On June 5th 2019, the European Commission recommended to the Council that it should open a debt-based excessive deficit procedure (EDP) against Italy, a procedure that can ultimately lead to a fine equivalent to 0.5% of the country’s GDP.
However, no further steps were taken immediately after, as the process was relegated to the background by the complex negotiations in the Council over the EU’s top jobs. In the meantime, the discussions between the Commission and the Italian government continued, and the Italian government finally adjusted its 2019 budget to try to avoid the launch of the procedure. As a result, the Commission back-tracked and decided on July 3rd not to recommend opening a procedure “at this stage”.
This is already the second time since the Five Star-League coalition took office in June 2018 that the Commission has been on the brink of launching a procedure. The last time, in the fourth quarter of 2018, a compromise was also reached after three months of negotiations: Italy took some actions to reduce its deficit target for 2019 and the procedure was avoided. However, despite these last-minute agreements, the discussions on Italian public finances will probably come back to haunt us again in the autumn when the Italian government will present a first draft of its 2020 budget.
Anyhow, what matters more than a hypothetical sanction – which might never be imposed in practice, as no country has ever been fined since the foundation of the Stability and Growth Pact – is the impact that the clash between the EU institutions and the Italian government might have on the financing conditions of the country and, as a result, on its budgetary decisions. Indeed, financial markets are more effective and quicker at disciplining countries. The 2018 episode suggests as much: the government decided to lower the path of its deficits and compromise with the Commission as a result of quickly rising yields. That is why Olivier Blanchard suggested recently that “the Commission’s main job should be to provide information to the markets about the health of a member state’s economy and its likely path of debt. This way, the markets would decide. Fiscal space, after all, is in the eye of the investor”.
In this blog post, we try to see if the European Commission's actions since September 2018 have had a visible impact on the Italian spread (vs Germany). In particular, we would like to see if the Commission’s warnings have acted as a ‘signalling device’ for bond-market participants.
In that regard, Blanchard’s comment – part of a welcome call to reform the European fiscal rules – is very interesting. But the situation might not be that simple in the always-complex monetary/fiscal architecture of the euro-area. The Commission cannot behave like a ratings agency that would inform markets about the debt sustainability of its member states from a neutral perspective. This is because, in the euro area, yields are not fully exogenous to the European institutions' assessment of the member states’ debt sustainability and to the respect of the EU fiscal rules.
If a country does not comply with the rules and is in an open confrontation with the Commission and the other member states, it will be more difficult for it to have access to a European Stability Mechanism (ESM) programme – given that these are decided by the euro-area finance ministers by unanimity and informed by the Commission’s debt sustainability analysis – and thus to the ECB’s Outright Monetary Transactions (OMT) programme if needed.
This would deprive the country of a central bank backstop, and thus leave it potentially exposed to a self-fulfilling crisis in the sovereign-bond market. The opening of an excessive deficit procedure could thus be seen as a first step in that direction and an indication that it could soon be difficult for Italy to obtain the support of the ESM or the ECB’s OMT programme if needed.
If financial markets take that into consideration, this should somehow be reflected in the risk premium paid by the country. As a market participant wrote recently in a note quoted by the Financial Times: “With this announcement [of the Italian decision to adjust its budget] and the broader backdrop that the ECB is standing ready to do whatever it takes, yet again, the notion of shorting Italy, even in the face of fiscal pressures, makes little sense.” This suggests that some market participants have assimilated the concept of ‘conditional safe asset’, i.e. that as long as a member state budget is 'validated' by the EU institutions and that its debt is considered sustainable, the ECB should in the end play its backstop role in the case of a liquidity crisis. Let’s see if this is reflected in the recent evolution of the Italian spreads.
Figure 1 shows the evolution of the Italian-German spread for the 10-year bonds since the beginning of 2018, combined with the main actions taken by the European Commission concerning Italy and the replies by the Italian government during that period, as well as other relevant events chronicled in the international financial press that could have affected Italian spreads. We also include the Italian-Spanish spread to control for developments that could be specific to the euro-area periphery and not only to the Italian situation.
Figure 1: Italian spreads (%) and notable events
Source: Bruegel based on Bloomberg, European Commission, Italian Ministry of Finance, and Financial Times. Notes: ‘IT-DE spread’ and ‘IT-ES spread’ represent the difference in the yields of 10-year sovereign bonds between Italy and, respectively Germany and Spain. ‘Positive EU’ (‘Negative EU’) represents an event related to the negotiations between Italy and the EU institutions that should affect positively (negatively) the spreads. ‘Positive Other’ and ‘Negative Other’ are other events collected from the financial press that could affect spreads.
