Italy: Markets rally as Italy and the EU sign budget truce, but structural weaknesses remain abound
The European Commission decided not to launch an excessive deficit procedure against Italy, following an agreement reached with the country’s government over the budget on 19 December. The deal provides EUR 10.25 billion of additional funds for deficit reduction, by delaying the two notable expansionary measures contained in the 2019 budget: the citizenship income and the rolling back of pension reform. Consequently, it sets a new fiscal deficit target for 2019, which is lowered to 2.04% of GDP from the 2.4% of GDP contained in the previous version of the budget, and also trims GDP growth forecasts to 1.0% for both 2019 and 2020 (from previous estimates of 1.5% and 1.6% growth, respectively). The expected lower growth is due to a lowered estimated expansionary impact of the budget as well as to the recent downturn in economic activity, which is partially attributable to the sharp fall in business confidence prompted by the clash between Italy and the EC.
Financial markets responded positively to the news, with government bond yields and the stock exchange both rallying, especially marked within the banking sector. Looking ahead, this could have a positive effect on Italy’s economy, which contracted for the first time in nearly four years in the third quarter, according to the latest National Accounts data.
Nevertheless, although the painful infringement procedure has been avoided for now, European Commission Vice-President Valdis Dombrovskis stressed that “the composition of the announced measures and the budget overall still raise concern”. Causing particular unease, the citizenship income and the rolling back of pension reforms have only been delayed and are still set to come into force. Further checks will thus be carried out in the coming weeks and the Commission will take stock of the situation in January once the budget law has been approved by both houses of parliament.
Meanwhile, Italy’s growth prospects remain extremely worrisome. An increase in current expenditure, dubious financial cover and a heavier tax burden on companies do not address the severe structural weaknesses afflicting the Italian economy, which include the second-highest public debt-to-GDP ratio in the European Union, sluggish productivity growth, a slow judicial system, high taxes and a cumbersome bureaucracy.