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italian budget and market implications

October 2018

Italy's looming budget bust-up

Italy's new coalition government is putting together a populist budget that won't be popular with the EU.

Italy has become the edgy uncle at the family gathering, leaving its European Union partners on perennial tenterhooks.

The latest furore centres on the proposed three year budget being hammered out by Rome’s new populist government.

Lega and Five Star, the two coalition partners, made a series of very expensive promises to Italian voters at this year’s general election. Proposed measures, which are heavily skewed towards transfer payments, include universal income, pension increases and a flat tax. Some public investment also pencilled in, designed to boost growth.

Initially, there were fears that putting these into practice would cause the government’s budget to wildly exceed the deficit limits previously agreed with the EU, ultimately threatening to put Italy in breach of its treaty obligations. At an extreme, an irresponsible budget could potentially lead to Italy’s eventual abandonment of the euro. The markets reacted accordingly, sending spreads on Italian government bonds sharply higher and causing the euro to wobble.

An element of backpedalling took some of the immediate pressure off the markets – maybe the proposed spending programme won’t be as big as investors feared, as suggested by the latest news coming from Rome.

But the tension between trying to satisfy a disgruntled populace and sticking to policies fundamental to membership of the euro suggest that Italy is likely to spur regular bouts of asset volatility – potentially infecting weaker member states.

The devil will be in the detail

Details are thin on the ground, but here’s some of what is being conjectured and our view on how it might matter:

The proposed budget leaves the government with a projected deficit of 2.4 per cent for 2019. That’s, on average, above the 2 per cent deficit previously estimated and well above official Stability and Growth Convergence Programme projections from April, which forecast a 0.8 per cent shortfall next year.

This is not necessarily hazardous to Italy’s financial health. Even with the new projected annual budget deficits, as Italy’s debt service costs remain stable at around 3.5 per cent of GDP, the debt to GDP ratio will not increase as long as nominal economic growth remains above 2 per cent.

The plans will, however, slow the pace at which Italy’s very high public debt to GDP ratio shrinks. Last year’s eye-watering debt ratio of 131.8 per cent was forecast to fall to 122 per cent in 2021 under the old budget projections. The new, higher deficits, would leave that ratio at 124.9 per cent in 2021 – assuming nominal GDP growth declining to 3.0 per cent over the coming three years. It does, however, run counter to requirements laid out by EU treaties.

This leaves Italy’s EU partners with a difficult choice. Do they enforce the bloc’s rules, possibly precipitating political and financial crises? Or do they avoid a confrontation and turn a blind eye to Italy’s transgressions. Signs aren’t hopeful for compromise.

troublesome numbers

Projections for the Italian economy, public finances and labour market, annual percent change except for public debt which is percentage of GDP

projection italian economy

Source: Pictet Asset Management, Italian Department of Economics and Finance (DEF). *Structural budget as updated by the DEF in October 2017. In black are current DEF forecasts, in red are revised projections based on government announcements made by 04.10.2018 and Pictet Asset Management calculations.

The markets, meanwhile, are trying to absorb all the various permutations. Spreads on Italian government bonds over equivalent German bunds have widened to around 300 basis points, bumping up against the top of recent ranges. About 110 of those basis points are related to redenomination risk, ie that Italy abandons the euro in favour of its own currency. Our models suggest the market is pricing a 10 per cent probability of an Italian exit. And the governing coalition is in no hurry to offer convincing reassurances of a commitment to the single currency.

In part, Italy’s ruling politicians are gambling on three propositions. One, that the EU’s leadership is weaker than ever and that the union’s political landscape will change at the next elections. Two, that anti-establishment parties will win sweeping victories. And three, that the EU will renegotiate its rules if Italy does not comply.

This is the sort of game of political chicken that runs a serious risk of ugly accidents. That’s a problem not just for Italy but for the rest of Europe as well, given that Italy’s financing needs are too big to be covered by EU and European Central Bank safety nets.

At some point in a confrontational process, the threat of leaving the euro zone develops its own unstoppable momentum. If there’s good news for now, it is that this latest iteration of Italian turmoil isn’t infecting other European peripheral markets. The Italian uncle has spilt wine on himself and twisted his ankle trying to jump over chairs, but hasn’t (yet) fallen off the balcony onto anyone.