Investors consider the health of Italy’s finances a major threat to the integrity of euro, so all eyes will be on an Italian budget proposal that could result in elevated tensions between Italy’s politicians and European Union.
Italy’s budget proposal is to be completed, including growth forecasts, Sep. 27, and traders are watching closely because Italy’s fiscal situation is widely viewed as one of the biggest risks for the euro EURUSD, -0.2547% and other European assets.
On top of that, clashes between Italy and the EU have the potential to rattle the global markets, sending investors fleeing for assets perceived as havens.
Against that backdrop, it is no wonder that the shared eurozone currency has fallen 2.1% in the year so far, according to FactSet.
With the European Central Bank expected to end its asset purchases and begin raising interest rates, market participants fret that Italy, the EU’s third-largest economy (once the U.K. has exited), is seen as vulnerable due to its reliance on the ECB to buy its bonds to finance spending.
Read: 3 reasons bond markets fret about Italy but ignore U.S.’s budget-busting deficits
“Details of what will be in the budget are rather sketchy with a lot of mixed messages coming out of the coalition partners, the prime minister and the finance minister,” wrote Aline Schuiling, senior economist, and Nick Kounis, head of financial markets research, at ABN Amro.
Indeed, Luigi di Maio, leader of the 5 Star Movement and Northern League head Matteo Salvini have clashed with Italy’s finance minister Giovanni Tria about the country’s finances. Di Maio even threatened to dismantle the coalition. Divisions around a budget plan could, indeed, lead to major cracks in the current administration, Schuiling and Kounis warned.
As keeping campaign promises that would lead to more government spending would weigh on Italy’s budget deficit, and 5 Star and the League think the deficit should be allowed to exceed 2%. Tria on the other hand, suggested a cap of 1.8%. On top of that, Italy has to adhere to the EU’s budget rules, which specify a maximum deficit that members of the Union must comply.
According to the EU’s Stability and Growth Pact, member states’ nominal budget deficits must be below 3% of gross domestic product, with public debt below 60% of GDP.
EU estimates forecast the budget balance at 1.7% of GDP without a change in policies, though given some loss of economic momentum, this would be closer to 2%, said Schuiling and Kounis.
“The two flagship policy measures—a flat tax and a guaranteed income for all citizens—which would together cost around €70 billion—equal to 4% of GDP—are extremely expensive,” they wrote. “Even if these measures are phased in over a number of budgets, they would probably by themselves take the deficit much higher than 2%.”
Under the assumption that the spending policies would boost economic activity and tax revenues, the government could argue that the measures are paying for themselves.
Cracking down on tax loopholes could also help shore up government finances, and may keep the deficit in check, the ABN Amro analysts said.
Finally, investors will be looking for clues for future policies, including what will be on the priority list for 2019.
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