EU Wants Investors to Put Thumbscrews on Italy: Budget Explainer

(Bloomberg) -- When Italy finally announced its 2019 budget-deficit target last week, it left investors and European Union officials unimpressed.

Italian bonds and stocks tumbled while euro-area finance chiefs warned Monday that Italy’s spending plans will most likely leave it in breach of EU rules.

With 2.3 trillion euros ($2.7 trillion) in debt, the idea of Italy running into trouble is the nightmare scenario that has haunted European leaders since Greece started the government debt crisis almost a decade ago.

Read More: ITALY INSIGHT -- Investors Can’t Ignore Debt Arithmetic Forever

Financial tensions in most of the bloc are nothing like they were back then. But the European project is facing a new threat from populists like Italy’s deputy premiers, Luigi Di Maio and Matteo Salvini, who blame the EU for their voters’ economic problems.

Many EU officials are hoping that the market will push Italy back into line and save them from having to step into the firing line armed only with their largely untested rule book.

How are the bond vigilantes doing?

Italy’s 10-year bond yields closed at the highest since 2014 on Tuesday and bank stocks saw the biggest plunge in two years on Friday.

But Di Maio and Salvini came out punching all the same. Di Maio said he’d never "sacrifice workers" to keep investors happy while Salvini said he was sure "the gentlemen" in the market would come around.

Still, the full budget outline was supposed to be released on Friday and it still hasn’t emerged. That suggests some difficult conversations are taking place in Rome.

Where is Italy’s pain threshold?

That’s the $2.7 trillion question.

The 10-year spread over German bunds broke through 300 basis points on Tuesday. Spain, the biggest euro-area economy ever to seek a bailout, saw its spread reach almost 540 basis points before it asked for help in 2012.

But there are other pressure points in Italy.

Read More: Bad News on Italy’s Budget Overshoot May Only Get Worse

If the sovereign were left without a single investment-grade credit rating its debt would be ineligible for European Central Bank refinancing operations and Italian banks have a LOT of government debt. That would accelerate the process.

If two of the three main ratings agencies cut Italy to junk, it would drop out of the main sovereign indexes, triggering a selloff that would put its market access at risk. S&P Global Ratings and Moody’s Investors Service are both due to review their assessments this month.

Finance Minister Giovanni Tria is another concern. He is seen as a bulwark against the worst excesses of the populists and reports of his possible resignation or ouster have fizzed around Rome for the past couple of weeks. If he goes, expect another jump in the risk premium.

So how far off base is this deficit target?

In private, EU officials say the 2.4 percent target is a long way off what they can tolerate.

Tria says debt will fall by 1 percentage point a year. That would bring it to 127 percent in 2021 whereas the previous plan saw 122 percent.

What next?

Di Maio said that the details of the spending plans may finally be released on Wednesday.

The draft budget has to be submitted to Brussels by Oct. 15. If the European Commission thinks there is a risk of a serious breach, officials have one week to raise the alarm and another seven days to request revisions -- something it has never done before.

For now, the Commission is insisting it will wait to see the formal budget before it makes an official assessment.

What can Brussels do?

Under EU rules, no country should have a deficit larger than 3 percent of GDP or debt above 60 percent of output, and governments are required to set annual targets to show they’re moving in the right direction. Even if Italy doesn’t breach the 3 percent target, it would still run afoul of EU rules if the deficit doesn’t narrow at the pace agreed, considering its high debt.

Read More: INSIGHT -- The Euro Area’s Loose-Fitting Fiscal Straitjacket

Brussels has the power to impose fines of up to 0.2 percent of GDP on countries that persistently break the rules. However, many officials have criticized their credibility as when push came to shove in 2016, the Commission opted to not penalize repeat offenders Spain and Portugal. France, too, has received plenty of leniency.

In any case, the process that could eventually lead to sanctions would typically be triggered in the spring when the Commission has final 2018 data to work with.

Does it Matter?

Oh yes.

Italy is not Greece.

Many officials are unsure whether the rest of the euro area would even be capable of rescuing the euro area’s third-biggest economy if investors fled. At the very least, that would pose unprecedented questions to a German political class that is growing uneasy with bailing out other European countries.

Officials are hoping the market will save them from ever having to learn what Germany’s answers would be.

©2018 Bloomberg L.P.