Italy’s Greek Moment?

Wed 21 Nov 2018

The European commission confirmed that it would be starting the excessive deficit procedure for Italy. Under Eurozone rules, no country is allowed a deficit higher than 3% of its GDP, but the Italian budget proposal challenged the EU directly by assuming significantly higher growth rates. According to Commission Vice President Valdis Dombrovskis “The Commission confirms the existence of a particularly serious case of non-compliance … With what the Italian government has put on the table, we see a risk of the country sleepwalking into instability”.

In the past many countries have breached the pact but no fines were imposed. France and Germany broke it in in 2003, Spain and Portugal in recent times. Greece’s deficit peaked at 15% and instead of fines it received aid to avert an outright default. Last year, the Italian government was allowed to flaunt European rules to recapitalise its banks.

The decision comes as no surprise for markets. In fact, yields on Italian sovereign debt fell in the morning, from 3.70% to c.3.50%, after Matteo Salvini’s comments that he would be willing to make some concessions in the budget.

The question for investors now is escalation. The EU issued a stern warning, but will it follow through with sanctions for the first time in history? We believe there’s a probability this will happen. Past experiences with Greece and Britain have shown that when directly challenged, EU institutions assume a combative position. In both cases they pressured to achieve significant concessions from the opposing side. The problem with this approach is twofold. Firstly it would probably alienate the Italian electorate and empower populist movements which complain about democracy in the Eurozone, and secondly it could trigger a 2011-12 like crisis in the Euro. Unlike Greece, Italy’s €2.1tr debt, 131% of GDP against an average of 86% for the Eurozone, cannot be covered by the European Stability Mechanism, and so far the ECB has shown no signs of willingness to extend its QE program beyond December.

Investors should watch out for signs of escalation, especially given the current weak environment for markets, as they could broadly affect European risk assets.