Italy testing the limits

Italy's in the front-view mirror again. Can the debt load be sustained, ask Jan von Gerich and Andreas Steno Larsen

Tranquilo?: It looks anything but in Italy as Rome tests Brussels’s patience. Source: YinYang/istock

  • The proposed 2019 deficit is unlikely to be funded without a further sell-off in BTPs.
  • While the government is likely to modify its stance momentarily, it remains popular, and will continue to try to implement as much of its programme as markets can stomach.
  • The government has some wiggle room on rates, as the average fixed coupon of Italian debt is around 3.05%, short of the 4.25% sustainability benchmark that we have estimated.
  • Should the Italian story continue to weigh on the EUR, we estimate a sensitivity of roughly 2.5-3% weaker EUR in trade-weighted terms per 100bp wider 10-year spread between Italy and Germany.
  • Credit rating downgrades are likely unavoidable.
  • Clashes with the European Commission are inevitable, but the Commission will probably lack the courage to fine Italy and will thus be a side story.

Italy has again been grabbing the headlines and worrying financial markets after a brief period of calmness. In a way, the increased volatility was to be expected after important deadlines regarding the Italian budget for 2019 were looming. For the first time, the budget provides more concrete information about the policy plans of the populist government, consisting of the anti-establishment Five Star Movement (M5S) and the anti-euro and anti-immigration Lega Nord (LN).

However, it has become blatantly apparent that the government is testing the limits of what it can get away with in terms of financial market reaction. Since the May sell-off, the government has several times softened its earlier comments in response to increasing market pressure, only to harden the stance again later, as markets have calmed down. Despite comments of the opposite from the government, the financial markets are already very much guiding Italian policies.

The financial market reaction is also the pressure valve that the Italian government is most worried about – not the response from the European Commission.

Many important dates ahead in the Italian saga


Latest budget numbers not overly scary any more …

The discussion over Italian deficit numbers has already moderated a lot from the unreasonable 5-6% deficit relative to GDP in the early days of the government as to whether Italy would breach the 3% Stability and Growth Pact deficit limit first and then to the proposal of a 2.4% deficit over the next three years. That has been toned down further to 2.4% for 2019, 2.1% for 2020 and 1.8% to 2021.

The 2.4% number is still a big deviation from the earlier target of 0.8%, but it is smaller than the 2.8% public deficit France aims for. The US, of course, is another story altogether, with much higher deficits. While these cases are not totally comparable, and the starting government debt burden is much higher in Italy, 2.4% is not something that would immediately wreck Italian debt sustainability calculations (see more below).

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