Italy's 2019 budget: Here's all you need to know (and why it matters)

Italy's coalition government is set to present its 2019 budget within the next few weeks, setting out its economic and financial plans for the coming year.

These will be closely watched to see if the country's euroskeptic leaders will stick to controversial spending plans which could increase Italy's budget deficit and debt, deepening a rift with the European Union.

CNBC has a guide to what we could see from Italy's next budget and why it matters:

Why is the budget important?

The unveiling of its economic policies and growth forecasts for the upcoming year are a key moment for the populist government, made up of the right-wing Lega party and the left-leaning Five Star Movement (M5S).

Both parties promised to reduce taxes and increase welfare spending when they took office in June.

But Italy's anti-establishment leaders, Lega's Matteo Salvini and M5S' Luigi Di Maio (who are joint deputy prime ministers, having chosen law professor Giuseppe Conte to be prime minister) have since been warned repeatedly by their European counterparts to ensure fiscal discipline is maintained.

Italy's Interior Minister and deputy PM Matteo Salvini (R) and Italy's Labor and Industry Minister and deputy PM Luigi Di Maio gesture during the swearing in ceremony of the new government led by Prime Minister Giuseppe Conte at Quirinale Palace in Rome on June 1, 2018.
Italy's Interior Minister and deputy PM Matteo Salvini (R) and Italy's Labor and Industry Minister and deputy PM Luigi Di Maio gesture during the swearing in ceremony of the new government led by Prime Minister Giuseppe Conte at Quirinale Palace in Rome on June 1, 2018.

The European Commission — the executive arm of the EU — requires government spending to not exceed 3 percent of a member country's gross domestic product (GDP). But there have been confusing and conflicting messages from Italy's leaders over whether they will stick within these budget parameters or not.

Whether they heed those warnings or go their own way — putting them on a collision course with Brussels — will be seen when the budget is revealed.

Italy has already had a warning shot from ratings agency Fitch which cut the outlook on Italy's debt rating on Friday to "negative" from "stable," citing concerns about the government's "new and untested nature" and its pledges to increase spending.

"Fitch expects a degree of fiscal loosening that would leave Italy's very high level of public debt more exposed to potential shocks," the agency said.

Italy's Economy Minister Giovanni Tria, an economics professor who is seen as a moderating influence in the government, responded pragmatically to the downgrade, saying Saturday that Italy would respect EU budget commitments and address the concerns of credit ratings agencies like Fitch.

But so far, there's been little sign of spending cuts by the government.

Hints at what's to come

If the coalition sticks to its manifesto promises — including the introduction of a basic universal income for the poor (a flagship M5S campaign pledge), a "flat" tax rate (of 15 and 20 percent) and pension reform — scrapping the so-called "Fornero" law of 2011 which raised the retirement age — these could cost some 80 billion ($92.6 billion) to 100 billion euros. That would be "enough to bust the budget," Italy's state news agency ANSA said Monday.

These main campaign pledges exclude other costly pledges such as promising to expel 500,000 illegal migrants and a possible splurge on infrastructure spending in the wake of the Genoa bridge collapse (soon after the disaster, Salvini said EU budget constraints had prevented his country from spending on infrastructure safety).

There's certainly been no sign recently that Lega and M5S are ready to cut spending, or row back on their promises to the electorate.

Rescuers at work amid the rubble after a highway bridge collapsed in Genoa, Italy, 14 August 2018. A large section of the Morandi viaduct upon which the A10 motorway runs collapsed in Genoa on Tuesday. 
Luca Zennaro
Rescuers at work amid the rubble after a highway bridge collapsed in Genoa, Italy, 14 August 2018. A large section of the Morandi viaduct upon which the A10 motorway runs collapsed in Genoa on Tuesday. 

Despite the Fitch downgrade and their economy minister's attempt at reassuring the markets, Salvini and Di Maio appeared bullish with the former tweeting Saturday that tax cuts would be implemented "step by step."

His colleague Di Maio stated Sunday that Italian citizens came before ratings agencies, pledging to see through his party's campaign promise to introduce a universal income for the poor. On Tuesday, Salvini also questioned the EU's fairness when it comes to the leeway over budget deficits and the independence of ratings agencies.

"But how, if France and Spain have been extending the 3% ceiling for years, nobody says anything, while if Italy tries to touch it to secure the country and boost the consumption of Italians is a problem?

But were not these rating agencies independent?" he said on Twitter.

Also on Tuesday, after his Lega party held a summit on the economy, Salvini was quoted listing the party's plans.

"We discussed the numbers, accounts and timeframes to achieve within the arc of the legislature our proposals for families and businesses: dismantling the Fornero law, (introducing a) flat tax, fiscal peace and closure of the disputes with (state tax collection agency) Equitalia, less bureaucracy for firms and VAT holders, elimination of the oldest levies on petrol … (and) a major national plan for ordinary and extraordinary maintenance (of infrastructure)," ANSA reported.

Northern League (LN) leader Matteo Salvini speaks with the press on May 28, 2018 after leaving the Chamber of Deputies in Rome, Italy.
Michele Spatari | NurPhoto | Getty Images
Northern League (LN) leader Matteo Salvini speaks with the press on May 28, 2018 after leaving the Chamber of Deputies in Rome, Italy.

Salvini said that the Lega-M5S government would have a "long life" if it "respects its duties towards Italians." On Wednesday, he also said Italy would seek to respect "all the commitments … imposed by others," referring to the European Union. Both Di Maio and Conte joined in on Wednesday, stating that the government will keep the accounts "in order."

