Italian Stocks, Bonds Slide After EU Triggers Disciplinary Process Over Public Debt

It's not just the trade war of 2018 that is back: as of moments ago, the feud between Italy and EU over the Mediterranean country's soaring debt (and spending) which sent Italian bond yields soaring last year, only to fade away as Brussels conceded to vague promises from Rome, is now officially back and moments ago Italian stocks, bonds and the Euro all slumped after the EU's executive arm formally took the first step toward "disciplining" Italy over its failure to rein in its debt, setting up a clash with the government in Rome and paving the way for an initial penalty of as much as €3.5 billion.

In a report published Wednesday, the European Commission said Italy hasn’t made sufficient progress in reducing its mountain of debt in line with the bloc’s fiscal rules, and now expects Italy's debt ratio to rise in both 2019 and 2020, up to over 135%, due to a large debt-increasing “snowball” effect, and that a disciplinary process is “warranted".

“Italy’s public debt remains a major source of vulnerability for the economy,” the commission said in its report. The ratio of the nation’s debt to gross domestic product will “rise in both 2019 and 2020, up to over 135%, due to a large debt-increasing ‘snowball’ effect, a declining primary surplus, and underachieved privatization proceeds,” according to the report. “While refinancing risks remain limited in the short term, the high public debt remains a source of vulnerability for Italy’s economy,” the commission added.

Additionally, in its damning report, the commission says that Italy made only limited progress in tackling tax evasion and improving market-based access to finance. “There has been no progress in shifting taxation away from productive factors, in reducing the share of old-age pensions in public spending (and indeed there has even been some backtracking in that field), in reducing trial length in civil justice, and in addressing restrictions on competition,” the commission said.

The step marks an escalation of the country’s budget tussle that roiled markets at the end of 2018 and is a warning for Italy’s populist leaders, particularly Deputy Premier Matteo Salvini who has vowed to change EU budget rules.

As Bloomberg notes, the commission’s move is just one step in a complicated process, which requires EU governments to weigh in several times, and while any fine would be relatively small, an official reprimand from the bloc could spell further trouble for Italy, "which is already buffeted by financial markets and plagued by tensions between the anti-establishment Five Star Movement and the anti-migration League, which are in a tenuous ruling coalition."

EU finance chiefs would also have to say whether they agree with the commission’s proposal, most likely at their next gathering in early July.

What happens then is a paradox: after being punished for having too much debt, the EU will fine Italy several billions in euros, forcing Rome to incur even more debt! Specifically, at that point the commission will have 20 days to say whether a “non-interest bearing deposit” of up to 0.2% of gross domestic product -- around 3.5 billion euros -- should be demanded from Italy. If Italy fails to comply with the EU’s recommendations on reducing its debt - which it will -  it could face even higher sanctions.

While the EU has started such procedures for other countries, it has never done so on the basis of excessive debt. It has also never actually fined any country, opting to set other sanctions for countries breaching fiscal rules at zero.

Even if Italy eventually evades a financial penalty, the stigma of the disciplinary process casts a shadow over its engagement with EU business and may reduce the Italian government’s leverage in everything from the scramble for European Central Bank board seats to its ability to negotiate politically thorny issues in Brussels.

Besides the purely monetary considerations, the Brussels escalation sets up a dilemma for Salvini and his fellow-Deputy Premier Luigi Di Maio. Salvini and Di Maio will have to establish how far to go in defying Brussels over the 2020 budget, which must be drafted in the fall. It’s also likely to exacerbate tensions in the coalition. Salvini insisted on renegotiating EU rules after Prime Minister Giuseppe Conte - who threatened Monday to resign if Salvini and Di Maio don’t stop electioneering - said that the rules “remain in force until we manage to change them.”

Italy’s debt ratio rose to 132.2% in 2018, and under Rome’s current plan is expected to reach 133.7% of GDP this year and 135.2% in 2020, according to the commission’s forecasts, which predict a higher debt-to-GDP ratio than the Italian government’s projections.

In what will likely be a self-fulfilling prophecy, the commission’s report warned that Italy is exposed to sudden increases in “financial market risk aversion due to still large rollover needs (around 17% of GDP in 2019) related to its large public debt" which can "lead to high volatility in sovereign bond markets and substantially higher debt servicing costs, with the subsequent risk of negative spillovers to the banking sector and to financing conditions for firms and households."

And while Italy’s deficit is well within the 3% limit, the commission has demanded smaller gaps for the country to bring down its debt load, which at more than 130% of GDP is second only to Greece within Europe. Under EU rules, no country should have a budget deficit larger than 3% of gross domestic product or debt above 60% of output; any country outside of those limits must set annual targets to show they’re moving in the right direction.

Finally, for those asking if the move is objective and justified or purely political, here is the answer:


In kneejerk response, the news sent Italian yields higher...

the Euro lower, and Italian stocks plunging like a rock.