The continuing budget battle between Brussels and Rome could ultimately result in financial sanctions against Italy. But the real weak link in the conflict is the country's banks, which could trigger a financial crisis across the eurozone due to their billions of euros in Italian debt.
Intent on defiance, Italy has refused the European Commission's requests to introduce meaningful changes to its budget for 2019. The commission is worried that Italy's budget will worsen the country's deficit and lead to low economic growth — not a small thing for a country where public debt is above 130 percent of the gross domestic product. The commission had given Italy a Nov. 13 deadline to present an updated budget, but Rome returned to Brussels with only minimal amendments. As a result, the commission will likely trigger a process that could lead to financial sanctions against Italy.
Italy's governing parties, the anti-establishment Five Star Movement and the right-wing League, recently presented a budget that includes tax cuts and substantial welfare payments for low-income Italians. According to Rome, the measures will foster an economic growth level of 1.5 percent next year while maintaining the fiscal deficit at 2.4 percent of the GDP, which is below the European Union's limit of 3 percent. The commission, however, does not share Rome's optimistic outlook. Because it believes that Italy's growth will be much lower and its deficit much higher, it asked Rome to make major changes to the budget. But, on Nov. 13, the Italian government announced only minor modifications such as "safeguard clauses" to keep the deficit at 2.4 percent in the event the economy fails to meet the government’s growth projections, as well as a promise to raise money by selling state-owned properties.
What makes this case different is that Rome is showing no signs of backing down.
Rome's decision will force the commission to act because the latter's credibility is now at stake. In the coming days, Stratfor expects the commission to trigger an Excessive Deficit Procedure (EDP), a mechanism that allows Brussels to demand corrective measures to countries with high deficits and threaten them with financial fines of up to 0.5 percent of their GDP. The procedure is common in the European Union, though it generally produces a compromise between the commission and the wayward country in which the latter cooperates and slowly reduces its deficit. What makes this case different is that Rome is showing no signs of backing down.
Once the commission triggers the EDP, it could grant Italy between three and six months to draft corrective measures. If Italy fails to make reforms by that deadline, the commission will have to decide whether to give Rome additional time or to seek sanctions, which must be approved by EU governments. Stratfor believes that the Italian government could make cosmetic changes to its budget to appear cooperative in the eyes of Brussels and delay the imposition of sanctions. But Rome is unlikely to introduce substantial reforms, at least until the elections for the European Parliament in May. The budget is popular among many Five Star Movement and League voters, so the parties have little interest in overhauling it before the election. After the European Parliament election, a new EU Commission will be appointed, meaning Rome could play a waiting game until the new leaders in Brussels assume their positions.
The Real Disciplinary Force
In the end, the real disciplinary force on Rome will not be the European Commission but financial markets. Italy's bond yields are at their highest level in four years and the country's credit rating is dangerously close to junk level. Because they hold billions of euros in Italian bonds, banks are the weakest link in the chain. This means that a drop in the value of Italian bonds will have a negative effect on the balance sheet of the lenders holding them. From further deterioration in banks' balance sheets to Italian savers moving their money abroad for fear of a crisis, any number of factors could expose the fragility of Italy's banks — as well as the wider eurozone.