Italy’s government has published its Update to the Economic and Financial Document 2018 (hereafter referred to as the Document), with its release having been delayed by exactly one week. Thus, the government has finally provided quantitative and qualitative policy details of its fiscal strategy. It envisages, in particular, an increase in the budget deficit to 2.4% of GDP in 2019 (from 1.8% in 2018) and improving it slightly to 2.1% in 2020 and to 1.8% of GDP in 2021 (the end of the forecasting horizon) – the government had initially announced that the budget deficit would be kept stable at 2.4% of GDP over the next three years.

Before we look at the Document’s contents (namely the forecast and the main measures it introduces), we provide our thoughts about the government’s plans.

Firstly, risks to the government’s GDP-growth forecasts are tilted to the downside, and this poses increasing challenges to its overall plan. Looking at the numbers (as we explain below), one could argue that the GDP-growth forecast for 2019 mainly reflects the bold and front-loaded fiscal expansion the government plans to implement next year (0.8% of GDP), together with its decision to avoid fiscal consolidation (previously planned) equivalent to 0.6% of GDP – mainly via an increase in indirect taxes. The impact of this expansionary fiscal policy would also positively spill over into GDP growth in 2020 at least.

However, the planned stimulus to domestic demand will come at a time when weakness in world trade and an intensification of tension between the US and China pose downside risks to the global economy. Italy has proved so far to be particularly vulnerable to a slowdown in global demand. Therefore, this increases the amount of clouds surrounding the government’s outlook for next year.

In addition, prolonged uncertainty regarding the implementation of future domestic policy might dampen any positive effect it has on private sector’s confidence, and, lastly, there is an increasing risk that tighter financial conditions might increase financing costs for the private sector, which would have a negative effect on domestic demand. A reversal of this tightening mainly hinges on the political credibility of the government’s action.

In addition, as it is the result of a combination of the electoral pledges of the two parties in the ruling coalition, the policy mix set forth by the government is broad, and its measures may be characterized by differing fiscal multipliers and therefore various degrees of effectiveness when it comes to stimulating economic growth in the short run.

Secondly, the budget deficit for 2019 envisages significant deviation from the EU’s Stability and Growth Pact rules and, if not corrected, will most likely lead to a severe confrontation with the European Commission (EC). The government has decided to take a step towards appeasing the EC and it now projects that the budget deficit (in percentage of GDP) will decline in 2020-21.

However, this mainly hinges on a final decision being made to keep some safeguard clauses concerning revenue in these two years, rather than on a review of public spending – although, in the Document, the government mentions that it is open to the possibility of introducing safeguard clauses on public spending to the Stability Program (to be approved in April 2019) should economic growth be less supportive than initially expected. In a letter recently sent to Italy’s finance minister, Giovanni Tria, the EC identifies the government’s budgetary targets as a source of serious concern. This anticipates that the dialogue between Italy’s government and the EC is likely to remain tense throughout the budgetary process.

Thirdly, the decline in public debt/GDP ratio projected by the government is entirely based on nominal GDP growth remaining higher than 3% over the forecasting horizon, while the primary surplus is to remain below 2%. This would reduce market and rating agency confidence about the sustainability of the public debt adjustment. Should this prevent a reduction of the cost of new funding from its current level – or worse, induce a further increase – the resulting negative loop might make the debt adjustment even more difficult. In addition, the projections of Italy’s public debt/GDP ratio do not allow Italy to be compliant with the EU’s debt rules; not even the most benign, forward-looking of these rules allows any headroom in this regard. The government’s decision to postpone to 2022 any structural correction towards Italy’s mediumterm objective is likely to make the compliance with the EU debt rules much more difficult than in the past (when the EC also focused on the relevant factors influencing public debt dynamic).

Lastly, the Document contains very little information about possible savings the government will implement in order to finance the main policy measures in addition to the sizeable increase in the budget deficit in 2019. These mainly come from some cuts to current public spending and from the use of existing resources. This remains the weakest point of the fiscal plan presented and that upon which we expect the EC to focus its discussion and recommendation.

Italy’s parliament is expecting to debate the Update to the Economic and Financial Document this week. Parliamentary approval usually goes smoothly, but this time, the vote is likely to attract market attention. It might also shed some light on whether the government is united and whether all MPs are in alignment with the decisions of the governing coalition’s two leaders.

After that, the next key step will be the approval of the budget law by around mid-October. At this time, all the resources available and their use will be clarified. Although important steps have already been taken, the road to the budget law’s approval is likely to remain bumpy, at least as indicated by the delays that have accumulated so far in the process and given the enticing opportunity this budget represents for the two governing parties to gain electoral support ahead of the May 2019 European parliamentary election. Therefore, both the Five Star Movement and the League will make an attempt to maximize (within the fiscal space discussed in this note) the portion of resources allocated to their flagship measures. The parliament will then have to approve the budget law before the end of the year.

The approval of the budget law will be followed by rating agencies announcing their verdicts. The three big rating agencies currently rate the Italian sovereign two notches above junk status, while DBRS currently rates Italy’s credit three notches above junk status. S&P is expected to make its review known on 26 October. Most likely, it will change its outlook from stable to negative while keeping its BBB rating (at least until the first half of 2019).

However, with Moody’s having already placed Italy under review for a downgrade (likely to be announced at the end of October at the latest), it is quite possible that S&P will use this opportunity to jump over Moody’s and downgrade Italy on 26 October. Fitch changed its outlook on Italy’s rating from stable to negative at the end of August, and no more reviews are scheduled for this year.

Parliamentary approval of the budget law will coincide with discussions with the EC, which is expected to be very uncertain in terms of what it will finally decide. If everything goes according to standard procedures, the EC – after considering all the approved policy measures and the underlying macro assumptions (with the latter being compared to the EC’s 2018 autumn forecast, which is to be approved at the beginning of November) – is likely to publish its opinion of the budget law by 30 November. However, it is worth highlighting that, should the EC detect serious non-compliance (as the EC already mentioned in its letter to Mr. Tria) it may react just a few weeks after the presentation of the budget law by asking the government to make revisions and recommending further action. Overall, we expect that Italy will face a severe confrontation with the EC. The resulting tension is likely to intensify if the government proves completely unable to reach a compromise with regard to how best to implement fiscal expansion (that is to benefit from an additional dose of flexibility). This uncertainty will all come at a time when negative spillovers from the external environment are significantly increasing.

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