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NUSA DUA, Indonesia, Oct 12 (Reuters) - Italy must respect European Union budget rules with its 2019 budget and improve public finances if it wants to create headroom to loosen fiscal policy during the next economic downturn, a top International Monetary Fund official said.
Poul Thomsen, the head of the IMF's European department, told a news conference on Friday that Rome was wrong to target an increase in its headline and structural budget deficit next year in breach of EU budget rules.
"We still project relatively strong growth in Italy next year. This is not the time to relax fiscal policy, this is the time to have some fiscal structural adjustment," Thomsen said at the IMF's annual meeting on the Indonesian resort island of Bali.
The populist government in Rome plans a headline gap of 2.4 percent of GDP next year, triple the previous administration's target. EU officials estimate this would translate in to a rise in the structural deficit of 0.8 percent of GDP, while EU rules ask for a 0.6 percent cut, rather than an increase.
"A fiscal relaxation of that magnitude... is not correct. The market reaction has been quite unfavorable and that illustrates the point about fiscal space," Thomsen said.
Investors have been selling Italian bonds in reaction to the higher borrowing plan with yields of the three year paper hitting 5-year highs at an auction on Thursday and 10-year benchmark paper trading at 4.5 year highs.
The European Commission, which is the guardian of EU rules, and euro zone finance ministers have said the planned deficit most likely meant a rise in Italy's public debt which is already the second biggest in Europe at 133 percent of GDP.
Italy's Economy Minister Giovanni Tria raised many eyebrows earlier this month at a meeting of euro zone finance ministers when he said in an ad-hoc presentation of the draft that despite the deficit increase, debt would fall.
EU officials at the Bali meeting said this would only be possible if economic growth generated by the higher deficit was very high.
But the 1.4 percent economic growth forecast by the Italian government for next year and 1.5 seen in 2020 has already been declared as too optimistic by the Italian Fiscal Board - an independent body set up to check budget assumptions.
EU officials also note that higher borrowing costs for Italy, triggered by the announcement of the higher deficit plans already offset much of the expected higher growth.
"If anybody has to give advice to Italy it's to be careful what it's doing," Germany's finance minister Olaf Scholz said in Bali on Friday.
Tria reaffirmed his "intention to maintain a constructive dialog with the EU Commission and the other euro area partners" on Friday after meeting U.S. Treasury Secretary Steven Mnuchin in the resort island. (Reporting by Jan Strupczewski and Francesco Canepa Editing by Shri Navaratnam)