September 4, 2018 / 3:25 PM / in 8 months

Breakingviews - Guest view: Italy’s autumn of discontent

PARIS (Reuters Breakingviews) - Negotiations over Italy’s next government budget are about to begin. After the country disrupted Europe’s financial markets in May, investors are braced for another turbulent autumn.

Street vendors are seen between Via dei Condotti street and Spain square in downtown Rome, Italy, June 11, 2018. Picture taken June 11, 2018. REUTERS/Alessandro Bianchi - RC15469F7150

While the final budget for 2019 will probably not be known until mid-October, chatter about Italy’s fiscal policy will intensify in the coming weeks. The dialogue between government officials and the European Commission is likely to pick up. Commentators and investors will closely scrutinize the country’s proposed national deficit and debt levels.

Signs of tension are already apparent. The yield on 10-year Italian government bonds is almost 300 basis points higher than equivalent German sovereign debt. The average for the last 12 months is less than 170 basis points. Nervousness is somehow spilling over into Spanish and Portuguese borrowing costs. The Italian Treasury’s recent decision to buy back short-term notes is another sign of market stress, though the move was not designed to provide longer-term debt relief.

At the same time, senior members of the Italian government have warned that the country’s financial markets should expect to come under “attack” in the coming weeks. Other politicians have gone so far as calling for the preparation of a “Plan B” – code for Italy’s exit from the euro.

Credit ratings agencies are also watching closely. On Friday, Fitch cut its outlook for Italy from stable to negative. Moody’s, which is already reviewing the country’s sovereign ratings, will publish its decision in a few weeks, while Standard & Poor’s will follow in October. A further downgrade could have wider repercussions for Italian sovereign and corporate borrowing costs.

Investors are likely to respond to these tremors. Any volatility may be amplified by the currency crises in Turkey and Argentina, and tensions in other emerging markets. The situation is reminiscent of August 2011, when the sovereign debt crisis in Greece spread across the euro zone.

However, this time really is different.

First, governments – including Italy’s – are fully aware of the risks. As in the past, the country’s Ministry of Finance will ensure that the next budget is acceptable to the European Union. By the end of September, the Ministry will present to Parliament a document which will reveal the “manovra” – the total expenses and revenue for 2019. It is unlikely that there will room for fiscal profligacy.

Ministry officials acknowledge that Italy’s national debt, currently around 130 percent of GDP, is unlikely to decline quickly. However, investors will focus more closely on long-term debt sustainability rather than short-term results.

Second, the European economy is stronger than it was in 2011, particularly in the so-called periphery. Spain and Portugal are growing quickly, while Italy is recovering from its prolonged crisis. A recent softening in growth cannot hide that, thanks to structural reforms and investment, Italy’s competitiveness and overall business environment have improved. Corporate balance sheets are healthier. In many cases, Italian companies can postpone refinancing if borrowing costs spike.

Third, the banking system has broadly overcome its past challenges. The net amount of non-performing loans on the balance sheets of Italian banks has reduced dramatically – from 86 billion euros in December 2016 to 41 billion euros today. Private equity and debt providers have stepped in with financing, while generous tax breaks have helped to channel more domestic savings towards the real economy. Capital markets and the asset management industry are bigger and more resilient.

Finally, both European and national institutions are better equipped to avert a crisis than they were in 2011. The euro zone has made much progress on forging a banking and capital markets union. Domestic structural reforms have also helped.

In situations of extreme financial stress, the euro zone has a range of fiscal and monetary tools to contain problems in one country and prevent them from spilling over to the rest of the single currency area. To activate these mechanisms, however, European governments must collaborate – including the country that is receiving the support.

In the coming weeks some investors will seek protection and others opportunity. However, it is important that they focus on the fundamentals, filter out the background noise and remain cognizant that there are institutions and procedures in place that did not exist at the time of the last euro zone crisis. The road ahead may be bumpy, but it’s well charted.


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