This week, Italian election headlines have been dominating financial markets, as there seems to have been a breakthrough in the formation of a new government. Benchmark yield spreads vis-à-vis Germany are now at higher levels than prior to the election. In the context of the famous spaghetti western movie, ‘The good, the bad, the ugly', we may be moving towards an ugly scenario for both Italy and Europe. The coalition's draft proposal is in clear breach of EU rules, in our view; hence, we expect a sharp reaction from Brussels. Consequently, heightened uncertainty should be expected in the near future, until a more fiscally modest policy programme is presented from the Italian side.
The draft agreement
A draft agreement leaked on Sunday entailed some very unrealistic initiatives, such as debt forgiveness by the ECB of EUR250bn, the ECB's PSPP holdings not counting in the Maastricht debt-to-GDP ratio as well as a euro opt-out mechanism spooked fears in markets. In addition, a flat tax (entailing a sizeable income tax cut) and rollback of pension reforms was received with the same scepticism by markets.
While the M5S/League coalition pushed back, pointing to this leaked agreement being an old version, the initiatives still took their toll on markets and indicated the kind of government proposals that may come. Early in the week, the prime positive note from the headlines was that the coalition indicated that it would only propose a budget that would be realistic for Brussels to accept.
Nevertheless, the most recent draft from Thursday, still including fiscal easing measures, indicated an order of expansion of around EUR109-126bn, according to Italian Observatoria CPI (see table to the right). The most expensive measure is the introduction of a flat tax estimated at EUR50bn, followed by citizenship income. What is striking with this proposal is that financing only accounts for EUR0.5bn. All in all, this proposal would equate to an expansion of fiscal expenditures by 6-7% of GDP, which on ‘back of the envelope' calculations could increase Italian fiscal deficit to 5-6% of GDP (adjusting for fiscal multiplier), and would clearly breach the EU's excessive deficit procedure rules.
Furthermore, the idea of excluding the ECB-held part of Italian sovereign debt from the Maastricht Treaty debt definition would not fly with the Eurostat and EU commission either. More concerning is that some of the proposed initiatives (such as citizenship income) even reinforce the structural problems that the economy is facing.
Looking ahead, as long as the president views a potential government formation with proposals that are not seen as unconstitutional, the negotiations could drag on. Nevertheless, Monday next week is claimed by the coalition to be the focal date when a prime minister candidate will be announced. Regarding the unconstitutional proposals, the current very unbalanced (expenditure financing) proposal could be seen as unconstitutional. In addition, the coalition's intentions to establish a government body that operated to settle disputes within the coalition could also be viewed as unconstitutional.
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