Opinion: Investing markets are on high alert over Italy's budget and debt load
Italy on Thursday sold 7.75 billion euros ($9.03 billion) of debt at the highest yield since 2013, reflecting increased investor concern over the countryâs finances.
Other indicators point to heightened alert in financial markets. Take the spread of the Italian 10-year bond over the German counterpart â" a measure of perceived risk â" which had widened to 285 basis points as of Aug. 30, up from around 120 points in May, when the populist League and Five Star parties formed a government, promising increased spending and tax cuts.
Additionally, foreign holdings of Italian debt declined by a record 38 billion euros in June and 34 billion euros in May, although recent indicators point to an easing of this movement in July. In any case, outward capital flows of this magnitude had not been seen since the height of the sovereign crisis that hit southern European co untries particularly hard in 2012-2013.
So what is behind these worsening conditions? Italyâs sheer load of debt, hovering at around 130% of gross domestic product (GDP), is not particularly relevant per se, as long as the debt is affordable on an annual basis. Japan provides a good example of manageable high-debt ratios. So far, Italyâs low cost of borrowing has been a function of reasonable budgetary policies with low deficits, even primary surpluses in some years and of course the support of the European Central Bankâs (ECB) expansionary policy.
Debt load getting heavier
But both conditions seem about to change, as the League/Five Star coalition sets a looser fiscal stance and the ECB starts to gradually phase out its quantitative-easing (QE) program. In this context, it is worth noting that Italy faces borrowing requirements this year of 47.9 billion euros in short-term notes and 65.7 billion euros in multi-year government bonds.
Attention ha s focused on the coalitionâs budget for 2019, a critical test of credibility. The budget needs to be approved by both chambers of Parliament and then be sent to the European Commission, which will try to ensure that the 3% deficit limit is not surpassed. The whole process is expected to be completed by late October.
The previous government estimated a deficit of 0.8% of GDP for 2019 in its April Economic and Financial Document (DEF, by its Italian name). The current coalition will present its own DEF in September, likely far surpassing that estimate.
Even before accounting for the governmentâs promised tax cuts and additional spending measures, the 2019 deficit should shoot up based on lower economic growth estimates (compared with previous estimates) and increased borrowing costs among other reasons.
On top of that, the coalition proposed measures, including increased income spending toward unemployed and low-income citizens; a reduction of income tax; a nd the rollback of a previous pension reform will likely put deficit above 3%, as Deputy Prime Minister Luigi Di Maio told an Italian newspaper earlier this week.
This sets up the stage for a confrontation with the European Commission that could potentially lead to an excessive deficit procedure, from which Italy had managed to exit in 2013. Since the government is aware of this, it is worth considering its actions in this light.
Testing ânormalâ behavior
Firstly, the coalition may be âtestingâ the markets and the European Union (EU) to see how much of a budgetary expansion it can get away with to immediately stimulate the economy and deliver on its electoral promises. This would be a relatively benign scenario, not too distant from past budget negotiations between the EU and member states.
A more ominous possibility is that the government, but especially Matteo Salviniâs League, is trying to destroy expectations of ânormalâ behavior. By being unpredictable and stemming chaos, the government would try to create leverage for a new dialogue with Brussels outside of established mechanisms. This scenario is not benign and would worsen current market conditions.
Finally, both the League and Five Stars have toyed in the past with leaving the euro, and even the EU. A worst-case scenario would see this lack of commitment to euro/EU membership come to light once again. Current government actions could be seen as staging the circumstances in which to blame external forces (the EU, the markets, immigrants) for Italyâs woes and proceed to attempt a breakout.
Markets are already on high alert, and every move will be looked at carefully. All three main rating agencies are expected to review Italyâs credit rating in the coming weeks.
Bart Oosterveld is the director of the Global Business & Economics Program at the Atlantic Council. Ãlvaro Morales Salto-Weis is a program assistant with the Globa l Business & Economics at the Atlantic Council.
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