The main observation from Figure 1 is that, overall, the current Italian government – with its confrontational stance towards the EU and its fiscal rules, and its unorthodox handling of public finances – has substantially increased funding costs for Italy relative to Germany. We observe a clear and persistent increase by around 100 basis points (bps) since May 2018 – even if, in recent days, the spread vs Germany has fallen significantly below 200 bps, its lowest level since June 2018.
Looking at the evolutions of the spread in more details, it is clear that the most significant shift took place when the coalition between the League and the Five Star Movement was discussed and when it effectively materialised in the form of a coalition contract. But such a large increase in the risk premium cannot be explained only by the budget deviation resulting from the costly promises appearing in the coalition contract. Even if we think that these policies will not particularly enhance Italy’s growth prospects, their budgetary impact is relatively limited and does not justify by itself such a large increase. It is clear that this large rise in the risk premium is also due to the potential clash with the EU over the fiscal rules, and in particular to a higher perceived probability of an exit from the monetary union, as Daniel Gros suggested last year.
After that first shift, it becomes more difficult to discern clearly the effect of any particular event with the naked eye. If our hypothesis is true, warnings from the European Commission about the breach of the rules, and more generally confrontational episodes (red dots in Figure 1), should be associated with an increase, while ‘truce’ episodes (green dots) should be associated with a fall. We also include episodes reported in the financial press in which Italian authorities have made declarations signalling a degradation of public finances, and other potentially relevant events for Italy, to see if they have been associated with a change in the spread (with lighter green and red dots).
Looking at Figure 1, there are some cases where the effect is clearly visible and goes in the expected direction. For instance, between the end of September 2018 (when the government announced a higher deficit for the next three years) and the end of October (when the clash with the EU was at its apex) the 10-year spread (vs Germany) quickly increased by 85 bps (from 237 to 321 bps), and oscillated around that level until the end of November. After that, when the tensions de-escalated and the negotiations led to new measures to reduce the deficit target, and when, finally, the Commission decided not to recommend an EDP, the spread fell back to 250bps.
The most recent episode of discussions between the Commission and Italy, between May and July 2019, is also remarkable. The beginning of this period is characterised only by a relatively small increase in the spread by around 20bps, which is quite difficult to interpret because it is also characterised by some strong declarations by Italian deputy prime minister Matteo Salvini, the victory of the League (Salvini’s party) in the European elections, and the mini-BOT saga, which are difficult to disentangle.
The last two weeks, characterised by a quick and significant fall in the spread by 60 bps, are somehow clearer. It is clear that part of the fall can be attributed to outgoing ECB president Mario Draghi’s dovish speech in Sintra on June 18th, and to the hinted the possibility of relaxing the 33% issuer limit to be able to re-start sovereign-bond purchases if necessary. Also of note is the nomination of Christine Lagarde as Draghi’s successor, which is seen by markets as a dovish development. Even so, the fall in the spread has accelerated in the first days of July (down 40 bps in only three days) after the Italian government announced extra measures to avoid an increase in the 2019 deficit, which led the Commission to review its position and renounce to recommend an EDP. In addition, the parallel fall in the spread vs Spain suggests that the driver of the most recent fall is specific to Italy. It is of course possible that this ends up being temporary noise, but the coincidence appears striking for the moment (and anecdotal evidence suggests that market participants have been following the negotiations and its outcome very closely).
After the first significant increase related to the coalition assuming power, the spread series becomes quite noisy: in some cases, the impact of the clash between Italy and the EU on the spread is clear, but there are also cases when the spread is not much affected. It is therefore difficult to conclude with certainty about the role of the Commission’s actions as a ‘signalling device’ without a more formal approach.
However, it appears that financial markets are following the budget negotiations between the EU institutions and Italy, and give some weight to the repercussions that could be felt in Italy for breaking the fiscal rules. In our view, they are absolutely right to pay close attention to this dialogue, as opening an EDP would not only represent a bad signal about the state of Italian public finances, but also a strong indication that Italy might not be able to resort to the crucial ESM and OMT tools created in 2012, if it becomes necessary at some point in the future.
The authors would like to thank Tanja Linta for her help with the data visualisation.