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Economic Insights

The 2019-2021 budget draft directly flouts eurozone rules and potentially increases the national debt.

 

In Brief

  • Italy is clearly renouncing its prior commitment to a budget strategy that would put the debt/GDP ratio (130%+) on a gradual downward path.
  • We believe if Italian government debt were to lose its investment-grade ratings, it would provoke an immediate liquidity crisis.
  • A budget crisis in Italy could trigger a broader crisis in the euro area that could quickly become systemic.

 

[Just back from Italy, where he met with Italian economists and political analysts, Giulio Martini shares his thoughts on the budget proposal recently put forth by Italy’s populist-leaning coalition party.]

The headlines say it all: “Euro on Brink,” “Sleepwalking into Crisis.”  Italy’s new ruling coalition—made up of the anti-establishment 5-Star Movement and the right-wing League—knows how to stir up a ruckus. And their draft budget for 2019-2021 was just such a ticket.

Let’s start with a few observations about the draft budget itself:

The draft budget sent to Parliament by the ruling coalition not only violates Italy’s commitments under the European Union’s (EU) Stability and Growth Pact (SGP)1 but also the Italian constitution. The plan proposes deficits averaging 2.1% of gross domestic product (GDP) in 2019, 2020, and 2021 (2.4%, 2.1%, and 1.8%, respectively), and it makes those projections on the basis of a 1.5% real GDP growth forecast. This compares with the previous plan, which met Italy’s commitments with deficit targets of 0.8% in 2019, 0% in 2020, and a small budget surplus in 2021. Moreover, the real GDP growth estimate underlying those projections only averaged 0.8%.2

While the analytical details underlying the latest budget proposal haven’t been released yet, it seems clear that the Italian government is on track for clashes with its own budgetary watchdog agency—equivalent to the Congressional Budget Office in the United States—and the European Commission (EC).  I believe such clashes are inevitable because:

  • First, the growth assumption underlying the projections is more than twice the 0.3%-0.8% range of current estimates of potential output growth.
  • Second, the revenue estimates very likely contain the impact of a number of “one-offs,” such as revenue gains from a tax amnesty.
  • Last, it appears that the 2019 deficit is likely to come in at 1.2% or more, which should have triggered additional austerity measures. Instead, Italy has responded by canceling the Value Added Tax increase, which had been scheduled for January 1, 2019, and by adding a set of new spending commitments for 2020 and 2021 amounting to at least 1.5% of GDP.

In short, Italy is clearly renouncing its prior commitment to a budget strategy that would put the debt/GDP ratio (130%+) on a gradual downward path.

So what happens from here? The next steps in the process are fairly straight forward. Near term they are:

  • A review of the proposal by the Italian parliament expert budget sub-committee by October 15;
  • Approval of the budget by the parliamentary budget committee October 15-20;
  • EC comments on the budget law and EC autumn forecast by the end of November; and
  • Approval of budget by the full Italian parliament by December 31, 2018.

Further down the road would be:

  • An evaluation of budgetary compliance under the SGP by the EU on April 10, 2022; and
  • Recommendation under the Excess Deficit Procedure clause of SGP as to whether Italy should be assessed fines for non-compliance with EU budgetary principles.

A Potential Liquidity Crisis
All of the above steps stretching out the timeline of the conflict could be pre-empted if the four credit agencies cut their ratings in the near future. We believe if Italian government debt were to lose its investment-grade ratings from all four agencies—S&P, Moody’s, Fitch, and DBRS—it would no longer be eligible for purchase by the European Central Bank and could no longer be posted as collateral by banks, provoking an immediate liquidity crisis.

The results of the next S&P review will be released on October 26 and Moody’s review by the end of the October. Both currently rate Italy two notches above junk. It is widely believed that both agencies will cut their ratings by one notch and there is roughly a 50% chance of a negative watch addendum. Fitch currently rates Italian government debt two notches above junk, and the next review is scheduled for March, 2019. The DBRS rating is currently three notches above junk and the next review is scheduled for January 2019.

Risk of Contagion
In our opinion, the reason investors need to follow developments in Italy closely is that a budget crisis in that nation could trigger a broader crisis in the euro area that could quickly become systemic.

We will keep you informed.

 

1The Stability and Growth Pact (SGP) is an agreement, among the member states of the European Union, to facilitate and maintain the stability of the Economic and Monetary Union (EMU).

2All data herein are sourced from Bloomberg.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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