Prime Minister Mario Draghi’s sudden resignation from Italy’s fractious government half a year earlier than planned spells trouble for Europe’s economic agenda, from changing EU fiscal rules to implementing reforms under the joint-debt pandemic relief program.
Barring surprises, a right-wing coalition uniting Silvio Berlusconi’s centrist Forza Italia, Matteo Salvini’s right-wing League and Giorgia Meloni’s post-fascist Brothers of Italy is on track to win well over 40 percent of the vote in Italy.
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Initial market reactions show uneasiness at that prospect, with the premium that the Italian government pays on its bonds compared to the ultra-safe German bund rising to above 230 basis points — and showing no signs of abating.
While right-wing parties have yet to formalize their economic agenda, the EU has causes to fret on multiple fronts as Italy approaches the polls on September 25. POLITICO breaks it down here.
One of the first tasks of the incoming government will be to draw up a draft budget law for 2023, which needs to be sent to the Commission by mid-October and approved by year’s end.
Given the tight timing, the government might ask for an extension to that deadline to have enough time to draw up a budget law.
Alternatively, the outgoing government could choose to present a budget on a “no-policy-change” basis, which would just update and extend the current one. The incoming government could later seek to amend it, subject to fresh approval by the Commission. This route is the most likely option, according to Italian officials.
The Commission says it expects the incoming government to submit an updated draft budget “once it takes office” and “at least one month before” it needs parliamentary approval, a Commission spokesperson said.
The right-wing coalition will push for lower taxes and a reversal of a contested pension reform that increased the retirement age, currently at 67. It also wants a near-doubling of minimum pension payments of €1,000 per month — all likely to weigh on the state’s revenue column.
Rome’s budget draft will be closely scrutinized by Brussels, which this year recommended that high-debt countries err on the side of budgetary caution. The Commission has also said that it’ll decide in the fall whether to open so-called “excessive deficit procedures” against countries planning to breach the bloc’s 3-percent-deficit threshold in their draft budgets.
In theory, Brussels could also use its other metric, a breach of the debt-to-GDP ratio of 60 percent. But it won’t go that route as most EU countries have blown past that cut-off, given all the debt racked up after three years of pandemic, war and inflation, the Commission says.
The Commission has a lot of leeway on whether to launch such procedures. But it would be under pressure to take action from EU capitals that see Italy’s fiscal laxity as a constant threat to the eurozone.
Fiscal rules overhaul
The change of guard in Rome also weighs heavily on a broader debate on how to reform the bloc’s fiscal rules. Under Draghi, Italy partnered up with France to spearhead sweeping changes, arguing in an op-ed in the Financial Times last December that growth-enhancing, debt-financed investments “should be favored by the fiscal rules.” Brussels should loosen the strings to let EU capitals ramp up public spending on priorities like digitalization and the green transition, they argued.
The joint call by two of the largest eurozone countries generated some pushback in eight budget-conscious capitals. Yet even so-called “hawks” came to realize that reform is needed — as demonstrated by the unlikely pairing up of Spain and the Netherlands on this topic.
But then Russia invaded Ukraine, eclipsing the French Council presidency’s efforts to advance EU fiscal reform during its tenure in the first half of the year.
The Commission recently said it’ll present its views on it after the summer break — likely in the form of an orientation paper rather than legislative proposals.
Brussels wants to scrap a required annual reduction by 5 percent of excess debt. Instead, it would opt for custom-made debt reduction plans spanning a number of years that would be agreed on with the country in question, according to two EU officials. In exchange for more leeway, countries would have to comply with structural reforms under the Commission’s “European Semester” cycle, complete with annual checkpoints and a more rigid enforcement of the rules.
Still, a landing zone for consensus is far away. The biggest heavyweight, Berlin, hasn’t yet spoken. But Germany’s governing coalition — comprised of Greens, Social Democrats and liberals — has drawn up a paper that shows little appetite for reform beyond minor tinkering, according to two people briefed on it.
Discounting investments in green or defense, the so-called “golden rule” that Italy and France had pitched earlier this year — or a central fiscal capacity that Rome had also supported — are unlikely to get traction with German Finance Minister Christian Lindner, a budget hawk.
With Draghi heading out, hopes for a grand bargain between the key players in this debate are now low.
