Italy's Budget Brinkmanship Sets Populist Against Populist

(Bloomberg) -- Reality is starting to bite for Italy’s populists.

After weeks of defiance, the governing coalition is retreating from the idea that it could fund both tax cuts and new benefits without incurring the wrath of the bond market and the European Union. Now officials have to decide whose pet programs get cut.

The finance ministry spent Monday drawing up scenarios for a lower 2019 budget deficit ahead of a crunch meeting between Prime Minister Giuseppe Conte and his key lieutenants scheduled for 7:30 p.m. in Rome.

Italian stocks surged the most since June as the administration considered acquiescing to the EU Commission’s calls for restraint, while the yield on two-year debt touched the lowest level in almost two months.

But negotiating cuts to individual programs is far harder than lowering the headline deficit target. Five Star is committed to delivering a citizen’s income to help poorer families, while the League is focused on defending the tax cuts that it has promised its own base. And those tensions may strain their alliance in the weeks ahead.

Populists Retreat

Deputy Premier Luigi Di Maio said Monday the government remains committed to deliver on its costly election campaign promises, even as it retreats from a head on clash with the European Commission.

“If as part of the negotiation, we need to reduce the forecast deficit slightly, that’s not important to us," Di Maio, leader of the anti-establishment Five Star Movement, said in a radio interview. "The issue is not the conflict with the EU on a deficit of 2.4 percent, what’s important is that not even a single person is kept out of the core measures.”

A similar openness was signaled by government partner Matteo Salvini of the League, who said in an interview with AdnKronos "nobody is fixated on this, if there is a budget which makes the country grow, it could be 2.2 percent or 2.6 percent.”

Neither has offered to sacrifice their key policies however and some analysts remain skeptical that they’ll offer enough to satisfy the commission.

Delayed Spending

The most likely scenario is that the populists will defer the start date of costly initiatives like citizens’ income and pension reform, saving up to 4 billion euros ($5 billion), Wolfango Piccoli co-president of Teneo Intelligence wrote in a note to clients.

“The alleged flexibility of the Italian government is nothing but accounting trickery, which would at best have an impact only on the 2019 budget deficit figure,” he said.

The EU Commission said this month that Italy isn’t respecting EU rules on borrowing, which may lead to a so-called excessive deficit procedure. That could involve fines of 0.2 percent of Italy’s gross domestic product, increasing to 0.5 percent if Rome doesn’t amend its budget.

For EU officials, a reduction of the deficit target to around 2.2 percent would likely not sway the commission’s assessment that the budget breaches EU rules -- especially as the bloc estimates that the deficit for next year would in fact be much higher. What is key to officials in Brussels is whether any tweaks affect the structural balance, a key measure in assessing countries’ budgets.

To contact the reporters on this story: Chiara Albanese in Rome at calbanese10@bloomberg.net;John Follain in Brussels at jfollain2@bloomberg.net

To contact the editors responsible for this story: Jerrold Colten at jcolten@bloomberg.net, Alessandra Migliaccio, Ben Sills

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