Markets alone will determine Italy’s future

Letters have been flying back and forth between Rome and Brussels in the last few weeks, as officials argue over Italy’s proposed budget. To my mind, these letters are a sideshow—the markets alone will determine Italy’s future.

To recap: Italy’s government submitted its 2019 budget plans to the European Comission on October 15, confirming plans to increase the country’s structural budget deficit rather than reduce it.¹ In reality, Italy’s budget deficit is likely to grow even more than projected, as the draft budget includes what most economists consider to be wildly optimistic growth projections.

In response, the Commission wrote to Italy last week, asking the government to explain why it believes the country should be allowed to break the bloc’s fiscal rules.

Italy’s Finance Minister Giovanni Tria promptly wrote back, explaining that “the Italian government is conscious that it has chosen a budget policy approach which is not in line” with the EU’s fiscal rules, but that the coalition government intends to deliver on some of its fiscally expansionary campaign promises to boost economic growth.¹

Cue the latest missive from the European Commission to Rome, rejecting Italy’s draft budget. The Italian government has three weeks to write a letter to Brussels, proposing a new budget for 2019. Brussels then has a further three weeks to respond with yet another letter, outlining what it thinks of the revisions. 

If the Commission rejects Italy’s revised budget, then disciplinary procedures will begin in December. The timing for Italy couldn’t be worse, as it coincides with the European Central Bank (ECB) phasing out its asset purchases, which have compressed the country’s borrowing costs significantly since 2012.² Without central bank support, the country will likely see its financing costs rise.

Once Eurostat (the EU’s statistical office) finalizes its fiscal data for 2018 in the second quarter of next year, the EU can eventually push to impose sanctions on Italy—which would start off at 0.2% of GDP—and cut some of Italy’s EU funding. 

“If the Commission rejects Italy’s revised budget, then disciplinary procedures will begin in December. The timing for Italy couldn’t be worse ...”

One thing we can be sure of—many more letters will be exchanged between now and then. In my view, however, this conflict between Italy and the European Commission is a bit of a sideshow. Sure, the Commission has a lot to lose. It can’t be seen to allow a eurozone country to flagrantly throw its fiscal rules to the wind, thereby weakening economic governance in the currency bloc. But, ultimately, it will be the response of the financial markets alone that will determine Italy’s course, not letters.

The leader of the Five Star Movement, Luigi Di Maio, recently asserted: “Markets love Italy more than some European institutions do.”³ The Italian government seems to be really banking on this. So far, the spread between Italian government bonds and their German equivalent has shot up to over 300 basis points—the widest in over five years, but still far off the highs of 2011.²

But what if Mr. Di Maio is wrong? If Italy’s borrowing costs spike further, it would be difficult to guess how the Italian government will react. It could finally feel the heat and snap back in line, deciding to comply with European rules—much like Greek Prime Minister Alexis Tsipras was forced to do in July 2015.³

But if market pressure isn’t enough to nudge them into an Italian volte-face, I see three main areas of concern.

First, Italy could be downgraded to junk status by the main credit ratings agencies. Moody’s downgraded Italy to one level above junk last week and S&P is due to review Italy’s rating on October 26.⁴ While it seems unlikely that Italy will be given junk rating status by three of the four main rating agencies, it remains a possibility, and the repercussions would be severe. Italy would be ineligible for the ECB’s asset purchases as well as its reinvestment scheme. Although the ECB has yet to spell out details of its reinvestment policy, it does seem there could be wiggle room for countries that need extra support. It would be a shame for Italy to forgo this at a time when it may need help the most (to lower its borrowing costs).

Second, Italy could face an investor strike to the extent that it’s unable to issue debt in the markets, which is problematic because there’s no feasible plan B. The ECB asserts that Italy can always ask for an Outright Monetary Transactions program, a bailout that comes with strict conditionality. It’s always been hard to imagine any Italian government accepting the conditions involved—and particularly this populist, Eurosceptic government.

Even more likely than an investment strike, Italian banks could suffer from higher government bond yields, given their heavy exposure to domestic sovereign debt. As Italian bond yields rise, prices fall—hitting capital ratios, potentially necessitating additional cash injections. And let’s not forget—the issue of nonperforming loans continues to lurk in the background.

At just under seven years, the average maturity on Italian bonds is fairly long, meaning a jump in borrowing costs shouldn’t push Italy into immediate bankruptcy.² This gives Rome and Brussels a lot of time to write each other yet more stern letters.

But keep an eye on market pressure—that alone will eventually reveal how dedicated the government is to Italy’s continued membership in the eurozone.

1 “Italy Vows to Stick to Budget That Breaches EU Rules,” the Wall Street Journal, October 22, 2018. 2 Bloomberg, as of October 23, 2018. 3 “In First for Europe, Brussels Rejects Italy’s Budget,” the Wall Street Journal, October 23, 2018. 4 “Moody’s downgrades Italy’s ratings to Baa3, stable outlook,” Moody’s Investors Service, October 19, 2018.