Since September, we have seen Rome play what can only be described as a calculated chess game with Brussels. The moves being made by both sides are unprecedented, and the conflict over Italy’s budget remains unresolved.

Whilst Brussels have turned their attention to the Brexit-induced chaos veiling the UK, conflict with Rome remains on hold. The markets also remain governed by Brexit with the GBP crashing against the EUR and struggling to hold above 1.2800 against the USD.

What happened?

Italy’s coalition government, formed earlier in June, unites the anti-establishment Five Star Movement and the hard-right League. The coalition government made an overnight agreement to set forth a budget deficit next year equalling 2.4% of Italian GDP. This figure was well above the country’s Finance Minister’s recommendation of 1.6%. After some attempts to compromise, Italy submitted its final budget with only slight revisions of the original draft rejected by the EU. Until now, the Italian government has refused to give into demands from Brussels to lower its excessive spending targets and optimistic growth estimates.

Why did this agitate the markets?

The budget disrupted the financial markets for several reasons. Firstly, the Italian economy is the third largest in the Eurozone following Germany and France. Despite its size, its debt stands at 131% of national output, making government debt second to Greece. Next, its banking system is facing deep fragility after two decades of stagnated economic growth. The yield on 10-year government bonds rose above 3% and the Milan stock exchange suffered. Indeed, the FTSE MIB was at its weakest level in 18 months. Moreover, the flat quarterly reading in the third quarter was the weakest figure since the fourth quarter of 2014.

Why did Italy’s budget prompt EU backlash?

Rome’s deficit plans simply breach rules on government borrowing. The 2.4% figure may be below the EU’s deficit limit of 3%, but it remains far too high for a country whose debt is as big as Italy’s. Under the current budget plan the structural deficit would rise which goes against EU regulations.

“The enemies of Europe are those sealed in the bunker of Brussels,” said vice prime minister Matteo Salvini.

What happens next?

On Wednesday, the European Commission is expected to announce that Italy’s budget breaches EU fiscal rules in a report. This is expected to take place when it issues its opinions on draft budgets in the Eurozone. The Austrian Finance Minister, Hartwig Loeger, has demanded a “clear response from the commission this week”.

The Austrian Finance Minister isn’t the only one to express concern. Dutch Finance Minister, Wopke Hoekstra, shared his concerns:

“We all are worried about the existing situation,”

“This is a matter that not only involves Italy but involves all of us because in the end we are a high-trust society and it’s imperative that the commission does what’s in the interest of all the different European countries.”

Italian Finance Minister, Giovanni Tria, has tried to diffuse the tension saying:

“We are talking about deviations that are not so huge, so I saw we need to bring the discussion back to reality.”

“The discussion goes on. Obviously, the plan of the government doesn’t change, but there’s the intention to carry on the discussion”.

On this remark, the yield on Italian benchmark 10-year bonds increased to 3.56%, the highest in over three weeks.

Could Italy’s government be a bigger threat to the Eurozone than Brexit?

At 10:40 GET, the FTSE MIB (INDEXBIT:FTSEMIB) was trading at -0.68%.

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