.

Unless otherwise noted, all Information and illustrations are as at 07 June 2019