Until Giuseppe Conte's government presents the Draft Budgetary Plan (DBP) for 2019 on 27 September (when Finance Minister Tria will present formal targets for borrowing and growth) it will be a difficult call to make. And there's no guarantee things will be much clearer afterwards.The DBP is the first draft of the 2019 budget law. It will be presented to the Italian parliament in early October and then sent to the Commission on 15 October.
For Italy's coalition government, laboriously constructed in the wake of the elections on 4 March, the moment of truth is approaching. The presentation of the draft budget for 2019 may start to reveal how the circle of promises made during the election campaign will be squared with the budget discipline demanded by the European Commission.
So far, there has been something of a cacophony with contradictory declarations from, on one side, the two deputy prime ministers (Matteo Salvini, leader of the League and Luigi di Maio of the Five Star Movement) and, on the other side, Finance Minister Giovanni Tria.
Finance Minister Tria's comments, along with investor's ongoing search for yield, paved the way for a fall in the yield of 10-year BTPs toward 2,80 % at the start of September after a somewhat fraught period in August when yields of the same bond rose above 3,20 %.
Exhibit 1: Erratic movements in yields of Italian sovereign debt recently reflect uncertainty about Italy's budget plans
Source : Datastream, BNP Paribas Asset Management, as at 12/09/2018
A much awaited announcement…
The content of Italy's draft budget will be a subject of much interest for investors, the European Commission (scheduled to receive official notification of Italy's budget proposals - and those of other EU member states - by 15 October) and rating agencies.
All will be able to judge whether or not government has adhered to its campaign promises.
Taken together the campaign promises (including a flat tax, citizenship income and pension reform) can only lead to a significant rise in Italy's budget deficit and public debt burden.
Recent declarations by those members of the government previously the most hostile to Brussels suggest they may be abandoning the loose talk of their early months in office intending to adopt a budget that will reassure financial markets and Italy’s eurozone partners. This would mean a draft budget presenting a modest improvement in the structural deficit – as recommended by the European Commission.
Given that economic growth in Italy is modest, the deficit should be close to 2 %. This, in our view, would represent an acceptable situation, reassure investors and avoid triggering the procedure for an excessive deficit against Italy.Exhibit 2 : Upcoming reviews by rating agencies of Italy's rating Source:BNP Paribas Asset Management, S&P, Moody's, Fitch, DBRS, as of September 2018
Nonetheless, rating agencies will doubtless be diligent in examining the underlying hypothisies on growth and expected fiscal revenues. There are a number of Italian institutions which also provide checks and balances. Article 81 of the Italian Constitution stiplutates a balanced budget principle and states that « any law leading to the creation or aggravation of public debt must indicate the source of financing"
Within the Italian Treasury the state accounting office estimates the cost of a reform and its fiscal implications while the parliamentary budget office, an independent entity created in 2014, supplies growth estimates and analysis of public accounts in a similar way to the US Congressional Budget Office. It also ensures conformity with European budget rules
…that will not fully clarify matters
Even if in our view the government is not, for the time being, seeking confrontation there are several scenarios which could lead to a standoff: an insistance on greater-than-expected respect of electoral promises, a more severe reaction from the European Commission and/or the rating agencies with regard to debt dynamics over the medium term, disagreement within the coalition that would lead to new elections.
While the data for 2019 may be acceptable the discrepancy between the trajectory necessary to respect the budgetary orthodoxy of the Pact for Stability and Growth and the projections for the state of Italy's public accounts in 2020 and 2021 is difficult to ignore.
Exhibit 3: Economic growth remains sluggish in Italy
Source : Datastream, BNP Paribas Asset Management, as at 20/08/2018
Finally, purely political considerations should not be overlooked.
Since the elections in March, the polls are showing an impressive progression of intentions to vote for the League of Matteo Salvini. As the European parliamentary elections approach he could chose to go head-to-head with European authorities and also France and Germany as he did during the summer over the question of immigrants. In my view, should such an attitude lead to an increase in risk premia for Italian debt sufficiently important to worry the Italian public, Matteo Salvini would likely adopt a more conciliatory manner.
The next months will likely see both a slowdown in Italy's economic activity and a stop to net purchases of debt by the European Central Bank in January . These will both be the subject of particular attention among investors and could lead to reallocations in portfolios.
Exhibit 4: Evolution of voting intentions
Source : https://www.termometropolitico.it, BNP Paribas Asset Management, as at 08/09/2018
To conclude: making a definitive call on Italy's draft budget is difficult but there are grounds for confidence.
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