ECB Officials Warn of Damage to Italy From Fiscal Fighting

(Bloomberg) -- European Central Bank officials warned that uncertainty and tension over Italy’s expansive budget risk causing damage to the country’s economy in the long-run.

“Italy’s current financing conditions are much too tight for a country with weak growth and low inflation,” ECB Chief Economist Peter Praet told Handelsblatt in an interview published Thursday. Italian central bank Governor Ignazio Visco urged his government to lower debt financing costs by reducing uncertainty.

While the country’s bonds have risen this week, 10-year yields are still far higher than at the start of the year. In addition to investor pressure, the European Commission has rejected the budget of the populist government.

Moody’s Investors Service, which downgraded Italy’s credit rating last month, said Friday that the confrontation will keep funding costs “high and volatile in the coming months.” But it added it doesn’t expect a funding crisis for the government.

“While the likelihood of an even more serious confrontation with the euro area raising the spectre of Italy’s exit is unlikely in our view, the imposition of sanctions ... could cause a further escalation in tensions. For that reason, we think it highly unlikely that the European authorities will take this step any time soon, as they will be cautious not to provide further ammunition to the Italian government’s anti-EU rhetoric.”

Key Insights

• Speaking in Munich on Thursday, ECB Executive Board member Yves Mersch said it was “imperative” for highly-indebted euro area members to balance their books and reduce debt. He also warned -- without specifically naming Italy -- that the lack of fiscal discipline in one euro-zone country could spill over to the rest of the region.
• Praet said that he doesn’t see any real contagion effects so far. He signaled that the ECB won’t intervene so long as the problem affects only Italy, as it conducts monetary policy for the euro area as a whole.
• If contagion did occur, “we would have to analyze the situation.” Outright Monetary Transactions -- a tool devised by the ECB at the height of the debt crisis and which has never been used -- would be the “appropriate instrument.” But the country would need to apply for assistance from the European Stability Mechanism.
• Asked about other ECB policy tools, such as recent speculation around a new round of cheap funding for banks, Praet responded that it’s “premature” to decide now. In December, the ECB will discuss guidelines for reinvesting maturing debt under its asset-purchase program.
• Italian Deputy Premier Luigi Di Maio said “we will not cut the key points of the budget plan,” in an interview published Friday in newspaper La Repubblica. He said he favors sitting down with the European Commission to discuss the government’s spending program.

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• On Thursday, the ECB acknowledged “uncertainties and fragilities” in the euro-area economy while agreeing they weren’t enough to weaken overall momentum.
• But euro-area PMI and consumer sentiment readings dropped more than expected in November, denting hopes that the region will rebound after a summer slowdown.

--With assistance from Xiaoqing Pi, Lorenzo Totaro and Lucy Meakin.

To contact the reporters on this story: Carolynn Look in Frankfurt at clook4@bloomberg.net;Oliver Sachgau in Munich at osachgau@bloomberg.net;Piotr Skolimowski in Frankfurt at pskolimowski@bloomberg.net

To contact the editors responsible for this story: Fergal O'Brien at fobrien@bloomberg.net, Kevin Costelloe

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