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Nov 21, 2018 | 20:03 GMT

4 mins read

Italy, EU: Brussels Escalates Its Fiscal Fight With Rome

(Stratfor)
The Big Picture

As the budgetary dispute between Rome and Brussels continues, the European Commission has suggested a disciplinary mechanism against Italy's government in the form of an Excessive Deficit Procedure. In addition to potential fines and exacerbated anti-European Union sentiments in Italy, the ongoing spat could create prolonged instability in financial markets and growing fragility in Italy's banking sector.

What Happened

The budget battle between Italy and the European Union is heating up, and the European Commission has decided to escalate its dispute with Italy over Rome's 2019 budget. On Nov. 21, the commission issued a report saying that Italy's fiscal plans — which include tax cuts and spending hikes — break EU rules and will not make the country's debt more sustainable. As a result, the commission suggested an Excessive Deficit Procedure (EDF), which could eventually lead to financial sanctions against Italy.

Rome claims its budget will cause Italy's economy to grow by 1.5 percent next year while keeping the fiscal deficit at 2.4 percent of the country's gross domestic product, which is below the EU threshold of 3 percent. Moreover, Rome has argued that the country's strong growth will cause the country's debt — which currently stands above 130 percent of its GDP — to decrease. However, the commission believes these predictions are too optimistic and that Rome's plan will actually cause limited growth and an increased deficit rather than a reduced debt burden. Brussels asked Rome to modify its budget last month, but the Italian government ignored the request.

What Happens Next

With its authority challenged, the commission has moved to request authorization for an EDF, which would give Brussels the power to ask Rome for policies to reduce its deficit and debt. According to Italian media, the commission will ask Italy to cut spending by some 20 billion euros in 2019, followed by annual cuts of around 10 billion euros for the following four years. If Rome refuses, the commission could apply fines of between 0.2 and 0.5 percent of Italy's GDP. In addition, the commission could temporarily withhold development funds and ask the European Investment Bank to freeze its operations in Italy.

Before any action is taken, EU governments must vote on starting the EDF. Because the EDF vote will probably be taken during a meeting of finance ministers in mid-January, Italy still has a few weeks to negotiate a compromise (potentially when Italian Prime Minister Giuseppe Conte meets with European Commission President Jean-Claude Juncker on Nov. 24). If Italy sticks to its guns, EU governments will probably support starting an EDF. After that, the commission can give Italy between three and six months to introduce measures to reduce its debt and deficit. If Italy misses that deadline, the commission can choose to give Rome more time or ask EU governments to approve sanctions against Italy.

The timing matters in this dispute because Italy, like all EU member states, will hold elections for the European Parliament in late May. If the commission asks for sanctions before elections, Italy's Euroskeptic parties could get a boost. But if the commission waits until after the elections, the sanctions could be delayed for months until a new European Commission is appointed later in the year.

The Financial Fallout

The Excessive Deficit Procedure has often been deployed in the European Union, but has never led to sanctions. Because Brussels is often lax in its requests to reduce deficit and debt, these processes tend to last for years. Most countries choose to cooperate with Brussels to avoid sanctions, but Italy will probably try to find a balance between criticizing the commission — at least until elections in May — and cosmetic, insubstantial changes to its budget. Rome has some wiggle room regarding its budget, but the financial markets are beyond Italy's control.

Rome's borrowing costs have increased in recent months, as has the difference in value between Italian bonds and German ones, which are considered the eurozone's safest. This puts Italian banks in a difficult situation because they hold billions of euros in Italian debt. If Italy's bonds continue to lose value, then many of the country's banks will see the impact on their balance sheets.

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