Eurozone faces critical budget issue as Italy defies the rules

By Jorge Valero | EURACTIV.com

For the first time since post-crisis rules entered into force, all eurozone countries are to submit their draft budget plans to the European Commission, but the Commission could also make an unprecedented move itself: sending one of budgets back to where it came from, most likely, Rome.

The Stability and Growth Pact, the EU’s rules that limit member states’ deficit and debt levels, proved to be insufficient to balance their public accounts.

In order to strengthen the fiscal oversight and avoid situations that could lead to a crisis or amplify existing ones, the EU adopted two sets of regulations in 2011 and 2013 to bolster the supervision of European economies.

This sixth cycle will be unprecedented for various reasons. Chief among them is Italy’s defiance of the EU rules that could lead to the Commission’s rejection of its draft budget for the first time.

It will be also the first time that all euro area countries will be part of the budgetary standard supervision, following Greece’s exit from the bailout programme.

Over past years, bailout countries were not subject to this monitoring, given that their budgets were assessed as part of the strict oversight of the macroeconomic situation by the institutions (Commission, IMF, ECB and lately the European Stability Mechanism).

In addition, this year’s budgetary submission follows the blunt criticism made by the European Fiscal Board against the Commission for being too “flexible” when applying the fiscal rules.

In the aftermath of the financial crisis, EU and national officials agreed that the Stability and Growth Pact was no longer useful. The loopholes introduced to avoid sanctioning member states, especially big economies like France and Germany, made the Pact useless.

As a result, the two-pack introduced a common budgetary timeline and rules to better control member states’ public accounts in 2013. Since then, all euro area countries must submit their national budgets for the following year by mid-October.

The aim is to give enough time for governments to take into account the Commission’s guidance when drafting their budgetary plans.

The rules also introduced a new system of enhanced surveillance for member states experiencing serious difficulties with financial stability, receiving financial assistance or emerging from adjustment programmes.

The new framework introduced swifter sanctions in case member states disobey recommendations to cut down their deficits, and can be gradually ramped up to reach a maximum of 0.5% of GDP. However, fines were bypassed when Spain and Portugal were the first countries to breach rules in 2016.

The two-pack came on top of another set of rules, (the ‘six-pack’) introduced in 2011 to reduce macroeconomic imbalances. It introduced an expenditure benchmark, as public spending should not rise faster than the medium-term GDP growth potential, unless it is matched by adequate revenue increases.

The six-pack also introduced the possibility of launching an excessive deficit procedure only on the basis of the debt target (60% of GDP). The Commission could use this possibility for the first time with Italy this year.

Italy, Spain and Greece, the difficult cases of this cycle. The Commission was prepared for a strict application of the EU rules this year, especially in the case of Italy.

The Italian government formed by the populists Five Star Movement and far-right La Lega said that they would not follow the EU recommendations and would fuel public spending.

The deficit will reach 2.4% of its GDP next year, three times higher than the target set by the previous government. More importantly, the government’s expansionary budget would include a boost totalling around 0.8% of its GDP, despite the Commission requested an adjustment of around 0.6% of GDP.

Commissioner for Economic Affairs, Pierre Moscovici, will travel to Rome later this week in a last-ditch effort to convince the Italian government to at least include a minimum adjustment. Otherwise, the Commission would issue a negative opinion on its budgetary plan in two weeks and would send the draft budget back to Rome.

Following that decision, Italy would have three weeks to amend its draft plan. If the Italian government continues to disregard the Commission’s demands, the EU executive could recommend reopening an excessive deficit procedure and the Council would approve a new adjustment path for Rome.

In the midst of the eurozone crisis, Spain was tied to Italy in the eyes of investors. However, EU officials welcomed the efforts made by the Spanish government to balance its public accounts. As a result, the difference between the risk premium on Spanish and Italian bonds recently reached a 20-year high.

Despite the spending increase included in the plan worth €5.2 billion, Madrid hopes to reach a structural adjustment worth 0.4 of its GDP (around €4.5 billion) which would qualify its national budget as “broadly compliant” with the fiscal rules.

But there is a lot of scepticism on whether the new taxes included in the draft could reach the revenues expected and whether the Commission would consider all of them as structural measures or one-off measures.

Meanwhile, the Greek government led by Alexis Tsipras wants to avoid implementing pension cuts agreed with the lenders for next January, given that it is overshooting its fiscal targets.

As a result, Athens included two scenarios in the budget: one factoring in the pension reform, and the other one excluding the pension cuts. In the first case, the primary budget surplus would be 4.14% of GDP and in the second one, it would reach 3.56%.

The Commission’s verdict will depend on whether it sees the pension cuts as one-off measures, or as a structural measure needed to make the Greek system sustainable.

‘Smart’ application or too much flexibility? The Commission will look into national budgets on the heels of the critical assessment made by the European Fiscal Board. The EU’s budgetary watchdog said last week that the EU executive was “generous” when applying the new flexibility added in 2015 to the Stability and Growth Pact to support the recovery.