Joint debt stress test
Italy’s new government will be tied to a demanding schedule of reforms and investments if it wants to unlock further funds from the EU’s Recovery and Resilience Facility, the joint-debt program agreed on at the height of the pandemic, of which Italy is the largest beneficiary.
Italy is on track so far, achieving 96 objectives corresponding to €67 billion in payments. Still, that represents less than a fifth of all objectives, and a little over a third of all funds it can access.
Draghi’s government and the Commission decided to “front-load” those reforms in the program’s two first years, banking on Draghi’s supermajority to pass key reforms. The next tranche consists of €19 billion in payments against the achievement of 55 objectives. They include implementing reforms of competition rules and the justice system; ramping up efforts to increase state revenues by fighting tax evasion; and overhauling the public school system.
Draghi will seek to continue this push as long as he’s in government, but further reform efforts will fall on the incoming one.
Any attempt to change the reform plan — a possibility foreseen under the fund’s rules — would require Brussels’ sign-off. Such a process could take at least a couple of months, adding to the uncertainty. Still, Meloni assured in an interview over the weekend that “we will ensure … that the deadlines are met on time.”
Whether Rome can keep its word will have consequences for the success of the bloc’s largest-ever joint-debt exercise and the willingness to repeat it in the future. Draghi noted as much last week in his eleventh-hour failed attempt to keep his majority: “If we do not show that we know how to spend this money efficiently and honestly, it will be impossible to demand new common crisis management tools,” he warned.
Growing out of debt
Arguably, Draghi’s tenure was always too short to make a dent in Italy’s decades-long spell of low growth.
Indeed, despite a strong rebound after the pandemic-induced slump and above-average growth rates for this year, the Commission forecast 0.9 percent growth for Italy in 2023, in line with pre-pandemic rates — the worst expected output in the eurozone.
Whether Italy can return to growing in a long-term and sustainable way has huge implications for Italy’s public debt, which hit 150 percent of GDP in 2021.
Healthy growth rates would suffice to bring down the country’s debt without requiring budget cuts, but stagnation would spell trouble for the perceived sustainability of its huge debt pile.
Spring projections by the Italian finance ministry that saw the debt pile recede steadily in the coming years now seem surpassed by reality, with Goldman Sachs projecting an increase in the debt-to-GDP for the coming two years.
While Italy doesn’t risk a debt crisis in the immediate future, thanks in large part to an average bond maturity of seven years, “the worsening in the debt outlook presents the most relevant medium run challenge for the Italian economy,” Goldman Sachs’ Filippo Taddei wrote in a recent note.
ECB to the rescue?
The ECB may have brandished its brand new crisis tool last week, but the central bank isn’t expected to race to Italy’s rescue if the cost of government borrowing spirals in the run-up to the polls.
The tool, dubbed the transmission protection instrument (TPI), allows the ECB to buy government bonds of single member states if the country’s borrowing costs jump due to market jitters rather than solid economic reasons. But the central bank made clear it would only do so under certain conditions, including fiscal sustainability and compliance with commitments made under the recovery fund.
As the rating agency Moody’s points out, the collapse of Italy’s government raises questions about whether the country can meet these conditions. Similarly, Barclays economist Silvia Ardagna argued the ECB is unlikely to “activate the TPI if the Italian bond market comes under pressure while there is political uncertainty.”
In face of the current political crisis, seen as self-inflicted, economists argue that the first line of defense for Italy should be the older bond-buying program, known as OMT, that the ECB has in its pocket. In this case, assistance could come if Italy entered a bailout program under the European Stability Mechanism, which also oversaw Greece’s return to fiscal health.
But the current political environment, with a war raging on Europe’s doorstep, may still compel the ECB to use TPI: If spreads spiral out of control and Italy refuses to apply for a program, would the ECB sit back and watch the eurozone unravel or use its discretion and buy Italian debt?
After all, the bank’s Governing Council has a great degree of leeway on when to use it, as ECB President Christine Lagarde noted last week, saying that “there is an element of discretion and judgement.”
“In contrast to the OMT, which was tied to an ESM program and thus [needed] the approval of all member states, no other institution now stands between the political pressure and the ECB Governing Council members,” noted Volker Wieland, economics professor at the University of Frankfurt and former consultant to the ECB and the Federal Reserve.
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