Italian budget negotiations signal risk; sanctions a possibility

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Source: Eurostat, AMECO European Commission

By Caroline Lupetini

BOLOGNA, Italy — Italy is playing a dangerous game. Government reforms by Italy’s populist government — the somewhat-shaky coalition between the anti-establishment Five Star Movement and the right-wing League — have drawn deep ire from Brussels for the “significant deviation” from previous commitments to lower Italy’s enormous public debt. Italy’s debt is currently more than 130 percent of the country’s GDP. The reforms promised by party leaders Luigi Di Maio and Matteo Salvini include an universal income for unemployed Italians (which is nearly 20 percent in the south) and reinstating a more generous pension scheme.

Though Di Maio and Salvini claim their expansionary budget for 2019 would boost consumption, pushing economic growth and reducing the government debt, EU leaders are less optimistic.  The European Commission predicts that GDP growth will be just one percent this year. The European Commission called the spending plan an “unprecedented” breach of EU rules and norms for spending, which could trigger sanctions against Italy of about $4.5 billion. Furthermore, Salvini and Di Maio lack support from both Angela Merkel and Emmanuel Macron, who have openly discussed their distaste for the Italy’s populist government.

As a result of this tension between Italy and the European Commission, the credit ratings agency Moody’s downgraded Italian sovereign bonds from Baa2 to Baa3 — just one level above junk status. The downgrade indicates that the market believes Italian bonds are highly risky due Italian financial entities’ potential inability to settle their debt and lending obligations. Moody’s shares the European Commission’s concern over Italian debt explaining, “Italy’s high debt level severely limits authorities’ ability to use fiscal policy to cushion any future economic downturn, which will inevitably come.” Additionally, Standard and Poor’s, another rating agency, revised its outlook on Italy to “negative,” though it left the bond rating at BBB (two levels above junk grade).

Andrea Carosi, professor of corporate finance at SAIS Europe, said in response to the debt downgrading that Italian bond rates will continue to rise. Higher interest rates on government bonds lower the price of those bonds, in hopes of enticing buyers despite the higher risk. The spread between Italian and German bonds’ interest rates – a proxy for the risk premium of buying Italian bonds – recently reached a high of several years and continues to hover at nearly 3 percent. Professor Carosi predicted that the spread will likely remain quite large. However, he said that the worst-case scenario would be that the Italian market becomes so risky that it becomes a risk for the entire European market, in which case German bond rates will increase as well. Despite this, Carosi feels that Italy will not be left to fail, despite the doom and gloom surrounding these budget negotiations.

Investors, meanwhile, are turning away from Italy: Goldman Sachs recently downgraded two major Italian banks to “sell” status, and said that major bank UniCredit “is now the only Italian bank we rate buy.” However, what is a financial nightmare for Italy may be a political boon for Di Maio and Salvini. Euroscepticism and fighting Brussels is popular at the polls, which will be important to watch ahead of European Parliament elections in 2019. Italians may continue to elect politicians that will put “Italy first,” turning Italy away from the European Union and towards the divisive rhetoric of the Five Star Movement and the League. Italian domestic politics have a penchant for being quite unstable; however, only time will tell if the coalition between these two parties – who have several disagreements over domestic policy – will last until the next elections.