Predictably, the fraught Italian budget negotiations went off the rails at the last minute on Thursday, casting further doubt on the country’s fiscal trajectory and underscoring deep fissures between Finance Minister Giovanni Tria and the country’s firebrand deputy Prime Minsters.
Matteo Salvini was characteristically defiant ahead of today’s deadline. “We’ll do a courageous budget, the deficit isn’t a problem”, he told Corriere della Sera over the weekend, adding that he “spoke to foreign investors and all of them told me the same thing: do a courageous, expansionary budget.”
That’s a lie, and it came just a day after Ignazio Visco warned the League leader to be careful.
For their part, Five Star was reportedly looking for a deficit of 2.6% of GDP in order to make sure they can pay for that damn “citizen’s income”.
Fast forward to Thursday and rumors were swirling that a planned cabinet meeting to decide on next year’s budget targets might be delayed. The initial reporting, from Corriere della Sera, cited “new complications”.
Apparently, Salvini threw his hat in with Di Maio in seeking a 2.4% deficit next year, while Tria drew a line in the sand at 1.9% of GDP. According to Il Sole 24 Ore, the Finance Minister is prepared to resign if this goes off the rails.
The euro was hit as soon as the headlines began to leak out:
“If you’re on the side of markets, you’re against citizens”, Di Maio was quoted as saying on Thursday, a characteristically ridiculous claim befitting of the kind of populist nonsense that leads countries to fiscal ruin.
BTPs are obviously under pressure with 2-year yields jumping as much as 21bps, bear flattening the the curve bear.
Italian financials fell sharply.
The usual suspects were all crushed on Thursday as UBI, Banco BPM, Intesa and UniCredit fell between 3% and 5%:
On the bright side, auctions for five- and 10-year debt went ok, all things considered, with the 10-year sale enjoying the most robust demand since May, when the bottom fell out for the Italian bond market.
The bottom line here is that no matter what the outcome of the budget process ends up being (and the worst case scenario would probably be Tria resigning in disgust), this eleventh hour wrangling is indicative of how Di Maio and Salvini are likely to approach things going forward.
They, like other populists, are torn between economic reality and the promises they made to voters. When push comes to shove, they will be inclined to throw caution to the wind, because their political survival depends on it.
The problem, as Goldman made clear over the weekend, is that there really isn’t much in the way of wiggle room. Consider the following from a note dated September 24:
Exhibit 1 uses the results from our European economists’ Italian debt sustainability model. The diagonal lines represent combinations of primary balances, yields (funding costs) and nominal growth that represent a stable debt-to-GDP ratio. Higher levels of nominal GDP growth can sustain higher yields, while a worsening primary balance requires lower yields for any given level of NGDP growth to keep debt constant. We use 7-year BTP yields as a proxy for the overall funding cost of Italy, as 7 years corresponds to the average maturity of outstanding debt.
This is, of course, a higher stylized representation of these variables — in reality these variables do not move one at a time but instead all affect one another. Moreover, moving toward the ‘top right’ of this map leads to non-linear outcomes, either through negatively reinforcing debt dynamics or through forced policy changes (either national or at a European level), which limits its ability to offer precise guidance on yields. But it nevertheless provides a useful macro map to determine the basic arithmetic of where we currently stand. As our European economists have been arguing, the exhibit shows that — especially given the trading range of Italian debt this year — there is little room for a simultaneous fiscal expansion and nominal GDP growth slowdown. This makes the combination of an upcoming fiscal expansion coupled with the weakening in higher frequency indicators in Italy (such as the PMI Manufacturing survey) a challenging backdrop for BTPs in the medium-term (Exhibit 2).
Even if this ultimately gets resolved on Thursday, you can expect the same type of contentious atmosphere going forward anytime the budget comes up.
There is no scenario in which Di Maio and Salvini don’t end up clashing with Brussels and upsetting markets, because at the end of the day, the kind of deficit they need to run in order to finance the populist agenda that got them elected isn’t going to be consistent with fiscal rectitude.