Italy still defiant as EU moves towards imposing fines over its budget

Brussels

ITALY'S markets shrugged off the European Union's first step towards imposing fines on the nation over its budget on hope there might still be room for dialogue.

Ten-year bond yields stayed on course for the biggest drop this month and bank stocks gained as the European Commission's censure had already been priced in by investors. The debt extended an early rally that came on reports Deputy Prime Minister Matteo Salvini may be open to spending revisions to avoid punishment.

The rebuke by the EU, which said Italy's budget was in serious non-compliance with its fiscal rules, had been expected by markets after Italy's populist government had refused to adjust its budget. Mr Salvini said he won't compromise on core items such as tax cuts and a basic income for the poorest, but is willing to make tweaks and is open to dialogue.

If "some sort of compromise is found, sanctions may even be avoided, which would make it likely indeed that the BTP-bund spread retightens back to the 250-275 area," said Martin van Vliet, senior interest-rate strategist at ING Groep NV.

Italy's markets have been pressured by the stand-off with the EU in recent weeks. Its economy, the euro-area's third largest, has a debt-to-GDP ratio of 130 per cent, second only to Greece, while its rate of growth lags most nations within the bloc. The Commission said the budget was a "particularly serious case of non-compliance".

"The positive for the market here is the likely relief that the EU has been relatively neutral in its language," said Peter Chatwell, head of European Rates Strategy at Mizuho International in London.

If the EU follows through with sanctions, it could levy fines of 0.2 per cent of Italy's gross domestic product, which could increase to 0.5 per cent if the government in Rome doesn't amend the budget. It would also mark the first time the bloc has levied fines on a member nation.

Despite Wednesday's debt rebound, some of Italy's most loyal bond buyers are showing signs of desertion. A sale of inflation-linked debt, popular with retail investors, garnered just a fifth of the orders by its second day compared to the previous sale in May.

"The question is whether investors think there is sufficient yield premium to compensate for the ongoing stress this will likely pass into the Italian real economy, and whether this drag will be the eventual cause of a change of tack from the government," said Mr Chatwell.

"The impact of this budget on growth is likely to be negative in our view. It does not contain significant measures to boost potential growth, possibly the opposite," said European Commission vice-president Valdis Dombrovskis. "With what the Italian government has put on the table, we see a risk of the country sleepwalking into instability."

The Commission, which checks that draft budgets comply with EU limits on deficits and debt before they are voted on by parliaments, rejects Rome's argument that by expanding the budget it can boost economic growth and revenues, bringing down the debt as a proportion of GDP. It is backed by euro zone governments worried that Rome's borrow-and-spend plans could trigger another debt crisis that would hurt them all. BLOOMBERG, REUTERS