Italy is fast approaching a key deadline that will test its market credibility 

  • Italy has the second-largest public government debt pile in the euro zone, at about 130 percent of its gross domestic product (GDP).
  • As a result, many traders question if the third-largest euro economy will be able to keep repaying its debt.
  • Bank of America said, in its Thursday note, that it is expecting Rome to put together a budget that will find a "middle way" between what the different parties promised ahead of the election and Europe's macro-economic rules.
The Italian flag waves over the Quirinal Palace in Rome, Italy May 30, 2018.
Tony Gentile | Reuters
The Italian flag waves over the Quirinal Palace in Rome, Italy May 30, 2018.

The Italian government has an important task ahead that could ultimately bring about further market turmoil.

Lawmakers have to approve a budget for the coming year and send it to the European Commission before mid-October. The financial plan will be closely scrutinized by European authorities, but, more importantly, by market players.

"This budget is a critical test of the credibility of the government in the eyes of market participants," Erik Jones, professor of international political economy at Johns Hopkins University, told CNBC via email.

"Here you have to pay close attention to longer-term debt sustainability. Even if the (European) Commission gives maximum flexibility and the coalition partners find some way to work together harmoniously, this could all go pear-shaped if market participants believe that the resulting increase in deficits puts Italian public debt on an unsustainable growth trajectory," he said.

Italy has the second-largest public government debt pile in the euro zone, at about 130 percent of its gross domestic product (GDP). As a result, many traders question if the third-largest euro economy will be able to keep repaying its debt.

The debt problem became particularly acute over the last year or so, particularly in the aftermath of March's general election. Two populist parties, the far-right Lega (League) and the leftist Five-Star (M5S), reached a coalition agreement after months of political impasse, but their promises to increase public spending caused jitters among market players.

"More than ever, this budget plan is a key event for the market. First, the budget will spell out the new government's economic policies and clarify the implementation timeline of the announced reforms," Bank of America Merrill Lynch said in a note Thursday.

"Second, it will define the new administration's stance on the fiscal discipline requirement. This is especially important in light of the busy calendar with the rating agencies' review of Italy's outlook."

The three major credit rating agencies are due to pass judgment on the Italian economy in the coming weeks and ahead of its final budget plan.

Stephen Cohen, head of EMEA iShares at BlackRock, told CNBC that comments from the rating agencies could be "potential market volatility triggers."

He also pointed that Italian assets have underperformed, with the main stock index down 1 percent since the start of the year. The yield on the Italian 10-year bond is currently at about 2.9 percent, which is 1.6 percent higher from the Spanish equivalent — a key indicator that markets are nervous about Italy.

This lack of confidence was evident Thursday after Deputy Prime Minister Luigi Di Maio told reporters that the new budget would include pension reform, tax cuts and a citizen's income, which could add billions more to the government's spending bill. Government debt yields rose on the news.

According to newspaper La Repubblica, the government is likely to push the budget deficit in 2019 to 1.7 percent of GDP. Although the number is well below the European Union's 3 percent threshold, it is also double the current target of 0.8 percent.

Prime Minister Giuseppe Conte has said there's not yet a precise figure for the budget deficit.

"This budget is (also) a test of how well the coalition partners stick together," Jones said.

He added that the two coalition parties have different economic aims, with Lega more focused on tax reform and M5S pushing to give more money to people.

"Where the two sides agree is on pension reform. Even there, however, they will only increase pressure on other (government) programs, so we have to see just how well they work together in the give and take."

Bank of America said, in its Thursday note, that it is expecting Rome to put together a budget that will find a "middle way" between what the different parties promised ahead of the election and Europe's macro-economic rules.

"We think the latter could be achieved with a nominal deficit target below 2 percent of GDP, which we consider the 'watershed level' for a negative market reaction," the bank said.

"In addition, while we expect the on-track but unspectacular recovery to continue, the economic architecture remains particularly vulnerable: many structural challenges are pending and low resilience to external shocks remains the major source of weakness."