The economists' view

A draft of Italy's 2019 budget must be approved by parliament before being sent to the European Commission for review by mid-October at the latest.

The European Commission has the power to reject budgets but it has been lenient over deficits in the past. With relations between Italy and the Commission already frosty, however, how much wiggle room Italy will be given is uncertain.

Most economists think Italy's government will be pragmatic and restrained when it comes to the crunch.

"While we expect confrontational rhetoric and claims to exceed the EU fiscal rules, we expect the government to set the 2019 deficit target at 1.5 percent to 2.0 percent of GDP. Such a target could be very reasonable and still compatible with a decline (albeit small) in the government debt-to-GDP ratio," Citi economists said in a note Tuesday.

A shopper stands at the meat counter at the renowned Tamburini salsamenteria on March 29, 2017 in Bologna, Italy.
David Silverman/Getty Images
A shopper stands at the meat counter at the renowned Tamburini salsamenteria on March 29, 2017 in Bologna, Italy.

"However, while the much-feared budget law might end up being a non-event, investors might soon have to start worrying about GDP growth. Still, we expect the 'fear factor' to spark substantial volatility in the coming weeks," Citi's research note, authored by Mauro Baragiola, Cosimo Recchia and Jonathan Stubbs, among others, said.

Clemente De Lucia, a senior European economist at Deutsche Bank, said in a note Wednesday that Italy did not have much room for maneuver in terms of the budget deficit it would target. A deficit of 3 percent of GDP would "clearly put public finances on an unsustainable path; in fact, a deficit above 2.3 percent would likely prevent the debt ratio from declining," he said.

"A deficit target in the range 2 to 2.3 percent of GDP may be consistent with a declining debt ratio but would still imply a significant violation of EU rules and would entail tough negotiations with Brussels," he added.

Growth in the spotlight

Rather than the budget deficit, Citi economists said Italy's "growth is likely to be the event."

"We are increasingly concerned about the strength of the economy which is already losing steam," they said, noting that they had recently revised down their 2018 GDP growth forecast from 1.6 percent to 1.1 percent. The European Commission expects 1.3 percent growth in Italy this year. Unemployment remains a problem in Italy too, at 10.9 percent in June 2018.

The Citi team said it remained "agnostic" over whether the government was up to the "(very) challenging task" of reforming the country.

It said the coalition's government plan had potential flaws due to being the "gross sum" of two very different electoral manifestos. They said it would be economically unsustainable "without a full overhaul of the Italian tax and legal architecture." At worst, the plan could do more damage to growth, Citi added.

Fresh fish stall in the Capo Market on August 10, 2016 in Palermo, Italy.
Stefano Montesi/Corbis via Getty Images
Fresh fish stall in the Capo Market on August 10, 2016 in Palermo, Italy.

"Partial execution (of the plan) might leave Italy even more exposed to the risk of a new recession," Citi said.

Other economists agree that whatever the Lega-M5S coalition promises, Italy's economy risks stagnating.

"The challenges to grow the economy are very, very high and continue to be difficult because the non-performing loan weight, and the exposure of banks to sovereign debt, create this constant problem," Daniel Lacalle, chief economist at Tressis Gestion, told CNBC Tuesday

"I think in Italy you also have a problem of stagnation that has nothing to do with the new government or the previous one, it's been ongoing for two decades ... Unfortunately, that's not going to be solved in the next budget," he said.

What's at stake?

Getting the budget right is crucial to Italy because its economic policies influence investor sentiment toward the country and, ultimately, government and business borrowing costs.

If these rise (with investors demanding higher interest payments due to the perceived higher risk of lending to Italy) this can have a knock-on effect from corporates to consumers.

The budget is important to Europe because Italy is the third-largest economy in the euro zone and any investor concerns over any possible economic collapse — or need for financial aid like many of its neighbors after the 2011 sovereign debt crisis — could damage the entire region's economic and political stability.

There is widespread concern about Italy's public finances. The country has the second highest debt pile in the euro zone, after Greece, at 133.4 percent of GDP, equivalent to 2.3 trillion euros, at the last reading in July by Eurostat.

Italy's attractiveness as a debtor is under scrutiny with investors. Last Thursday, ahead of the Fitch ratings review and as speculation mounted of a downgrade, the gap between Italian and German bond yields (a measure of perceived risk) reached its widest point in just over five years. Meanwhile, the yield (interest paid) on two and five-year Italian bonds hit near three-month highs.

Fotia Francesco | AGF | UIG | Getty Images

Italy's banking system is already hard-pressed, dealing with a financial crisis-era legacy of non-performing loans (last December, Italy was estimated to hold around a quarter of all the euro zone's bad loans) although these are on the decline thanks to a scheme helping banks to sell bad debts. In fact, 2017 saw NPLs in the Italian banking sector fall for the first time in 10 years. Fitch estimates that gross "sofferenze," the worst category of impaired loans, fell from a peak of 203 billion euros in April 2017 to 174 billion euros in August 2018.

Unlike Spain, which rescued its own ailing banking system in 2012, or Greece, Ireland, Portugal and Cyprus, which had to resort to sovereign bailout programs after the crisis, Italy has been viewed as too big to fail, or rather, too big to bail. That's what makes its economic plans and growth forecasts so important for Europe and investors, and why the government's unpredictable economic policies are a risk.

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