Europe is at an impasse over fiscal reform — and Italy’s bond market may have the most to lose

Italy could face yet more economic pressure as the European Union faces a standoff over new debt rules.

The 27 member states of the EU have been at odds over new debt rules for several months. The idea is to make it simpler for governments to correct their finances, but disagreements over how to do it have dragged on the discussions.

With a Europe-wide election looming, however, there’s growing pressure on finance ministers to get a deal done in the coming months.

“Time is running out and the risk of a ‘no deal’ is rising against an unfavourable growth and monetary policy backdrop, potentially weighing on the euro and reigniting fragmentation fears in the EGB [European government bond] market,” Davide Oneglia, director of European and global macro at TS Lombard, said in a note last week.

He added that Italy could be at the forefront of potential bond market moves.

“Higher perceived risk of a return to old, stringent fiscal rules forcing a faster deficit reduction would worsen medium-term growth expectations for the EU, weighing on the euro. This would also reintroduce some fear of fragmentation for peripheral, mostly Italian, bonds — all at a time of cyclical growth slowdown, monetary tightening and challenging global market environment,” Oneglia said.

Italian bonds have been under pressure lately. On top of global concerns that higher interest rates will last longer than expected, Rome’s budgetary plans for 2024 did not appease the markets.

The government led by Giorgia Meloni cut its growth expectations for the Italian economy for this year and the next and increased its budget deficit targets. The yield on the 10-year Italian bond rose on the news and hovered around the 5% mark in the following days. It traded at 4.76% at about 5.30am London time on Wednesday.

“With European elections coming up, we see a significant chance that the negotiations on fiscal rules are delayed to the second half of next year,” analysts at Goldman Sachs said in a note Monday.

European member states have had to comply with fiscal rules that require they respect a 60% debt-to-GDP threshold and a public deficit of 3%. But those rules were often neither complied with nor enforced by the European Commission, which oversees them.

In 2020, the fiscal rulebook was frozen so member states could deviate from their fiscal targets and spend on pandemic-related matters, such as protecting jobs. And with Russia’s invasion of Ukraine in 2022, the fiscal rules were kept on hold because governments were faced with new energy costs and inflationary pressures. The suspension of those rules ends in December.

European nations will therefore be obliged to abide by the rulebook once again in 2024. Looking ahead to 2025 — after three years of suspension and decades of criticism — there is pressure for the rules to be reformed, but next year’s political calendar could get in the way.

“If there is no agreement on new rules, as [it] seems likely, the existing rules, currently suspended, would kick in [in 2025]. And they are stricter than whatever is being discussed now,” Moritz Kraemer, chief economist at LBBW, told CNBC.

“So in principle, a non-agreement would give Italy less rope to harm itself with,” he said, referencing the fact that stricter rules might force Italy to follow a tougher fiscal position and therefore see less bond market volatility.

Italy and the other European nations might be required to follow the stricter old rules, but the question of enforcement is still in doubt.

“We also consider quite unlikely that the EU Commission can trigger an excessive deficit procedure against any member country before the negotiation on the fiscal rules is completed,” Goldman Sachs analysts said.

An excessive deficit acts as a watchlist of countries that are not correcting their finances at the required pace.

“If there is a compromise on fiscal rules, it is more likely to happen under the Belgian presidency in the first quarter of 2024. The real deadline is the end of March, so that the legal text can go before the European Parliament before the June 2024 elections,” Didier Borowski, head of macro policy research at the Amundi Investment Institute, told CNBC.