Markets Holding Breath Ahead of EU Reaction to Italian Budget

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The following article was written by FXTM Senior Staff Writer Nikola Grozdanovic.

Nikola Grozdanovic FXTM

Nikola Grozdanovic, FXTM

The deadline for Italy submitting its proposed national budget to the European Commission has arrived, and the markets are holding their proverbial breath as the review process gets underway. There have been jitters already, thanks to growing fears of the proposal’s plan to increase the budget deficit to 2.4% which directly contradicts EU policy (incidentally, it’s also three times bigger than the previous administration’s target). Added to that, the butting of heads between the two Italian Deputy Prime Ministers – Five Star’s Luigi Di Maio and Lega Nord’s Matteo Salvini – and EU policymakers isn’t helping.

Italy’s coalition government is already used to being under the microscope, ever since its turbulent rise to power in March. The proposed budget, with its clear signs of stubborn disregard for the advice from the European Commission, is shaking up matters again – and the markets are feeling it. FXTM Senior Staff Writer Nikola Grozdanovic explains and looks into the possible consequences.

One quick overview of recent market activity within Italy itself, and across the wider Eurozone spectrum, shows clear signs of uncertainty and fear. Earlier in September, Italian bond yields started to climb up and since then they’ve reached their highest level in close to five years. Meanwhile, Italian stocks have dropped amidst rising tensions and European Central Bank’s Mario Draghi’s words of caution. On September 28, Italy’s FTSE MIB index dropped by nearly 4% – its worst daily drop in over two years.

Meanwhile, the Euro has been bearing the brunt of the controversy as well. A week ago, the most traded currency pair on the market – the EURUSD – fell to seven-week lows thanks mostly to the destabilising consequences Italy’s budget plan will have on the Eurozone. All of this stemming, by the way, from a clear lack of confidence in the Italian government. On 14 October, that’s one day before the review process is set to begin, The Financial Times reported on the shorting of Italian bonds as the clearest indication of how negative the sentiment towards Italy’s government has gotten – citing $35 billion of Italian bonds out on government loan.

So, the markets are clearly buckling under the increasing pressure, but why has this pressure reached such high levels to begin with? Apart from concerns regarding a ballooning deficit, the most relevant fear factor ahead of the budget review is Italy’s status as the holder of the second-largest sovereign debt in the eurozone – a debt the size of 130% of the country’s GDP. The Italian coalition government is arguing that their proposed deficit numbers will help resuscitate the Italian economy and, eventually, lead to growth and out of debt. Meanwhile, the ECB and the European Commission have the rules laid out pretty clearly: any country that’s over 60% GDP in debt is obliged to decrease the burden. The current argument between Di Maio and Salvini on one side, and Draghi and Jean-Claude Juncker (President of the European Commission) on the other, is just how Italy will alleviate this burden.

Will the Commission be persuaded by Italy’s proposed ends-justify-the-means angle? This week will  move us closer to the answer. With the budget submitted, the final version must be approved within five days. Rumours that the Commission may pull off the unprecedented and outright reject the budget are multiplying, in which case Italy will be given a grace period to revise the proposal before submitting it again.

While we wait for answers and speculate on the Commission’s decisions (and Italy’s reaction to that decision), one thing remains sure: the Euro and the Italian market are going through aches and pains throughout this whole process. On October 12, the New York Times published a comprehensive, and alarmingly plausible, article by Jack Ewing and Jason Horowitz titled ‘Why Italy Could be the Epicentre of the Next Financial Crisis.’ If the budget is indeed rejected today, and Italy’s Five Star-League government remain stubborn, Ewing and Horowitz may be hitting the nail on the head.

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