Italy: Rome and Brussels Gear Up for Another Deficit Fight

4 MINS READMay 28, 2019 | 15:13 GMT
The Big Picture

Stratfor's annual forecast identified Italy as the main source of economic risk in the eurozone this year. Now that Rome has announced plans to move ahead with expansionary fiscal policies despite pressure from Brussels, concerns about Italy's political and financial future are set to continue.

What Happened

Italy is rolling up its sleeves for another showdown with the European Commission. On May 27, Italian Deputy Prime Minister Matteo Salvini said he planned to proceed with his economic program, which includes lowering taxes and increasing expenditures for big infrastructure projects — regardless of whether the European Commission likes it or not. On June 5, meanwhile, the commission is expected to issue an assessment of the Italian economy that will likely include calls to lower the country's deficit.

Pressure From Within

Salvini is the leader of the right-wing League party, which governs Italy alongside the populist Five Star Movement. The League had a strong performance in elections for the European Parliament on May 26, winning 34.3 percent of the vote. (The Five Star Movement, by contrast, scored only 17.1 percent). Fresh off the European Parliament success, Salvini said the League now planned to implement its main policy goals, which include the introduction of a so-called "flat tax" (which, despite its name, is actually expected to feature different rates for several tax brackets), the completion of large infrastructure projects (such as a high-speed train connection between Turin in Italy and Lyon in France), the resumption of oil and gas exploration off Italy's coast (which was suspended earlier this year to the Five Star Movement's delight and the League's chagrin) and the provision of more fiscal autonomy to northern regions (a key demand of the League's strongholds in Italy's industrial north).

But the Five Star Movement is not thrilled about some of Salvini's plans. The party opposes infrastructure projects that could damage the environment and has demanded that a current moratorium on offshore energy exploration remain in place. Furthermore, the Five Star Movement is popular in the south of Italy, meaning it rejects any fiscal concessions to the wealthy north that could hurt the poorer south. The movement, accordingly, now faces a dilemma: It could support the League, which would preserve the unity of the government but damage its own popularity, or it could oppose the League, which would preserve its anti-establishment edge but could topple the government and usher in early elections. Disputes between the two partners will likely increase in the coming weeks, as the League will use its growing popularity to try to expand its influence in the Italian government.

A defiant Italy may choose to play hardball, which could force Brussels to respond in kind.

And Pressure From Without

The Italian government doesn't just have domestic concerns to worry about. Last year, Rome and Brussels reached a deal in which Italy agreed to limit its deficit to 2.04 percent of gross domestic product in 2019. The country's low growth rates and expansive fiscal policies, however, mean that its deficit will probably exceed that figure. As a result, the commission could launch an excessive deficit procedure, a process that could ultimately result in Brussels issuing Rome a fine of up to 0.2 percent of its GDP (roughly $4 billion). The commission tends to give wayward members long periods to implement policy changes before introducing any sanctions, but such tolerance depends largely on cooperation from the national governments in question. A defiant Italy may choose to play hardball, which could force Brussels to accelerate the sanctions procedure.

Markets are also likely to pressure Italy to reduce its deficit. Italy's borrowing costs are currently within tolerable margins, but they are higher than what they were before the Five Star Movement and the League came to power in March 2018. What's more, two large credit ratings agencies, Fitch and Moody's, will release their assessments of Italy in August and September, respectively. Any downgrade to Italy's debt profile would lead to higher borrowing costs for Rome, which will represent far more than a minor inconvenience in a country where debt exceeds 130 percent of GDP. Faced with pressure at home and abroad, the partners in Italy's government are ultimately likely to stick together and try to find internal compromises on policy, at least for a few more months. Domestic disputes and external pressure, however, are only set to increase, meaning Italy is set for an uncertain political and fiscal future.

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