Italy’s populist government is intent on keeping its promises of higher spending, after the European Commission (EC) rejected its draft budget plan.

The government, in power since June, wants to raise spending to finance lowering the retirement age and provide a universal benefit to the unemployed. The draft also implies an increase in the country’s budget deficit, which has put Italy on a collision course with the Commission and financial markets.

The EC rejected the budget on the grounds that it deviates from previously agreed deficit reduction targets and, according to the Commission, endangers Italy’s debt position.

The rejection means the Italian government has three weeks to present a new draft or face further action from the Commission, which could include the enforcement of an excessive deficit procedure. This would entail fines for Italy, uncertainty over its financial stability and a wave of market volatility.

Earlier this month, after tense discussions, the coalition government agreed on a budget deficit target of 2.4% of GDP. This is broadly in line with last year, but higher than the 0.8% recommended by the European Commission.

Italy's government

Source: Presidenza Della Repubblica

Italy’s government, appointed earlier this year

One of the largest items in the draft budget is pension reform. The government’s coalition partners, the Five Star Movement and the League, had promised to roll back the Fornero pension reform of 2011, which raised the state retirement age in an effort to secure Italy’s public pension system.

The draft budget foresees spending increasing by €8bn next year. This will allow over 400,000 people to retire once they have reached 62 and contributed to the system for 38 years, as opposed to the current retirement age of 67.

The government also plans to reduce pension benefits of more than €4,500 per month, making sure they are in line with contributions.

The government has earmarked €7bn to provide a ‘citizen’s income’ to the unemployed and the poor. It is forecast that 5m people will be eligible for this benefit.

The budget also includes a tax cut to small businesses and self-employed workers. Funds have also been allocated to grant an amnesty for unpaid taxes to citizens deemed unable to pay.

Spending plan

The government plans to spend money on infrastructure and security. While the draft budget includes some saving measures, the emphasis is on spending. There is speculation that the measures will not foster economic growth but merely add to the country’s huge debt pile.

Giovanni Tria

Source: Italian finance ministry

Giovanni Tria

Finance minister Giovanni Tria has defended the budget, emphasising that the measures will boost growth and reduce the debt-to- GDP ratio, which currently exceeds 130%.

However, commentators have highlighted that the GDP forecasts used are optimistic. If growth does not materialise, the debt-to- GDP ratio could increase dangerously.

The draft was submitted to the EC earlier this month amid bitter exchanges between Italian and EU politicians.

Commission president Jean-Claude Juncker was quoted as saying that the Commission was unlikely to make concessions to Italy. Commission vice-president Valdis Dombrovskis and commissioner for economic and financial affairs Pierre Moscovici responded by highlighting breaches of EU targets.

The Italian government has clearly signalled that it does not intend to review its spending plans before presenting the draft budget law to parliament.

According to Italian law, policymakers have to approve the budget law by the end of the year. While the country has entered uncharted territory, the government has assured that it does not plan an exit from the euro and the European Union.

Alessio de Longis, portfolio manager for the global multi-asset group at OppenheimerFunds, says: “Italy has a buffer through the primary surplus and the current account surplus. These conditions mean the Italian debt situation is not explosive.

“However, the country is planning to do fiscal expansion next year and no fiscal tightening for the following two years, while there is a high probability that we are facing a very pronounced slowdown in global growth. That is when we would need to do fiscal expansion.”

Market reaction

Investors did not take kindly to this prospect. An aggressive sell-off of Italian government bonds over the past two months has sent the spread between Italian 10-year government bonds (BTPs) and German Bunds well past the 300-basis-points level, a level not seen since Europe’s sovereign debt crisis – prompting speculation that Italy would be plunged into a new crisis.

Bond prices rebounded after Moody’s downgraded Italy’s sovereign debt to one level above ‘junk’ status but have remained volatile for the past week.

De Longis adds: “If markets maintain a negative view of this budget, spreads could continue to widen. That increases cost of debt and tightens financial conditions for banks, creating a negative feedback loop that could affect the economy itself. This is even before fiscal expansion is enacted.”

Danilo Verdecanna, Italy country manager at State Street Global Advisors, says: “The yield on 10-year BTPs does not entirely reflect the uncertainty surrounding the budget. The market is still affected by the European Central Bank’s quantitative easing programme.

“Italian banks have also stepped in to buy domestic sovereign debt to compensate the sell-off. In normal market conditions, spreads could be much wider, and the sustainability of government debt would come into question.”

He adds that “rising yields could also trigger instability within the banking sector, since banks invest so heavily in government paper”.

The tussle between Italy and the Commission is likely to be one of the strongest factors driving European markets over the next few months.