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Abu Dhabi, UAEFriday 16 November 2018

Italy and the EU at loggerheads over budget deficit

The Italian government’s plans to increase spending to boost its economy are fuelling a heated debate between Brussels and Rome

Italian Deputy PM Luigi Di Maio. The country insists it will not alter its budget plans. Reuters
Italian Deputy PM Luigi Di Maio. The country insists it will not alter its budget plans. Reuters

The relations between Brussels and Rome have reached a low point as the EU rejected Italy’s draft budget following a month-long standoff that threatens to ignite a fresh financial crisis for the single currency area.

The high-stakes battle the Italian government is waging against what it sees as Europe’s “wobbly” leadership is less about its yearly budget than about who has the final say in the country’s government spending. The Italian banking system is still recovering from the 2008 financial crisis and is burdened with bad debt, but the current populist government inherited plans to shrink Italy’s budget deficit in 2019 to levels that would have received the approval of a lenient European Commission.

Instead, the new administration announced earlier this month its intention to run a deficit of 2.4 per cent – three times what it had previously targeted – until 2021, in blatant breach of EU standards. Giovanni Tria, the economy minister, later said the budget deficit would grow to 2.4 per cent in 2019 but would gradually taper down in the following two years in compliance to EU demands.

But Brussels, home to the EU's budget chief Pierre Moscovici, fears that Italy’s estimates may also be too optimistic, as its budget deficit projections rely on an economic growth of 1.6 for 2019 despite growth being frozen at 1 per cent in the first half of 2018.

“Had they asked me to draft a budget law that would have surely been rejected by Brussels, I would have devised it exactly like this,” Carlo Altomonte, professor of Economics of European Integration at Milan’s Bocconi University, told The National.

“There are different possible interpretations but they all point to the fact that this draft budget seeks a confrontation with Brussels,” he added.

In an unprecedented move, the European Commission rejected the Italian draft last week and invited the bloc’s third-biggest economy to reconsider or face consequences. If Italy fails to comply it could face fines under the EU’s excessive deficit rule.

The Italian government does not seem willing to budge. “We are calm,” said Matteo Salvini, leader of the far-right populist party League and deputy prime minister. “Being polite as we are, we open the little letters from Brussels, we read them, we respond to them. They write back and we respond, but we are not changing a comma of the budget that will lead Italy to growth.”

Luigi Di Maio, the leader of the Five Star Movement who also serves as deputy prime minister, is also flexing his muscles. “We know that, if we were to surrender, we would quickly return to the pro-bank and pro-austerity ‘experts’,” he said in a Facebook post. “And we will not give up. We know that we are on the right track. And so we will not stop.”

Italian Deputy PM Luigi Di Maio. The country insists it will not alter its budget plans. Reuters
Italian Deputy PM Luigi Di Maio. The country insists it will not alter its budget plans. Reuters

According to Mr Altomonte, the uncompromising draft budget can be read as an attempt by both parties to appease the electorate ahead of the European parliamentary elections in May 2019. The League – a party that bagged little more than 17 per cent of the votes at the 2018 national elections – is expected to surpass its coalition partner, the Five Star Movement, which won over 30 per cent.

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The populist coalition needs to stray from the European austerity measures in order to fulfil the electoral promises and push forward a radical agenda that includes raising pensions and introducing a basic income. It also argues that a sharp increase in spending is necessary to jump-start the Italian economy after years of malaise.

In the face of a stalling Italian economy and of an imminent recession that the EU austerity measures have not been able to prevent, injecting capital into the Italian economy may just be what the country needs, the government coalition argued.

Understandably, financial markets are jittery about events in Rome. Italy is the third-biggest economy in the euro zone after Germany and France, it recorded little or no growth over the past two decades and it holds the second highest public debt after Greece, standing at around 130 per cent of GDP.

Credit rating agency Moody's downgraded Italy’s bonds this month to a notch above junk level and medium-term bond yields have climbed to the highest in nearly five years.

However, Standard & Poor's rating decided only to lower its outlook on the nation’s creditworthiness.

Italy's fundamentals are much more solid than those of Greece, as the country had only a limited nominal deficit and a current account surplus, while its debt has a relatively long average maturity which helps shield the country from market pressure.

"One should not really get into panic here," Klaus Regling, the current and first managing director of the European Stability Mechanism, said last week, listing the differences between Italy's current situation and Greece's long crisis.

European Commission vice president Valdis Dombrovskis, however, said that the bloc sees “no alternative but to request the Italian government to revise its draft budgetary plan”.

“It is tempting to cure debt with more debt … but this would not be fair for the younger generation … keeping sound fiscal policy and confidence is crucial,” he said.

The European Union could see its credibility eroded should it fail to take a tough stand on a country that refuses to keep its spending in check.

According to Mr Altomonte, the government’s desired outcome is for the European Commission to give Italy a one-year deadline to turn the boat around and comply to EU rules.

If it succeeds, the parties in the government coalition will have bought enough time to reach the European parliamentary elections while still being able to present themselves as the strongmen who resisted bullying by the bloc.

But this plan is contingent to markets keeping cool in the face of blunt Italian manoeuvres, as well as unforeseen external shocks on the global financial market. Should Italy be caught in a downward credit spiral that requires the intervention on the European Central Bank (ECB), the institution could refuse to lend a hand to a country that actively defies its recommendations.

Some Italian investors have begun to move their capital abroad.

“The numbers are not alarming at the moment,” Mr Altomonte said. “But the more the government flirts with instability and with the idea of exiting the single currency, the bigger the risk that Italian investors may move their assets abroad and lead the country into the void.”