EU Sets in Motion Discipline Process Against Italy Over Debt

(Bloomberg) -- The European Union took the first step toward disciplining Italy over its failure to rein in debt, intensifying a dispute with Rome and paving the way for an initial penalty of as much as 3.5 billion euros ($4 billion).

In a report published Wednesday, the European Commission said Italy hasn’t made sufficient progress in reducing its mountain of debt in line with the bloc’s fiscal rules, and that a disciplinary process is “warranted.” The step marks an escalation of the country’s budget tussle that roiled markets at the end of 2018 and is a warning for Italy’s populist leaders, particularly Deputy Premier Matteo Salvini who has vowed to change EU budget rules.

Italy’s FTSE MIB index of stocks dropped as much as 0.7% on the news, with banks including UniCredit and Intesa Sanpaolo posting some of the steepest declines. Italian bonds fell following the report, with the 10-year yield spread over Germany, a widely watched gauge of risk in the nation, touching 280 basis points -- more than twice the rate since before the League-Five Star government was formed.

“Italy’s public debt remains a major source of vulnerability for the economy,” the commission said in its report. The ratio of the nation’s debt to gross domestic product will “rise in both 2019 and 2020, up to over 135%, due to a large debt-increasing ‘snowball’ effect, a declining primary surplus, and underachieved privatization proceeds,” according to the report.

“While refinancing risks remain limited in the short term, the high public debt remains a source of vulnerability for Italy’s economy,” the commission added.

First Step

The commission’s move is only one step in a complicated process, which requires EU governments to weigh in several times. While any fine would be relatively small, an official reprimand from the bloc could spell further trouble for Italy, which is already buffeted by financial markets and plagued by tensions between the anti-establishment Five Star Movement and the anti-migration League, which are in a tenuous ruling coalition.

EU finance chiefs would also have to say whether they agree with the commission’s proposal -- probably at their next gathering in early July. At that point, the commission will have 20 days to say whether a “non-interest bearing deposit” of up to 0.2% of gross domestic product -- around 3.5 billion euros -- should be demanded from Italy. If Italy fails to comply with the EU’s recommendations on reducing its debt, it could face higher sanctions.

While the EU has started such procedures for other countries, it has never done so on the basis of excessive debt. It has also never actually fined any country, opting to set other sanctions for countries breaching fiscal rules at zero.

Even if Italy eventually evades a financial penalty, the stigma of the disciplinary process casts a shadow over its engagement with EU business and may reduce the Italian government’s leverage in everything from the scramble for European Central Bank board seats to its ability to negotiate politically thorny issues in Brussels.

Marco Zanni, foreign affairs chief for the League party, said the commission’s action was politically motivated and repeated his group’s call for the EU’s rules to be changed.

“We’re not concerned about the procedure, we will work so that there is no longer a political use of EU economic rules,” Zanni said in comments cited by news wire Ansa. “If we look at the numbers and at who doesn’t respect the rules, there are other states which preach to Italy and which don’t respect them.”

EU Rules

The Brussels move poses a dilemma for Salvini and fellow-Deputy Premier Luigi Di Maio, who call the shots in Rome. Salvini and Di Maio will have to establish how far to go in defying Brussels over the 2020 budget, which must be drafted in the fall.

It’s also likely to exacerbate tensions in the coalition. Salvini insisted on renegotiating EU rules after Prime Minister Giuseppe Conte -- who threatened Monday to resign if Salvini and Di Maio don’t stop electioneering -- said that the rules “remain in force until we manage to change them.”

Read more: A QuickTake on how countries test the EU’s rules

In its damning report, the commission says that Italy made only limited progress in tackling tax evasion and improving market-based access to finance. “There has been no progress in shifting taxation away from productive factors, in reducing the share of old-age pensions in public spending (and indeed there has even been some backtracking in that field), in reducing trial length in civil justice, and in addressing restrictions on competition,” the commission said.

Italy’s debt ratio rose to 132.2% in 2018, and under Rome’s current plan is expected to reach 133.7% of GDP this year and 135.2% in 2020, according to the commission’s forecasts, which predict a higher debt-to-GDP ratio than the Italian government’s projections.

The commission’s report warned that Italy is exposed to sudden increases in “financial market risk aversion” due to its large rollover needs related to its public debt, which can lead to higher bond volatility and increased debt servicing costs.

Under EU rules, no country should have a budget deficit larger than 3% of gross domestic product or debt above 60% of output; any country outside of those limits must set annual targets to show they’re moving in the right direction.

While Italy’s deficit is well within the 3% limit, the commission has demanded smaller gaps for the country to bring down its debt load, which at more than 130% of GDP is second only to Greece within Europe.

EU Commissioner for Economic and Financial Affairs Pierre Moscovici told reporters on Wednesday that the bloc is ready to look at any new data that could change the current analysis.

“My door is open,” Moscovici said.

--With assistance from John Follain, John Ainger and Paul Dobson.

To contact the reporters on this story: Viktoria Dendrinou in Brussels at vdendrinou@bloomberg.net;Nikos Chrysoloras in Brussels at nchrysoloras@bloomberg.net

To contact the editors responsible for this story: Ben Sills at bsills@bloomberg.net, Richard Bravo

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