Silvia Dall’Angelo, Senior Economist, Hermes Investment Management:

Italy is under special scrutiny as budget deadlines are approaching: the government will have to come up with fiscal targets by 27^th September, and a fully-detailed document will have to be submitted to Parliament by 20^th October.

The starting point is challenging. Italy’s public debt is running at a whopping 132% GDP, and recent developments have made debt sustainability going forward even shakier: GDP growth has slowed down this year, and funding costs have increased in recent months in response to domestic political uncertainty. The latter is still weighing on the budget process, as a three-way division has emerged within the government. Finance Minister Tria has conveyed a reassuring message to European institutions and financial markets by endorsing an orthodox approach to the budget and the respect of the fiscal rules. But the leaders of the two main parties supporting the coalition government are pushing for their respective flagship polices, i.e. the flat tax for the League and the basic income guarantee for the 5SM. Each policy is expensive on its own, so the combination of the two (jointly worth €80-100bn or 5-6% GDP) would blow the deficit.

Eventually the government is likely to respect the fiscal rules, because at the end of the day, they need financial markets on their side to raise funding for at least part of their plans. The budget might show a fiscal deficit of 1.6-2% GDP for 2019, higher than last year’s target (0.8% GDP), but roughly in line with this year’s expected outcome, and likely to be reluctantly accepted by Brussels. It will probably include some watered-down versions of the promised policies and gradualism will probably be the government’s key word.

That said, there are risks of a policy accident. If the government components do not manage to reach a compromise on the budget, the strictness of the EU fiscal rules could provide an alibi for a government crisis. However, our base case is that other than some bumps along the way, a budget compromise will emerge and the coalition government will hold for now.  However, tensions are likely to re-intensify ahead of the European Parliamentary elections in May next year. For the time being, the budget is likely to be another missed opportunity: the focus will be on whatever limited achievement in the direction of higher spending and lower taxes, while there will be little emphasis on structural reforms, which are needed to boost the country’s depressed potential.

The above is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instrument. The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products.