Italy: The Master of Its Fate

With a current account surplus of 2.8% of its GDP in 2017, Italy does not depend on net capital imports. About 68% of its sovereign bonds are held at home, including a 20% share bought by the Bank of Italy under the ECB’s asset purchase program.

First and foremost, Rome needs to maintain the confidence of its rich domestic investor base.

The euro exchange rate to the Swiss franc and, to a lesser extent, sudden unusual changes in Italy’s Target2 balances with the ECB can be rough gauges of capital flight. Italy’s Target2 liabilities rose by €39bn to a record €465bn in May, probably reflecting both ongoing ECB asset purchases and some capital flight.

The EU does not have much direct leverage over Rome. Italy pays more into the EU budget than it gets back directly (net contribution of €3.2 billion in 2016). A risk that the EU may eventually suspend funding for regional or structural adjustment programmes would matter much less for Italy than for the big net recipients of EU funds in east-central Europe such as Poland and Hungary.

If Italy ignores the fiscal rules, the EU could eventually impose a fine of 0.2% of GDP (about €3.5 billion) after a lengthy procedure. Even if a dispute with the EU were to heat up soon, a decision about potential penalties would probably not be taken before June 2019, and possibly later than that.

Relative to the sums which Italy’s radicals intend to spend anyway according to the 5Star/Lega coalition agreement, the risk of such a fine may seem like a minor nuisance.

Big risks

On its own, potential trouble with the EU would not be a serious constraint on Italy’s populist government. Bashing the EU may even serve the radicals well for a while to fire up parts of their base and deflect from other problems. However, a noisy confrontation with the EU would raise two big risks:

• First, the dispute and frank comments from European leaders about Italy’s fiscal situation as well as downgrades from rating agencies could make foreign and domestic investors look for the exit.

• Second, a major conflict could bring the issue of euro exit (“shrug off the Brussels yoke“) onto Italy’s political agenda. In turn, this could fuel capital flight until Italy faces the hard choice of either returning to prudence or printing its own low-credibility money.

Timeline for a potential confrontation with the EU

If Italy’s new government embarks on policies that raise the fiscal deficit, it may take up to a year until Rome may get into serious trouble with the EU. The key milestones of a process that could lead to potential EU sanctions against Italy are:

Summer 2018: Italy’s government draws up its plans, deciding which policy pledges of the 5Stars/Lega coalition agreement it wants to implement when and in which stages.

15 October 2018: Italy has to submit its draft 2019 budget to its own parliament and present it to the EU Commission.

30 November 2018: After some to-and-fro between Rome and Brussels, the EU Commission passes its verdict on the 2019 budget, possibly saying that it breaches the requirement to bring down the fiscal deficit and/or the debt ratio.

13/14 December 2018: At the EU summit, EU leaders may confirm the EU Commission’s negative verdict on Italy’s 2019 budget. Under the “excessive deficit procedure,” Italy could then be given six months (or possibly only three months if EU leaders consider the breach of fiscal rules “serious”) to present a concrete plan to correct the excessive deficit.

Spring 2019: The EU Commission assesses whether Italy complied with the fiscal rules in 2018 based on the actual budget outcomes for that year under the separate “significant deviation procedure.”

June 2019: An EU summit may decide to impose sanctions on Italy if Rome has breached its 2018 fiscal commitments and/or failed to correct its 2019 budget plan in line with the recommendations the EU may have issued in December 2019.

In short, the most likely flashpoints for an escalating conflict between Rome and Brussels would be October 2018 (Italy presents its 2019 budget) and June 2019 (the EU may have to decide about sanctions against Italy). In time-honoured fashion, the EU may well choose to delay any judgement on Italy if that were to seem politically convenient.

The politics of sanctions

As to potential sanctions, the EU could reduce Italy’s access to the European Investment Bank (EIB), suspend regional support funds, demand a non-interest bearing deposit until the excessive deficit has been corrected or even levy a fine of up to 0.2% of Italy’s GDP. With continued non-compliance, the fine may be raised year by year thereafter.

The EU Commission wields significant power in the process. If the Commission proposes sanctions, an EU summit could only reject them with a qualified majority representing at least 15 countries with at least 65% of the EU population.

For example, if France, Germany and the Netherlands were all to agree with the EU Commission that Italy should be fined, their votes would suffice to validate such an EU Commission proposal.

EU rules can be quite flexible, if required. For example, France had been in an excessive deficit procedure for nearly ten years until spring 2018 for persistent fiscal overshoots without ever getting close to being fined. The political clout of a country and the political will — and goodwill — of its partners matter.

That holds a lesson for the new rulers of Italy: If 5Stars and Lega tame their radical instincts, water down their fiscal plans substantially and adopt a constructive rather than a disruptive role in the EU, they could be allowed to get away with a few things.

In the absence of a serious conflict with the EU, low borrowing costs could even help them to finance some of their ideas to some extent. But if they start out as confrontational as Tsipras/Varoufakis had done in Greece in early 2015, they will be heading for trouble.

A headache for the EU

Even in the wake of the euro crisis, the EU never imposed genuine sanctions on any Eurozone member for breaching the fiscal rules. In July 2016, Spain and Portugal narrowly escaped sanctions by promising a stronger fiscal correction.

In a conflict with its EU partners, Italy could try to blackmail them by threatening to veto other key EU decisions, for instance on EU/Eurozone reforms. That can complicate matters in Europe.

But as the EU has shown when Britain’s then-prime minister David Cameron tried to block an EU fiscal agreement in December 2011, the EU can find ways around attempted vetoes by recalcitrant members. It may not be easy, though.

Incidentally, at the EU summit in June 2019 when EU leaders may potentially have to discuss sanctions against Italy, they may also need to unanimously nominate the successor to Mario Draghi at the helm of the ECB. Draghi’s term expires at the end of October 2019.

Unless the radicals ruling Rome were to get real early enough so that the issue of penalties would not have to come up in the first place, things could get quite noisy.