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20-09-2018 | Insight

Financial markets nervous about Italy ahead of new budget

  • Léon  Cornelissen
    Léon
    Cornelissen
    Chief Economist

Italian far right populist and Deputy Prime Minister Matteo Salvini has himself said that he checks the Italian/German bond spread every morning before calling his kids (a son and a daughter from two previous marriages). Now at 2.4% (or 240 basis points, in financialese), it recently came down a half a percentage point after peaking a short time ago at 290 basis points. That was partly due to Salvini’s description of his morning routine, pointing to a healthy respect for the power of the financial markets.

The spread had widened considerably after the formation of the populist coalition of Lega and the Five Star Movement since the parties’ campaign promises seemed irreconcilable with the budgetary discipline required by Brussels. While Lega is in favor of a low flat tax rate, the Five Star Movement wants to introduce a guaranteed minimum income.

Rough estimations suggest that these expensive measures could easily lead to a government deficit of around 6% of GDP by next year. And according to European regulations, Italy doesn’t have that leeway. Currently, the deficit is 2.4% and so, on the face of it, the room Italy has left before reaching the magic upper limit of 3%, as set out in the Lisbon Treaty, is limited. But because of its sky-high national debt (to the tune of 130% of GDP, compared to the 60% ceiling), Italy is not allowed to raise its deficit above the current levels.

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Not on a collision course

So Italy's new budget, due to be presented to the European Commission in mid-October, is anxiously awaited. Naturally, the financial markets are already anticipating the outcome and have driven up the bond yield premium on Italian government loans for fear that the new government is on a collision course with Brussels, thereby placing Italy’s future membership of the Eurozone in jeopardy. If Italy reverted to the lira, we need not delude ourselves about what would happen to the exchange rate with the euro and if Italy withdrew, it’s highly likely that the Italian debt would need restructuring. Incidentally, Italy’s economy is almost ten times the size of Greece’s and three-quarters the size of the France’s, so an Italian collapse could easily endanger the euro’s long-term future. Basically, Italy is simply too big to be allowed to collapse or to be bailed out.

So it’s comforting that the leaders of both parties, after rethinking the situation, have indicated they want to follow the rules, after all. And the lower bond yield premium also means that they reap an immediate benefit from saying so. But understandably, the financial markets are still a bit wary. And so the suspense remains until the budget is actually presented late this month or in early October.

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