The Daily Update - Italy Faces Calls for Budget and QE "Capital Key" Revisions

Again the euro took a hit touching 1.14 versus the dollar earlier today following: first yesterday’s unprecedented demands by the European Commission on the Italian government to revise their budget for 2019, followed by today’s weak PMI data across European majors – including 1 and 2 point shortfalls from forecasts for German manufacturing and services respectively.

EU’s Moscovici warned that Italian public debt may not go down for a further 2 years, that their 1.5% GDP growth target was too optimistic and decisively that their spending plans were in violation of the block’s debt limit and so needed revising. Valdis Dombrovskis, EC Vice President, stated that they saw “no alternative” and that “for the first time the Commission is obliged to request a euro area country to revise its draft budgetary plan”. With Italian public debt above 130% of GDP – surpassed only by Greece within the EU – the annual cost of just servicing this debt is already around 4% of GDP, estimated to be above €65 billion. Perhaps not really the best time to consider lowering the pension age. As laudable as many of the budget’s aims are, markets and now even the EC have demonstrated that although "It is tempting to try and cure debt with more debt. At some point, the debt weighs too heavy… you end up having no freedom at all."

The Italian government has said it has no intention of backing down, but such fraying relations with the EU come at an unfortunate time; not only will the European Central Bank stop buying government bonds from the end of this year, but the ECB will be revising the “capital key” calculations next month which determine the direction of billions of euros of future bond repurchases in the months ahead as existing QE positions mature. So although the €2.5tn quantitative easing programme is ending there will be around €120bn of maturing debt needing to be reinvested in just the first 9 months of 2019. The economies across the Eurozone have changed notably since these allocation formulas were last set 5 years ago and Italy will be one of the countries penalised by the update, not just because of economic factors but also because existing QE holdings of Italian debt are typically of longer maturity. The ECB will have an even smaller role in the rolling-over of Italian bonds in 2019 by as much as €28bn. But as much as this creates more distance between willing investment and the Italian deficit it also creates more distance in the already strained relationship between the ECB and Italy.

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