On September 27th, Italy’s ruling coalition surprised markets and its European partners when it announced its plan to increase the Italian public deficit to 2.4% of GDP in 2019, even though the previous government had promised a decline of the deficit to 0.8% for that same year. Moreover, this first announcement foresaw a 2.4% deficit in 2020 and 2021 too.
The pressure from the European Commission and its European partners, as well as the strong reaction from the bond market, forced the government to partially reconsider its plans. On October 4th, Prime Minister Conte announced that the government had amended its plan and that, although the deficit would still reach 2.4% in 2019, it would be reduced to 2.1% of GDP in 2020, and to 1.8% in 2021 (see Figure 1).
Also on October 4th, the government revealed the details of its budget plan in its 'economic and financial document' for 2019, as well as in a letter to the European Commission. As expected, these documents show that the deficit increase is intended to finance the tax cuts promised by the League, a version of the citizen’s income promised by the Five Star Movement, a loosening of the previous government’s pension reform (as promised by both parties in the new coalition), as well as an increase in public investment.
The headline deficit numbers announced for the moment are not dramatic per se (and should still be smaller than, for example, the French deficit figure), but the stock of public debt was already as high as 131.2% of GDP at the end of 2017. So, how will the new Italian fiscal plans affect the path of its debt-to-GDP ratio? According to the new documents published on October 4th, given the predictions of the government (i.e. a real growth rate of 1.5% for 2019, 1.6% for 2020 and 1.4% for the year after), Italy’s public debt as a share of GDP is supposed to fall over the forecast horizon to 124.6% in 2021 (see Figure 2).
However, these forecasts might be too optimistic. They appear at odds not only with the European Commission’s own forecasts (1.1% real growth for 2019), but with the perceived reduced growth prospects for 2019 at the global level and, more importantly, with the potential negative impact coming from the recent strong increase in Italian bond yields and the resulting tightening of financial conditions for the real economy.
Even if the increased deficit should have some short-term stimulating effect on an Italian economy that is still operating below potential, the government growth forecasts thus appear to be quite optimistic. If they do not materialise and if, as a result, deficits are higher than foreseen, it means that Italy’s public-debt-to-GDP will, at best, stagnate at a high level and, more probably, will be on the rise again in the next few years as a result of the new fiscal plans.
What does the EU fiscal framework say about the current Italian situation?
First, the Italian government, like other EU Member States, will have to formally submit to the Commission its budgetary plan for next year before mid-October. If the European Commission identifies serious non-compliance with Italy’s budgetary obligations, it will be able to react to this draft immediately and request a revision of the budgetary draft within three weeks (Art 7.2 of regulation 473/2013). After that, the Commission should also publish its formal opinion on the Italian plan for next year (and on those of other Member States) before the end of November.
If the Italian government does not revise its budget plans in response to the Commission’s recommendations, the Commission can mobilise the rules from the European fiscal framework to try to steer Italy’s fiscal policy towards a sustainable path. The Stability and Growth Pact (SGP), the backbone of the EU fiscal framework, is composed of a preventive and a corrective arm (the latter is also known as the excessive deficit procedure). Both levers could be activated in the Italian case.
First option: The European Commission could sanction Italy for not respecting the preventive arm of the Stability and Growth Pact (SGP)
The preventive arm requires Member States’ structural balance to converge towards a country-specific medium-term budgetary objective (MTO), i.e. 0% in the case of Italy. Like other members, Italy should be at its MTO, or on a path to reach it, with an improvement of its structural balance. The size of this adjustment depends on the macro conditions and level of debt (see flexibility matrix p20). In the case of Italy, given the country’s high debt level, the structural balance adjustment most recently recommended by the Commission was 0.6% for 2019 (see p18).
The preventive arm also requires Member States to abide by the expenditure benchmark (see details on the various fiscal rules in Claeys et al., 2016). If one of these two conditions are breached, the European Commission can launch a Significant Deviation Procedure. It constitutes the first step before (or to avoid) the opening of an Excessive Deficit Procedure.
In our case, the published budget plan suggests that the Italian government will indeed breach the rules of the preventive arm of the SGP by deliberately drifting away from its MTO (the new plan forecasts a worsening of the structural balance by 0.8 percentage points in 2019, see Table III. 6 p49) and by exceeding its expenditure benchmark.
The European Commission could thus send a warning to Italy. If the Italian government does not react within one month of the date of the adoption of the warning, the Council should, at that point, issue a recommendation urging the country to take the necessary policy measures to fulfil its European commitments. At its limit, in the preventive arm, a Council recommendation which is not respected can lead to an interest-bearing deposit of 0.2% of GDP, unless the Council decides otherwise by a qualified majority (Article 4 of regulation 1173/2011).
