Italy Responds To EU Commission, Admits Deficit Breach But Refuses To Budge

Initial relief over a favorable Moody's downgrade of Italy, which pushed the rating just one notch above junk but kept the outlook stable (which in turn prompted the following sarcastic remark from Deutsche Bank's Jim Reid "If there’s one thing the outlook isn’t for Italy at the moment it’s stable but rating agencies are unlikely to want to create a vicious circle") faded after Italy’s populist government promised it won’t let its budget deficit widen further than currently planned and called for dialogue with the European Union to address their differences.

In its letter response to the European Commission published Monday and seen by Bloomberg, Italy acknowledged Europe's concerns about the budget, but refused to change the proposed plan.

Finance Minister Giovanni Tria said the government is ready to act to ensure it doesn’t exceed the 2.4% target for 2019, noting that he’s aware that his spending plans don’t comply with EU rules and he wants "constructive" talks with officials in Brussels.

The decision to increase spending was “difficult though necessary,” Tria said in his letter. He cited slow economic growth and the “difficult economic situation the poorest segments of the Italian society are facing.”

Seeking to placate Brussels, Prime Minister Giuseppe Conte, speaking in Rome, said the deficit target should be seen as an upper limit and it could still be narrower.

"We can still reassess during the budget implementation whether to contain the target so we don’t necessarily need to reach that 2.4%, for sure we won’t exceed it" Cointe said even as he refused to budge from the controversial target which assures that Italy remains on collision course with the EU.

As Bloomberg notes, Italy's PM and finmin have both come under fire from officials and investors since bowing to pressure from Italy’s coalition heavyweights Matteo Salvini and Luigi Di Maio to allocate resources to their key election promises: tax cuts, more benefits spending, and a lower retirement age. The Commission expressed “serious concern” about Italy’s budget plans in a letter on Thursday.

Interestingly over the weekend an Ipsos survey published by the Corriere della Sera newspaper indicated that 59% of Italians back the Government’s deficit target. The survey also found that 55% believe that higher government debt is needed to stimulate the economy. As Deutsche Bank noted, after years of very weak growth and continued austerity "you can’t blame the voters for wanting something different whether it eventually works or not. Europe needs to tread very carefully as it responds."

And while we await Europe's response to Italy's response, Italian bonds faded initial gains, with the spread over German 10-year yields narrowing by 6 basis points to 296. The gap reached a five-year high of 341 bps during trading on Friday.

Sentiment was dented after Tria offered no indication that he plans to back down from the headline spending targets, paving the way for the EU to take the unprecedented step of demanding revisions. EU commissioners will discuss the letter response at a meeting in Strasbourg Tuesday, commission spokesman Margaritis Schinastold reporters in Brussels.

“While recognizing the divergence of the respective evaluations, the Italian government will remain in a constructive and fair dialogue,” Tria added. "The government is confident it can get investment and GDP growth moving again and that the recent rise in the government bond yields will be reabsorbed as the investors learn about all the details of the measures in the budget law."

He added that after 2019 the government doesn’t intend to raise the structural budget deficit -- adjusted to take account of the economic cycle and one-time items.

At the same time, Italian Prime Minister Conte signaled that Italy may not implement some of its most controversial spending plans until later next year, which could potentially lead to a narrower deficit. While the move is unlikely to appease the EU Commission, it was a sign that the government in Rome is looking at ways to reach a face-saving compromise.

And now attention turns to Brussels, where as Jim Reid said overnight, "Europe needs to tread very carefully as it responds" with the danger of further alienating the Italian population from the European "dream" looming.