EU Fiscal: A Likely Deal with Italy, Spat with France

Published on October 23, 2014

European Commissioner for Economic and Monetary Affairs Jyrki Katainen sent a formal letter to the Italian government in response to its 2015 draft budget asking why it intends to deviate from its previously agreed budget consolidation path and inviting the Italian Finance Ministry to provide any “clarifications” that could be useful to the Commission’s budget review process.

*** The Italian government created a bit of a political stir in publishing the contents of that letter today, but from what we understand Brussels is more than willing to find a compromise solution with Rome. It has already been clear for a while that the Commission would have a somewhat negative reaction to the Italian budget, which only provides for a 0.1% correction for 2015 instead of a total the 0.8% of additional cuts needed to reach the deficit targets for both 2014 and 2015, and the letter is indeed sent when the Commission is considering a rejection of a member state’s budget. ***

*** But Prime Minister Matteo Renzi and Finance Minister Pier Carlo Padoan have been in touch with Brussels on a regular basis since the summer, and an agreement to avoid an outright rejection, most likely with just a small further effort by the Italian government, is from what we understand by all means possible if not likely. The ball is now in Italy’s court, and from what we hear Italy has already responded with its own letter proposing some further adjustments. ***

*** The situation with France is much simpler, and worse. France we believe has also received a letter from the Commission – which has not been made public nor yet been leaked – asking for possible “explanations” for its proposed budget target misses. But fierce internal political and economic constraints make it extremely difficult for President Francois Hollande and Prime Minister Manuel Valls to make the necessary adjustments, which are far larger than what is required of the Italian government. ***

*** And the French government, with no small degree of grandeur and defiance, has not only refused to open up to any further corrections, but has also dismissed any possibility a compromise with the European Commission could be found. Most indications at this point are that, short of an unlikely political solution with Berlin, the French budget is in fact likely to be rejected by the European Commission. ***

*** In any case, even in the case of rejection, however, there would be no financial consequences, meaning potential fines, for France until next spring – for the 2014 budget – and in spring of 2016 – for the 2015 budget. And with the coming of a new Commissioner (Frenchman Pierre Moscovici), a new ECOFIN Director General (the head of the bureaucracy), and the possibility of new fining Guidelines, it is anything but clear that the outstanding excessive deficit procedures would indeed lead to a fine, at all. ***

Back and Forth between Rome and Brussels

The writing of the Italian letter has been taken as a negative sign by the press, but it is in reality largely irrelevant to Italy at this point. The Commission’s services, the Commissioner’s cabinet, and Member States are in constant dialogue with other Member States during the “budget season,” and with Italy that is even more so as the country happens to be holding the European Semester Presidency.

Add to that the fact that current ECOFIN Director General Marco Buti and Renzi were born in the same town, are quite friendly, and belong to the same political party, and the impression is that Italy may already have known beforehand what the Commission was going to do – in other words, the letter most likely did not come as a surprise.

The letter is the indication that a formal procedure is ongoing, but it does not preclude a possible compromise solution. And three possible negotiating positions were included in a document that was presented in an ECOFIN meeting last week.

One, totally political, would allow Italy to get by “clean.” Another one, purely technical, would lead to the rejection “tout court” and to the budget being sent back to the government – as it is technically in infringement of EU rules. The third solution, a compromise, was to request a small cut, behind the scenes and thus before any formal public rejection, as a face–saving solution for the Commission that would avoid a major public relations embarrassment for Italy.

Italian Numbers

The actual figures being negotiated and reported back and forth can be quite confusing, but here is what they are and how they are derived:

The Commission had projected a headline deficit for Italy of 2.6% of GDP for 2014 (from 3% in 2013) in its spring 2014 economic forecasts.

In the document, the Commission then stated that in a “policy neutral” environment, the 2015 Italian headline deficit should go down to 2.2%. And since Italy is obliged under the “two-pack” agreement to reduce its deficit by 0.5% each year in order to cut into its enormous debt overhang, it could have reached that slightly lower, 2.1%, objective as well with a further small correction of 0.1% of GDP (a billion or so – basically the size of an increase in the cigarette tax). That is, assuming economic forecasts panned out.

