EU Says Italy's Planned Budget Deviation is ‘Unprecedented’

(Bloomberg) -- The European Commission said Italy’s spending plans are excessive and asked for an explanation, the first step in what threatens to become a full-blown standoff between Brussels and Rome.

Bonds plunged Thursday as the European Union’s executive body dispatched a letter to the Italian government requesting changes to its draft budget plan by Oct. 22.

“We are writing to consult you on the reasons why Italy plans an obvious significant deviation of the recommendations adopted by the Council under the Stability and Growth Pact,” EU Commissioners Valdis Dombrovskis and Pierre Moscovici said in the letter, referring to the bloc’s fiscal rulebook. Both the budget’s fiscal expansion plans “and the size of the deviation are unprecedented,” they said.

The letter was delivered by Moscovici, the EU’s economics chief, during a meeting in Rome with Italian Finance Minister Giovanni Tria on Thursday. It marks the start of a process which could culminate in a decision by the Commission to issue a negative opinion next week -- essentially rejecting Italy’s budget -- and asking the Italian government to send it back with revisions. That has never happened before.

“There is no discrimination against Italy,” Moscovici said during a press conference alongside Tria. “This letter asks some questions, now it’s up to the Italian government to respond.” He said the letter is not final and there is still time which should be “used productively” to continue to exchange views.

EU Says Italy's Planned Budget Deviation is ‘Unprecedented’

Tria said the EU and Italy have different views about the country’s policies and he hoped “with dialogue” these views would “come closer together.”

Bonds plunged on widespread expectations that the EU would come down hard on the populist government’s defiant spending plans. The extra yield investors demand to hold Italy’s 10-year bonds over comparable notes in Germany touched 327 basis points, the most since April 2013. The increase in the yield premium spilled over elsewhere, with the FTSE-MIB Index of shares extending its losses to tumble 1.9 percent at the close. Spreads of other peripheral economies widened too, with the difference between benchmark notes in Spain and Germany touching the highest since May.

Deputy Prime Minister Luigi Di Maio, who heads the Five Star Movement, blamed Brussels for the movement, saying in a video posted on his Facebook page that the spread widened “because the markets think that the government is no longer united.”

“Come here among the people instead of pontificating from Brussels with letters,” he said. “Come here and have the courage to say to Italians that they don’t have the same rights as other European peoples.”

Watchdog Refused

The EU letter also noted that Italy’s Parliamentary Budget Office watchdog refused to validate the budget saying its economic assumptions, including a 1.5 percent economic expansion in 2019, were too optimistic. “We would therefore ask for your arguments for not taking on board the PBO’s opinion,” the commission said.

EU officials have long signaled it will be very difficult for the commission not to reject Italy’s spending plans if the government’s targets remained unchanged. This is not just because the planned 2.4 percent headline deficit is too high to be within EU limits.

The so-called structural deficit, a key measure for the commission, which strips out effects of the economic cycle and one-off spending items, is also off the mark. Italy projects this will widen by 0.8 percent, more than the 0.6 percent improvement Brussels wants.

Won’t Back Down

Di Maio and his fellow deputy premier, Matteo Salvini of the anti-immigrant League, are unlikely to back down. They argue that they were elected to implement expensive measures such as tax cuts, a lower retirement age and new benefits for the poor which can’t be put off. Italy needs the extra spending to help boost economic growth, they say.

While Italy’s deficit is well within the 3 percent limit laid out in treaties, the commission has demanded smaller gaps for Italy to bring down its debt load, the largest in Europe in absolute terms and second only to Greece’s as a percentage of the economy.

An escalation is programmed in if Italy opts not to change its spending plans and sticks to its deficit target. In response, the commission would likely find Italy’s budget in serious breach of EU rules.

While Brussels has no real powers over countries’ budgets, governments go to great lengths to avoid a reprimand because of the potential market implications it could have. If the commission finds a country to persistently break deficit rules, it could open a so-called excessive deficit procedure -- a process where a country has to reduce its deficit by a set deadline or risk sanctions of up to 0.2 percent of output.

“The fact that the EU Commission is clear in its rejection of Italy’s draft budget is an important message from the EU to Italy,” said Guntram Wolff, Director of Brussels-based Bruegel think-tank, describing the letter as a “significant political rift” with the rest of the euro area.

“It is of course correct that sanctions come late and the process to sanctions is long,” Wolff said. “But what matters is not the sanction itself but the fact that there is a clear political conflict that the Commission cannot and does not want to sweep under the carpet.”

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