However, one element could delay the procedure: the SGP code of conduct stipulates that “the identification of a significant deviation […] should be based on outcomes as opposed to plans”. As a result, the intervention of the European Commission (at least as far as the preventive arm is concerned) could be deferred until the deviations are actually observed next year when the budget is executed.
Second option: Italy could also be placed under the corrective arm of the SGP
However, the Commission could also directly decide to open an Excessive Deficit Procedure (EDP) for Italy, following article 126 of the Treaty of the Functioning of the European Union.
EU countries are required to keep their budget deficit below 3% and their public-debt-to-GDP ratio lower than 60% – or if the debt ratio is above 60%, it should diminish at a sufficient pace. The Six-Pack legislation of 2011 quantified what “sufficient pace” means: the debt ratio should decline by 1/20th of the gap between the actual debt-to-GDP ratio and the 60% threshold, on average over three years. Given that Italy’s debt ratio stands at 131% of GDP, the gap to the 60% threshold is 71 percentage points, so the average annual decline should in theory be 71% divided by 20 – i.e. 3.55% of GDP per year. Therefore, the debt ratio should fall below 120% in the next three years, a criterion that the new projection of the Italian government does not meet.
So, it is not the 2.4% deficit figure that would be put forward as an argument by the European Commission, but an insufficient decline of Italy’s 131% debt-to-GDP ratio. Even though this justification has, to the extent of our knowledge, never been used until now, it is legally possible to open an EDP when a Member State’s debt is larger than 60% of GDP and is not being reduced at a satisfactory pace – even if its deficit is below 3%.
The SGP allows exceptions from this 1/20th debt-reduction rule, when a country implements reforms improving the long-run sustainability of the budget. This clause has been used in recent years to avoid placing Italy under an EDP. However, this year the proposed deviation from the debt-reduction trajectory is very significant and Italy is actually planning to reverse some reforms put in place in recent years, like the pension reform, so it might be difficult for the Commission to use this exception clause this time. We also note that the debt-reduction rule should be met ex ante too – that is, its fulfilment should be reflected in forecasts.
In terms of procedure, the first step would be a report by the Commission on whether to open an EDP against Italy. Three months after the submission of the budget, on the basis of this recommendation, the Council would decide whether an excessive deficit exists and, if so, to open an EDP with recommendations, deadlines and targets. At this stage, Italy would have three to six months to comply with the given recommendations – i.e. to amend its budget – before the Commission assesses if Italy has taken ‘effective action’. At that point, if Italy does not meet the given targets, the Council could decide on the type (and size) of sanctions it wants to impose on the country and assign new targets. If the non-compliance persists, the process would repeat itself.
In terms of possible sanctions, once it would enter the corrective arm of the SGP, Italy could be required (in case of serious non-compliance or if it has already been required to post an interest-bearing deposit under the preventive arm) to make a non-interest-bearing deposit until the deficit has been corrected. The country could also be sanctioned with a fine worth up to 0.5% of GDP (with a fixed component of 0.2% of GDP and a variable component). The Council could also decide to suspend part or all of the commitments or payments linked to European Structural and Investment Funds in Italy (recital 24 of regulation 1303/2013).
Will the Commission exercise its powers?
From a purely legal perspective, the EU fiscal framework provides two options for the European Commission to try to influence the Italian fiscal policy, in order to put it on a sustainable path (these options are summarised in the timeline in Figure 3). However, in the end political considerations might dominate the next few months: as the European elections are approaching, the European Commission and the Council will be put in a delicate position. If they decide to apply the rules of the fiscal framework forcefully, they risk being used as a scapegoat for Italians’ bleak situation and face a further populist backlash in the country. But if they decide against applying the fiscal rules to Italy, they might embolden its government and reduce the credibility of the fiscal rules further, which would support populist movements in northern Europe.
In addition, market reaction and the opinion of rating agencies in the next few weeks (as S&P and Moody’s are supposed to review their ratings before the end of the month) might also ultimately matter more than the European institutions’ decisions. Given the importance of ratings in the collateral framework of the ECB, downgrades could be dangerous for Italy: a downgrade by two notches by the three major rating agencies and by three notches by DBRS would make Italian bonds ineligible as collateral in the ECB monetary operations. Although the probability of such a strong downgrade might not be that high for the moment – as a comparison, Italy was only downgraded three times in the heat of the crisis, between 2011 and 2013, at a time when the deficit was much higher – such an outcome would be highly damaging for the Italian banking sector and as a result for the Italian economy.