What’s next for Italy?

Yesterday we had a look at the slide in oil markets one of the apparent catalysts for the loss of confidence over the past two months.

Let's turn to another situation that has given the market the jitters recently.

The vexing problem of the Italian budget.

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Italy's bluff is not yet being called

This week, Brussels said that Italy's budget plans for 2019 were not acceptable. Italy wants to spend more money than it previously agreed. That breaks the rules. Indeed, it's an "unprecedented" breach, according to the European Commission.

We're now likely to see the Excessive Deficit Procedure (EDP) put into action. That involves a closer look at the budget, and it also could result in fines. So it sounds serious. However, plenty of countries have broken the rules in the past and been subject to the EDP. Never once has this resulted in a country actually being fined.

Equally, Italy's leaders seemed far more open to compromise than they normally are. And so markets greeted the move with a big shrug. Italian bonds didn't do very much at all.

Let's be clear: the Italian problem will continue for a long time from here. Italy's problem is that it has a lot of debt and is unlikely to be able to grow rapidly enough to get rid of that debt (even if it does spend more money on trying to do so). Inflating its way out is also not really an option because it is part of the euro.

Does that mean Italy is doomed to default? Not at all. As Jack Allen of Capital Economics points out, there are many ways in which the European Central Bank (ECB) could help Italy.

More quantitative easing and interest rate cuts are, of course, classic parts of the central bank recipe book. But the ECB can't set monetary policy for one country alone. Given that the ECB seems set on following every other global central bank, and tightening monetary policy, Italy alone is unlikely to sway it from this path.

What else can the ECB do? There's the OMT (Outright Monetary Transaction) programme. This would in effect, allow the ECB to just buy Italian sovereign bonds in order to drive the yields down. This is a "whatever it takes" move.

OMT is not cost-free. There's a quid pro quo there you can't expect the ECB to print money to buy your debt and not have any expectations placed on you in return. As Allen notes, "countries receiving OMTs have to comply with the conditions of European Stability Mechanism programme, which would mean budget cuts" which of course, the Italian government would not be keen to accept.

So that leaves OMTs as very much a "break glass in case of existential crisis"-type measure.

What are the other options? There's the Long-Term Refinancing Operations (LTROs). In effect, this would enable Italy's banks to get access to cheap debt. They've already used this service far more widely than any other country in the eurozone.

There's another snag here though. To access the LTRO, a bank has to pledge collateral to the ECB. That collateral typically a country's government bonds has to be investment grade. It's certainly not out of the question that Italian sovereign debt could be downgraded to junk. If that happened, it'd be much harder for Italian banks to get access to the ECB.

To cut a long story short, Italy can be bailed out, whatever happens. When push comes to shove, there are mechanisms in place that allow the ECB to open the floodgates as long as the situation is desperate enough and the political will is there.

This is what Greece (and to an extent, Brexit) should have taught us all. It's not about the money it's about the politics.

This problem isn't over but it might not flare up for a few months

This means that what you have to watch out for with the Italian issue is anything that can exacerbate the political side of the problem.

For now, Italy and Brussels can both pretend that they're defending their own patches without any actual consequences coming about. Brussels can act stern with the EDP, which is a nice time-consuming process. Italy can act as though it's being firm but reasonable willing to talk, though not give way on the substance of the budget.

Meanwhile, Italy will be hoping that the Europe-wide elections in May will lead to a lot more ideologically friendly faces in the European Parliament, and possibly a bit more leverage with Brussels.

And while they're both talking nicely, there's no real reason for markets to get worried. That will change at some point there will be some truly awful piece of economic data out of Italy which clearly demonstrates the futility of the government's plans. Or one or other of Brussels or the Italian government will leave the script and say something stupid.

But between now and Christmas, there's every chance that this particular market jitter will calm down too which is another reason to imagine that the wider market might start to wake up from its post-October panic and get it together for one more session of "buy-the-dip".