Brussels and Rome are engaged in a war of letters over Italys budget-busting spending plans.
The countrys populist government now has three weeks to respond to the latest missive from the European Commission — asking that it revise a draft budget that both sides have acknowledged is “not in line” with the European Unions fiscal rules.
Its a notable moment in the history of the eurozone. The request marks the first time Brussels has rejected a countrys budgetary plans. If Rome refuses, the Commission could put in place unprecedented sanctions.
But the truth is that the history of the common currency area is unlikely to be written in the letters flying back and forth between Rome and Brussels. That showdown is a bit of a sideshow. Its the markets — not the European Commission — that will determine whether Italy can get away with a budget that increases rather than cuts its structural deficit.
The stakes are high for all sides. If the Commission allows Rome to throw its fiscal rules to the wind, it will undermine the integrity of the eurozone and infuriate national leaders from The Hague to Vienna. But the populists in Romes ruling coalition cant afford to be seen capitulating to Brussels and reneging on its campaign promises.
So far, the markets seem to be withholding judgment, even if borrowing costs for the Italian government are rising.
The economics seem to side with the Commission, which points out that a country with a debt-to-GDP ratio of 131 percent can hardly afford to be piling on additional obligations — nor be allowed to blatantly break the blocs fiscal rule that debt levels above 60 percent of GDP should come down, not go up.
Romes riposte is that its big spending plans will supercharge the economy, boosting economic growth and bringing down its debt burden in relation to its GDP. But here too, the Commission has the high ground. Most economists consider Romes growth projections to be wildly optimistic, which means Italys deficit would likely grow even more than projected.
If the Commission rejects Italys new draft budget, disciplinary procedures will begin in December. The timing for Italy couldnt be worse, as it coincides with the European Central Bank phasing out its asset purchases, which have compressed Italys borrowing costs significantly since 2012. Once Eurostat finalizes its fiscal data for 2018 in the second quarter of next year, the EU can eventually push to cut some of Italys EU funding and impose fines of up to 0.2 percent of GDP — or nearly €4 billion.
But Brussels wont find it easy to force Rome to bend its knee. After years in which it has turned a blind eye as Berlin, Paris, Madrid and Lisbon broke the EUs fiscal rule, the Commission has chosen to pick a fight with a government thats spoiling for just such a clash.
Italian Minister of Economy and Finances Giovanni Tria attends a press conference in Rome on October 18, 2018 | Alberto Pizzoli/AFP via Getty Images
This is not the first time the Italian coalition, comprising the League and 5Star Movement, has picked a fight with the EU. Over the summer, the Italian government held the fate of German Chancellor Angela Merkels coalition in question by refusing to agree on a migration deal until the last second.
Defiance toward Brussels has paid off for the League and 5Stars, which have seen their support rise to around 60 percent (from around 50 percent in the 2018 general election), with a similar share of voters supporting the draft budget. Both parties in the ruling coalition aim to translate this clash into electoral success in next years European Parliament election. If the EU imposes sanctions on Italy, it will probably be in April at the earliest, and the League and 5Stars will be reticent to cave to Brussels just before the European election in May.
Real pressure, if it arrives, will come from elsewhere — as investors weigh whether Italian government debt is a good place to park their money.
So far, the markets seem to be withholding judgment, even if borrowing costs for the Italian government are rising. The spread between 10-year Italian government bonds and their German equivalent has shot up to over 300 basis points — the widest in over five years but still far off the highs of 2011.
The Italian government seems to be sanguine about market pressure, with 5Star leader Luigi Di Maio recently asserting: “The markets love Italy more than some European institutions do.” But its easy to imagine how things get worse if Italian borrowing costs rise.
First, Italian debt could be downgraded to junk status by the main credit ratings agencies as rising yields call Italys debt sustainability into question. Moodys last week cut Italy to one level above junk and S&P is due to review Italys rating later this week. While it seems unlikely, should three of the four main agencies rate Italy below investment grade, the repercussions would be severe.
If Di Maio is wrong, and if Italian borrowing costs spike suddenly, it is hard to guess how Rome will react.
The country would be ineligible for the European Central Banks asset purchases program as well as its reinvestment scheme. We do not yet have details on the ECBs plans for reinvestment, but there could be wiggle room for countries that need extra support. It would be a shame for Italy to forgo this at a time when it may need help bringing its borrowing costs down the most.
Italy could also face an investor strike so that it is unable to issue debt in the markets. This is problematic because there is no feasible plan for what to do if Italy gets into trouble. The ECB asserts that Italy can always ask for an Outright Monetary Transactions program, a bailout that comes with strict conditionality. However, it has always been hard to imagine any Italian government accepting the conditions involved — and particularly this populist, anti-European government.
Even more likely than an investment strike, Italian banks could suffer from higher government bond yields because they are heavily exposed to domestic sovereign debt. As Italian bond yields rise, prices fall — hitting the banks capital ratios. Add this to continued elevated levels of non-performing loans and Italian banks may need recapitalizations at a time when the government can least afford them.
If Di Maio is wrong, and if Italian borrowing costs spike suddenly, it is hard to guess how Rome will react. It could finally feel the heat and snap back into line, deciding to comply with European rules much like Greek Prime Minister Alexis Tsipras was forced to do in July 2015. Or the populist, anti-European government could decide to stick to its guns.
The average maturity on Italian bonds is fairly long at just under seven years, so a jump in borrowing costs shouldnt push Italy into immediate bankruptcy. This gives Rome and Brussels a lot of time to write their stern letters.
But keep an eye on market pressure — a jump in yields could push the Italian government to decide that eurozone membership isnt worth a loss of sovereignty or the EU to decide that you cant help a country that wont help itself by playing by the rules. Then we will see how dedicated the government is to Italys continued membership of the eurozone.
Megan Greene is global chief economist at Manulife Asset Management.
[contf] [contfnew] 
