Plenty of dates to watch out for
The Italian government‘s Draft Budgetary Plan (DBP), published on 28 September, came as a surprise to financial markets*. Expectations had been building around the scenario of a ‘compromise’ incorporating a modest improvement in the structural position and a headline deficit target below 2%.
Such a compromise would, however, have meant that the new administration would be able to implement only a fraction of the programme on which it was elected. Even so, the pace of debt consolidation would have been more gradual than the 0.6% improvement in the structural position that the European Commission (EC) wants Italy to deliver.
In the event, the government has proposed a deficit target of 2.4% for the next three years, which implies an easing in the underlying fiscal stance and the effective postponement of debt consolidation for the next three years.
The Italian government now expects growth of 1.6% and 1.7% in 2019 and 2020 respectively. This forecast is based on an optimistic assessment of the stimulatory effect of the Budget. If the economy doesn’t meet these forecasts then the debt-to-GDP ratio may rise instead of falling.
The government will have to submit its Draft Budgetary Plan by 15 October and the European Commission has said it will complete its assessment before the end of November, although the Italian government is likely to receive a letter within a week or two informing it of the Commission’s concerns.
In the absence of significant changes in the draft budget it seems more likely than not that Italy will be placed in an Excessive Deficit Procedure (EDP) and in theory at least, Italy could incur financial penalties.
The ratings agencies will also have to publish their assessment of the government’s programme – not just the 2019 deficit target, but also the trajectory of the public finances as well as the consequences of labour market and pension reforms. Moody’s will have to publish an assessment by the end of October and Standard & Poors is due to announce the outcome of its latest review on 26 October. Downgrades seem likely.
The Italian Parliament is likely to pass the Budget but there are still domestic risk events on the horizon. Although Finance Minister Giovanni Tria has sought to reassure investors that he supports the Budget package, it is not implausible that he could leave his post in the near future, given that he appears to have been consistently arguing for a materially lower deficit target. Italy’s president, Sergio Mattarella, is likely to reject the Budget on the grounds that it is inconsistent with the European fiscal rules, although he will ultimately have to sign the Budget if Parliament refuses to revise it and sends it back to his desk.
This does not have to be the last word on the deficit. There is plenty of scope for the government to revise its plans – for example, in light of comments by the Commission. However, it seems unlikely that the Italian government will be easily persuaded to reverse course. In recent days Matteo Salvini sounded defiant: “No-one in Brussels can tell me it is not time…. If Brussels says I cannot do it, I do not care, I will do it anyway”.
Only a reversal in the electoral fortunes of the members of the coalition government or a severe increase in the cost of servicing government debt seems likely to precipitate a shift in the fiscal stance, although it should be noted that Salvini claims to be somewhat indifferent about the market’s verdict on the Budget: “risk premia and stock markets can go up or down, ours is a budget which invests in labour and so the results will become visible and the gentlemen of the risk premia will understand”.
The market has reacted negatively to the 2.4% deficit figure with the 10-year Italian Treasury yield raising from around 2.90% prior to the announcement to 3.40% (as of 05/10/18).
Exhibit 1: Recent changes in the yields of the Italian Treasury bond (BTP)
Source: BNP Paribas Asset Management, as at 05/10/18
Although the yield of the 2-year Italian Treasury note has risen from around 0.90% to 1.40% (as of 05/10/18) on the news, it remains lower than it was at the end of August, when it reached 1.45%.
In the coming days, the market will have a closer look at the details of the Budget and the growth assumptions may lead to further volatility. Debates with the European Commission on the DBP will continue during the second part of this month.
Given that we don’t expect Italy to default or exit the eurozone, we remain constructive on short-dated Italian government bonds. Volatility of risk premia will likely remain high, but the roll-down effect is strong and we are comfortable with the overall risk of this maturity.
However, we remain cautious about the outlook for medium to long-term Italian debt. S&P will revise Italy’s rating on 26 October and Moody’s will do the same by the end of October. Italy is already rated Baa2 with a negative outlook by Moody’s, meaning, as indicated earlier, that the next move might be a downgrade to Baa3 – just one notch above the high-yield category. In this case, the negative or stable outlook may make a strong difference in terms of market impact.
Dates to watch out for:
This text was written on 1 October 2018.