But the economy did not pan out, and went south instead, and the deficit/GDP ratio now appears will be 3% for 2014. That would force Italy not only to keep in place the budget cuts from last year (plus a 0.1% to reach the 2015 “two-pack” target), but also to include another 0.4% correction to offset the consequences of slower growth than expected this year to get from 3% to pre-set target of 2.1% in 2015.

Instead, Padoan and Renzi decided to give the country a little boost by taking this year’s 3% deficit and doing just the small 0.1% correction to get to a 2.9% deficit in 2015: in other words, they responded as if the economic projections for 2014 had indeed come true.

The new total correction however should have been 0.9% (to bring the deficit down from the new figure of 3% this year to 2.1% in 2015), or 0.8% more than in the proposed budget. Hence talk of a 0.8% “miss.”

What the Commission appears to be proposing is to disregard the 0.4% missed target of 2014, attributable to slow growth, and to add roughly half, or 0.25%, of the additional 0.4% further cut to the 0.1% put forward by the Italian government, to get to a deficit of around 2.65% or maybe even 2.75% in 2015.

Our understanding is that the reason the Commission is inclined to let the 2014 “miss” go is that Italy did deliver on its cuts, and the miss was due to a slump in growth projections that the Commission itself, (and the IMF), got completely wrong.

Renzi today has sent encouraging signals he may attempt to head off a formal rejection in the pass.

French Defiance

France on the other hand is facing an entirely different dynamic with the European Commission.

The Commission had projected a headline deficit for France of 3.9% of GDP for 2014 (from 4.3% in 2013) in its spring 2014 economic forecasts.

In the document, the Commission then stated that in a “policy neutral” environment, the 2015 French headline deficit should go down to 3.4%. But it also scolded France by saying the risk was “on the downside” (in other words, the chances of the policy environment being “neutral” were slim), and France’s figures were way too optimistic.

France has furthermore been in the Commission’s “excessive deficit procedure” for two years, and already had to ask and obtain a two-year extension to bring its deficit down to under 3% in 2015 (the 3% target was originally supposed to be met in 2013).

France was also whipped by the European Council last spring, and subsequently again by the Commission in June, as its projections remained clearly too optimistic and its corrective measures too vague.

In other words, France was already on a collision course with the Commission even before the current leg of the economic downturn hit Europe this late summer.

Instead, France’s deficit will be 4.4% of GDP this year, and its budget is projected at 4.3% next year.

In theory, France would now have to cut its deficit by half a point to make up for the miss in this year’s objectives (4.4% versus the original 3.9%), plus another half a point to reach next year’s objective of 3.4%, and from the now higher baseline it would still wildly miss the 3% objective it had been “conceded” with the two-year extension.

The major difference with Italy lies not with the size of the deviation, but with the different quality of the consolidation projections and programs – the French plan has been repeatedly criticized for being both too vague and far too optimistic on growth figures – and coming from the significantly different status of France being in the corrective arm of the excessive deficit procedure, where its finances are supposed to be strictly monitored by the Commission.

In addition the French government has overtly dismissed the possibility of modifying its budget – perhaps understandable given its extremely thin majority in the Assemblée Nationale and the disastrous results of the recently concluded European and Senate elections for the Socialist party.

A further preoccupation comes from the return of Nicolas Sarkozy to the political scene for the UMP center-right, and polls that have circulated privately within the Socialist leadership that indicate National Front leader Marine Le Pen could now have a concrete chance of even winning a second round run-off vote in future Presidential elections.

So while Paris may come back with some small measures to try and avoid seeing its budget rejected, those measures may well be unlikely to be seen as enough.

But even so there would be no immediate consequences of a rejection beyond political embarrassment on both sides, as any consideration of a fine being put on the table – both for this year and next year’s misses – would not even come into play under EU rules until the spring of each respective budget year, i.e. the spring of 2015 and 2016.

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