Key takeaways

• Italy’s economy is sluggish with the lowest growth in the Eurozone, and is now in a dispute with the European Commission
• The eurozone’s governments are committed to a 60% ceiling on debt to GDP ratio, while Italy’s ratio is expected to rise to 135% this year
• Italy faces the prospect of a 3.5 billion euro fine
• The European Parliament election results have increased tensions between the Italian government coalition’s parties as they look to fund a 2020 budget without alienating their supporters
• While the European Commission/ Italian government frictions are likely to impact the euro, the Italian economy remains fundamentally sustainable
• We are watching developments as the European Commission prepares to review the Italian budget on 5 June.

The outlook for the Italian economy, the eurozone’s third largest, is sluggish with the lowest growth in the currency region. As it exits its third technical recession in a decade, Italy is now setting up a re-fight with the European Commission over how to accelerate its stalled economy.

After one year of coalition, the Italian government’s cohesion is being tested by the vastly differing European Parliament election results of the far-right Lega party and the anti-establishment Movimento 5 Stelle (Five Star Movement or M5S). While la Lega won 34.3% of the vote in last month’s European elections, making it the country’s largest party in Italy, in contrast its coalition partner saw its share shrink from 32% in 2018’s national elections (making it the biggest single party) to 17.7% in the recent vote May. That dropped M5S to third place.

The European election results strengthen the position of Matteo Salvini, Lega party leader and deputy prime minister, who has called for a 30 billion euro “fiscal shock” to help the Italian economy expand.

The coalition built a joint platform last year pledging a universal minimum wage, corporate and personal tax changes and undoing 2011’s raised retirement age. Those ambitions set the new government on a collision path with the European Commission.

Under the plan, the government would cut income tax through a “flat tax” funded through a higher deficit. At the time of writing, Bloomberg reported that the two parties were looking for an agreement with the possibility that M5S would back the plan. Unless M5S, led by the government’s other deputy prime minister Luigi Di Maio, agrees to the plan, Salvini has threatened to dissolve the coalition.

The average lifespan of Italian governments in the post-war period is 14 months. It remains to be seen whether the current coalition can survive longer than most. It will be tested as it becomes clear to all parties just how difficult it will be to fund the 2020 budget without alienating their voters. In the short term, investors appear to show little faith in the current coalition (the spread to Greek sovereign debt is around 15 bps), although in the long run, the Italian economy has proven resilient.

A stagnant economy

Italy is nevertheless the weakest economy in the eurozone in terms of growth. First quarter Gross Domestic Product was revised down to 0.1% last week, according to the country’s statistics agency Istat, after Italy was technically in recession in the second half of last year. In comparison, the eurozone recorded growth of 0.3% over the three-month period.

The country’s debt to GDP is expected to rise to 135% this year, from 132% in 2018. Italy’s debt to GDP ratio has fallen below 100% only once in the last two decades (in 2007 when it was 99.79%, according to FactSet data). Today’s Italian debt is the second highest ratio in the eurozone after Greece at 182%. Cyprus and Belgium have also already received European Commission warnings while Spain and France are also forecast to continue exceeding the deficit ratio.

However, political tensions do not mean that Italy’s economic fundamentals are threatened. 

Italy’s debt profile remains sustainable with reasonably long maturities. Unemployment is at a seven-month low and remains one of the lowest in the eurozone. In addition to running a primary surplus (tax income is higher than spending excluding interest on debt), the country also has a current account surplus (see chart) while interest rates remain low and the worst of the Italian banks have been cleaned up.

The spread between the Italian benchmark government 10-year notes and German sovereign debt was 287 bps on 31 May, the widest since February 2019. Five-year credit default swaps, which indicate the cost of insuring Italian debt, rose as high as 22.81 last week, the highest in almost four months. The yield on Italian 10-year government paper rose to 2.589%[1]. Rating agencies Moody’s has Italian government debt on a “negative” outlook, while S&P’s agency rates it “stable.” But should spreads widen above 300 bps, concerns about Italy’s debt sustainability will likely start growing.

A re-escalation of frictions between Italy and the European Commission should also have some negative impact on the euro. This is likely to be mostly visible in downside pressures on EURCHF, given the franc’s sensitivity to European risk premia (CHF has been positively correlated with the BTP-Bund yield spread in periods of Italian-related stresses). However, to the extent that these disputes are largely seen as idiosyncratic, our central scenario, rather than pose systemic risks to the euro area, the impact should be limited in both size and duration.

3.5 billion euro fine

And now, once again, Italy’s debt trajectory is escalating tensions between Italian government and the European Commission and raising the prospect of sanctions.

Under the eurozone’s Stability and Growth Pact, the European Commission has to warn governments in the eurozone about breaching a 60% debt to GDP ceiling as part of “excessive deficit procedure.”

In December, the Italian government reached an agreement with the European Commission to side-step any sanctions by agreeing to postpone public spending. That commitment has since been ignored, according to the European Commission.

"Based on notified data for 2018, Italy is confirmed not to have made sufficient progress towards compliance with debt criterion in 2018," a letter from the European Commission to the Italian government read last week.

The common currency’s treaty allows for a fine of as much as 3.5 billion euros, equivalent of 0.2% of Italy’s GDP. However, any fine would need the approval of the EU’s finance ministers and the Commission has never fined a eurozone economy over budget rules.

“I think Italians gave me and the government a mandate to completely, calmly and constructively re-discuss the parameters that led to unprecedented job instability, unemployment and anxiety,” Bloomberg reported Salvini saying last week.

Faced with a choice between further destabilising Italy’s coalition and disappointing supporters by reneging on their own election pledges, or a fight with the European Commission, the Italian government looks set to choose the less domestically damaging confrontation with the eurozone’s guardians.

In the immediate future, we are watching for signs at a European Commission review of the Italian budget on 5 June whether both sides are looking to calm the dispute, or are for now prepared to see it escalate further.

[1] Data as at 3 June 2019