Consistent with recent rhetoric, Italy has not yet budged on the headline deficit figure of 2.4%, thus setting up a clash with European leaders. The budget delivers on many of the League and Five Star Movement’s pre-election promises such as rolling back pension reform, lowering the retirement age, tax deductions and a citizens’ minimum income.
Even so, it was impossible for the EC to accept the proposal. League leader and Deputy Prime Minster Matteo Salvini, who leads in opinion polls, knows this and his strategy is becoming clearer. In our opinion, he is prepared to gamble with Italy’s solvency in order to trigger political change at the European Parliament elections in May.
The EC will be hoping that budget discipline will be enforced by the now infamous ‘spread’, the yield difference between Italian and German government debt, but Italy has termed out its debt. With an average maturity of over seven years, higher interest costs hurt, but it is a slow burn and Salvini has indicated that his tolerance for the spread to widen is higher than the current level, perhaps 100 basis points from here. He believes he has a window before Italian debt finds itself on an unsustainable path.
Between now and the May elections, the budget dispute will provide plenty of opportunity for Salvini to talk down the current European Union (EU) leadership. He sees the elections, where the relatively liberal UK members will disappear from the chamber, as a chance to deliver the European Parliament to the populists. His recent grandstanding with Marine Le Pen, president of the recently re-named National Rally party in France, makes this clear. The first casualty would be the EU’s Stability and Growth Pact, which enforces budget discipline.
It would take a large shift in opinion polls for Salvini to achieve this, especially if French President Emmanuel Macron’s En Marche! movement performs well, so perhaps the deputy prime minister feels he has little to lose. Still, we expect a big change in the make-up of the European parliament that will make cross-border policymaking more difficult and keep risk premiums high, especially without the European Central Bank’s bond-buying backstop.