Italy nears EU green light on deficit, but fiscal risks remain ahead

By Sara Rossi and Valentina Consiglio

Italy’s deficit outlook: EU procedure, debt costs, and growth headwinds

MILAN/ROME, Feb 27 (Reuters) - Italy's Prime Minister Giorgia Meloni is poised for good news on Monday, when the national statistics agency is expected to certify that the budget deficit fell last year within the EU's 3% of gross domestic product ceiling for the first time since 2019.

That would allow Rome to exit a European Union disciplinary procedure a year ahead of schedule, rewarding its spending restraint, but analysts warn of a difficult period ahead for the euro zone's third-largest economy.

From the autumn, Italy will no longer receive EU post-Covid recovery funds (NGEU) which have propped up its listless growth in recent years, while some investors fear Meloni will be more spendthrift ahead of a 2027 national election.

NEXT GOVERNMENT MAY RECEIVE 'DIFFICULT LEGACY'

Exiting the EDP now vs. pressures later

"The risk is that the effort to exit the procedure sooner than expected could be paid for with a substantial deterioration of public finances from next year, partly due to the end of the NGEU funds", said HSBC senior economist Fabio Balboni.

"It would leave a difficult legacy for the next parliament," he added.

Why the EU’s excessive deficit procedure matters

Brussels opened an "excessive deficit procedure" (EDP) against Italy, along with France and several other EU countries, in 2024 after Rome's deficit the previous year hit 7.2% of GDP, pushed up by costly building incentives to fuel a post-Covid growth recovery.

The deficit fell sharply to 3.4% of GDP in 2024, and is seen at 3% in 2025, 2.8% this year and 2.6% in 2027, according to the government's projections.

Being under an EDP reduces countries' room for manoeuvre on tax and spending because EU rules oblige them to cut their fiscal gap by a prescribed amount each year until it falls to 3% of GDP or below.

Near-term measures and deferred spending

HSBC's Balboni said that to exit the EDP this year, Italy postponed some 2025-related expenditures to 2026, reflected in a near doubling of the state sector deficit in January to 9.8 billion euros, versus 5.4 billion a year earlier.

Other analysts echoed his concerns about Italy's fiscal path.

"Going forward, our economists are sceptical of a further improvement in the deficit ratio, mainly because interest expenses are likely to rise," said Hauke Siemssen, rate strategist at Commerzbank.

With a public debt stably above 3 trillion euros ($3.54 trillion), Italy's interest spending on its debt will rise from around 90 billion euros this year to some 105 billion in 2028, according to the government's estimates.

Italy's politics, uncharacteristically stable since Meloni took office in 2022, are now also seen as a public finance risk.

With an election scheduled for next year, the ruling coalition is currently trying to change voting rules to improve its prospects, and some investors said it will also be tempted to loosen public purse strings ahead of the vote.

ECONOMIC GROWTH RISKS

Markets, forecasts, and the end of recovery funding

Filippo Mormando, strategist at Spanish bank BBVA, said a 2025 deficit below 3% would confirm a better-than-expected fiscal trajectory and trigger a request to exit the EDP.

"The market will then start questioning which fiscal choices the government will make in the autumn, with the 2027 elections looming," he said.

BBVA does not expect any "meaningful deviation" from the government's current trajectory, Mormando added, projecting a 2027 deficit no higher than 2.9%, versus the official 2.6% target.

The government estimates the economy grew by just 0.5% last year and projects 0.7% expansion in 2026, below the EU average in both years.

Without the steady inflow of NGEU funds the country may have fallen into recession last year, some analysts say.

Those disbursements will end in the autumn, posing a question mark against Rome's growth forecasts of 0.8% and 0.9% in 2027 and 2028 and potentially straining public finances.

However, UniCredit's Chief Italian Economist Loredana Federico said she felt Rome's recent fiscal consolidation - based on a broadening tax base, more disciplined current spending and rising public investment - had solid foundations.

"If maintained, this shift could help anchor a more sustainable and resilient fiscal path in the years ahead," she said.

($1 = 0.8473 euros)

(Reporting by Sara Rossi and Valentina Consiglio, additional reporting by Giuseppe Fonte, editing by Alvise Armellini and Gavin Jones)