Italy is testing the limits

1 October 2018 11:58 RaboResearch

On 27 September the Italian government presented its budget target for 2019. The worsened outlook has shocked markets and kept them busy since. The government will expectedly temper part of its plans if necessary to calm markets. That said, the risk that it will do too little too late cannot be neglected.

Rome, Italy - The Consulta Palace, home of the Constitutional Court of the Italian Republic. In Piazza del Quirinale, Roma, Italy. Architect: Ferdinando Fuga.

Deficit up, confidence down?

In the evening of 27 October, the Italian government announced that it has lowered the budget target for next year to -2.4% from the -0.8% set by the previous government in April. The increase in the deficit target implies a defeat for Finance Minister Giovanni Tria who supposedly had aimed for a target between 1.6% and 2%. So while Tria has been able to prevent the implementation of the entire government contract, which would have led to a deficit of more than 6% of GDP, he seems to have accommodated the wishes of both coalition partners more than initially planned. It leads one to question both his influence over government policy and his future within this cabinet.

An update to the economic growth outlook and targets for the structural budget deficit and public debt have not yet been published. If we adjust the increase in the deficit target for a weakened growth outlook and higher than expected bond yields, current figures suggest that the government intends to spend around EUR 20bn more than the previous government had intended to do. In this example we assume that the government has adjusted down the economic growth outlook for 2019 from 1.4% (forecast of last April) to 1% or just above that, based on suggestive comments by government officials in the past weeks. Recall that the total costs of the government contract are estimated at between EUR 100 and EUR 150bn.

Plans still rather vague

While the detailed budget plan for 2019 is not yet known, last night government officials made clear that the government will (partly) implement the Five Star’s flagship citizen’s income, reduce tax rates for 1 million self-employed (part of the League’s flat tax proposal) and lower the possible retirement age for about 400.000 workers. According to the government, it will set aside EUR 10bn for the citizen’s income plan. Recall that estimates of the full implementation of Five Star’s initial plan range from EUR 15bn to EUR 30bn a year. The costs of the other measures in the budget 2019 have not been clarified yet, but figures that were mentioned by government officials in the past week(s) are EUR 5 to 7bn for the pension reform and up to EUR 5bn for the first flat tax measures, also less than the costs of the initial plans. When we add up these figures it becomes clear that the government would have next to nothing more to spend on public investment and not have enough room to compensate for the cancellation of the scheduled VAT hike in January, which the government has previously committed to scrap. Cancelling the VAT hike would lead to lower revenues of about EUR 12bn. As the government does not seem to have changed its mind on these issues, it follows that they intend to compensate for these measures by cutting other spending or raising other revenues. Alternatively, the growth forecast for next year could be substantially higher economic than the number we have done the math with (1%). Comments by PM Conte, speaking to the press on Friday, seem to point in that direction. Indeed, he said that the government plans EUR15bn of investments over the next three years and that this budget aims to spur growth and that that is the way to improve the debt. Whilst the prime minister believes that markets will support the budget when details are given, we would not be so sure.

Market reaction points at further risk going forward

The release of the headline target was not received well by the markets, with Italian 10-year bond yields up by more than 35bp (more than 40bp wider versus Bunds) and the stock market down by more than 4% (figure 1). Especially banks are bearing the brunt given their large exposure to government debt (figure 2). Trading in several banks was even temporarily halted. Importantly, the current budget targets are (still) compatible with a decline in the debt to GDP ratio based on our current growth forecast, but only just. Looking forward, we think the current targets are not the end of the saga. We believe tough negotiations between Brussel’s and Rome lie ahead, which will make for multiple headlines in the press, feeding uncertainty over the ultimate outcome. Hence, we believe market volatility is here to stay for some more months.

Figure 1: Investors show discontent with budget target (intraday 28 September)

Source: Macrobond, Bloomberg

Figure 2: Public debt remains on downward path with deficit of 2.4%

Note: We expect nominal GDP growth to be 2.6% in 2018 and 2.4% in 2019. Source: Macrobond, Italian government, Rabobank

Brussels is not going to be happy

The 2019 budget deficit target falls within the 3% deficit limits in the European budget rules, but the current settings (for as far as has been made known) makes it impossible for government finances to comply with the rule for debt reduction and structural budget balance improvement. The latter, for example, requires Italy to reduce its structural budget balance, i.e. the cyclically adjusted budget balance excluding one-offs, by 0.3%-points in 2018 and 0.6%-points in 2019. From the general budget target it follows that the structural balance is set to deteriorate instead. A general budget balance of 1.6% would supposedly imply a minor improvement in the structural balance. Moreover, next year’s target seems to be based on either too high growth expectations and/ or too optimistic gains from spending cuts and revenue raising measures, although –again- we have to warn that not many details are available at this point.

It will be up to the European Commission to decide whether the figures presented in the 2019 budget later on are realistic and compatible with the budget rules. In the end we expect the Italian government to reach a compromise with Brussels, including substantial flexibility regarding the budget rules, but only after tough negotiations, accompanied by a defiant and anti-euro rhetoric by both government parties. Neither Brussels nor the government parties would seem to benefit from a failure to reach a compromise, but also not from pleasing the other side of the table too much. On the one hand, Brussel probably wants to prevent looking too weak and induce other countries to significantly loosen their fiscal stance, while on the other it likely wants to prevent that Eurosceptic parties win support in next year’s European elections by blaming Europe for economic malaise. The government parties meanwhile could be punished by voters if the economy suffers too much from financial market turbulence on the back of fiscal policy uncertainty, but also if they give in too easy. At the end of the day, a budget target a bit closer to 2% and/ or a sufficiently convincing promise by the government to increase the effort in later years in return for flexibility now - a promise often made by its predecessors - is likely in our view.

That said the outcome remains uncertain, and the risk that the government pushes it too far, failing to reach a compromise with the European Commission and ultimately being unable to comfort financial markets cannot be neglected.

Government break-up over budget not very likely at this moment

A government break-up over the budget is not impossible, but the odds are quite low at this point. Neither party would seem to benefit from early elections. Five Star has been losing some ground in the polls and now finds itself in second place, after the League. Yet for the League it would be a big gamble as well, despite significant gains in the polls recently. A (centre-)right government, if Berlusconi would be up for it, would likely still lack a majority, while Five Star would expectedly be unwilling to re-enter a government with the League based on recent experience. Instead early elections could drive Five Star to other leftist parties. Besides, Salvini has been recorded saying multiple times that he is in for the long game.

What about the economy?

We will not yet alter our economic outlook for Italy based on next year’s budget target and the market’s reaction. In our most recent forecast we already penciled in an expansionary budget and financial market volatility. Moreover details of next year’s budget are still missing. We expect the economy to grow by 1.1% this year and 0.9% next year. For this year, risks are mostly tilted to the downside, given that uncertainty and increased interest rates could do more damage than currently expected, while the possible benefits of higher spending plans will not materialise before next year. For next year, risks are still quite balanced at this point. Higher interest rates and uncertainty might hit business investment more than currently expected, while especially consumption and public investment might benefit more from the expansionary fiscal policy than currently expected. We expect that the budget deficit for 2019 will ultimately come in at close to 2.5% of GDP.