Italy's government could send markets on another rollercoaster ride

  • The coalition has promised to implement a universal citizens' income, reduce taxes, review an unpopular pension reform and promised to stop a VAT increase scheduled to start in January 2019.
  • The higher spending could be a problem for Italy, given its large public debt.
ROME, ITALY - JULY 24: Minister of Economy Giovanni Tria attends a press conference.
Simona Granati | Corbis News | Getty Images
ROME, ITALY - JULY 24: Minister of Economy Giovanni Tria attends a press conference.

Italy could create further market volatility on Thursday, as the government presents its new budget targets for the next three years.

Markets have been nervous about new spending plans in Italy, following a general election that led to a populist government.

The coalition — formed by the right-wing League and the leftist Five Star Movement — has promised to implement a universal citizens' income, reduce taxes, review an unpopular pension reform and promised to stop a VAT increase scheduled to start in January 2019. According to UBS analysts, these measures could cost up to between 4.5 and 7 percent of Italy's total gross domestic product (GDP).

The higher spending could be a problem for Italy, given its large public debt. Rome has the second biggest debt pile in Europe, at 130 percent of GDP.

What can we expect Thursday?

The government will publish new GDP, debt and spending figures. The 2019 deficit number will be particularly important to understand the direction that the government will take in terms of fiscal policy.

Recent media reports have suggested that the finance minister, Giovanni Tria, will announce a deficit of 1.6 percent – which would be in line with European rules. Nonetheless, the figure would be much higher than the 0.8 percent that the previous government had forecast for 2019.

Perhaps more importantly, the leaders of the two coalition parties have said they do not mind increasing the deficit by a large margin, if that is what it takes to boost the Italian economy.

According to Bank of America analysts, 2 percent of deficit to GDP is the "watershed level".

What can happen in terms of market reaction?

It is going to depend on the deficit figure for 2019.

"We expect the budget to target a deficit of close to 2 percent of GDP, and if so, markets ought to welcome that, correcting the recent additional concern over an excessive deficit to fulfill all their promises – and with that, I would expect a further tightening of spreads," Erik Nielsen, chief economist at UniCredit, told CNBC Monday in an email.

The yield on the 10-year Italian bond is currently at about 2.8 percent. Market players have focused on the past few days on comments from the finance minister that he will respect European fiscal rules.

But earlier this month, the same yield was at 3.2 percent and has tested new highs in different occasions this year as investors have feared Italy's coalition could go on a spending spree.

What are the political implications?

The spending plans for 2019 will be a key test for the coalition government, given that this is the first time that both parties have worked together.

At the same time, there are tensions between both coalition parties. A poll released this week by the SWG Institute showed that voters are increasingly supportive of the right-wing League and its leader Matteo Salvini. The party has risen to 32 percent of support from 17.4 percent at the election in March.

On the other hand, the Five Star Movement has fallen to 28.7 percent from 32.7 percent in March.

At the same time, the 2019 deficit could spark further problems with the European Union, if it disrespects its 3 percent deficit threshold.

The relationship between Rome and Brussels is already a challenging one. The populist government has been very critical about the lack of European efforts to help with the number of refugees arriving in Italy.

Earlier this summer, the collapse of a bridge in the city of Genoa has also led Rome to blame the European Commission for not giving enough funds for infrastructure. Brussels immediately said denied such accusations.

Following the presentation of the budget targets, the Italian government will conclude in the coming weeks the specific policies to implement next year. This document needs to be submitted to the European Commission by the 15th of October.