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The Italian chicken game

Rome and Brussels are locked in a chicken game over the budget.

The pressure is on Italy, as the cost of refinancing its sovereign debt is rising. On Monday the cost of Italian borrowing continued to climb, stretching to a 286 point spread compared to benchmark German 10-year bonds. That is double the yield Italy was paying in May. However, Italy is too big to fail: too big for the Eurozone and too big for the EU.

Markets mount pressure

On Friday, August 31st, Fitch ratings changed Italy’s debt outlook from “stable” to “negative”;  the agency held its overall ‘BBB’ credit rating steady. Moody’s was expected to publish its own report on the Italian economy on September 7 but decided to postpone that until the end of October. Standard and Poors’ (S&P) will publish their own report on October 26.

On Wednesday, September 5, Fitch downgraded the credit profile of five systemically significant Italian banks, namely UniCredit, Intesa Sanpaolo, Mediobanca, Credem and BNL. The agency made an explicit link between the credit rating of the bank and the sovereign political risk.

On September 27 Giuseppe Conte’s government is due to release its Economic and Financial document, that is, a precursor to the budget. A draft budget will be submitted to the European Commission on October 15, which may be rejected if it does not abide by the EU fiscal compact.

Rome sends mixed messages

In a statement to the Italian public news agency ANSA on Saturday, the Italian Minister of the Economy Giovanni Tria vowed that Italy would abide by the EU 3% ceiling. “We have commitments to Europe that must be respected,” Tria said.

On Monday, Tria was more specific, reassuring investors that the Italian deficit would not be more than 2%. But, who can believe Tria?

Cabinet Secretary Giancarlo Giorgetti confirmed on Friday that the government “may breach” the EU’s 3% budget deficit-to-GDP ratio if it is “necessary to put the country into safety.”

“Safety” in this context means growth above 2-3%, Giorgetti clarified.

Deputy Prime Minister Luigi Di Maio is also undermining Tria’s credibility.  “We can’t think about listening to the rating agencies and reassuring the markets, and then stab Italians in the back,” Reuters quotes Di Maio saying.

The leader of the Five Star Movement (MS5) has promised a guaranteed universal income for all Italians to the tune of €780. He has vowed to keep this promise in the first budget of his government.

Deputy Italian prime minister Matteo Salvini vowed on Monday, September 3, that Italy’s 2019 budget will slash taxes; however, he added, the budget would “brush” the EU’s 3% deficit ceiling, but will not breach it. In any event, this is not in tune with Tria’s commitments. On Wednesday, European Commissioner Pierre Moscovici told El Pais that it would be in Italy’s “national interest” not to take “a step backwards” and breach the 3% limit.

As it stands, Rome’s government program could burden the budget by 5% of the GDP, undermining Italy’s debt profile. Italy is the second most indebted sovereign after Greece in the Eurozone with a 131% debt-to-GDP ratio.

Pressure is mounting as economic indicators suggest that the Italian recovery is lagging behind the rest of the Eurozone, leaving a thinner fiscal space for manoeuvre. And this whole discussion is not taking place in an economic vacuum.

Systemic concerns

As Italy is the third biggest economy in the Eurozone, the crisis has systemic implications. The Vice President of the European Central Bank, Luis de Guindos, offered reassurances on Friday.

Speaking at the University of Oviedo, Spain, de Guindos expressed confidence in the Eurozone’s economic recovery but said it was “essential” for Rome to abide by the EU deficit terms. He also called for the acceleration of capital markets union so that Europe can improve “the private sector’s capacity to absorb local shocks, reducing the burden on fiscal policies.”

De Guindos was apparently referring to increased concerns about the exposure of Spanish, French and Italian banks to Turkish debt.