BRUSSELS: EU officials will probably not do much to enforce their borrowing rules on Italy’s new government, but they are hoping they won’t have to because financial markets will do the job for them.

A new government is expected to take office in Italy next week, a coalition of the anti-establishment 5-Star Movement and far-right League, who have jointly promised a bonanza of tax cuts and spending in­­c­rea­ses that would burst through the EU’s limits on borrowing by member states.

Slovak Finance Minister Peter Kaz­­imir on Thurs­day called the policy mix a “suicide mission”. Mar­­­kets have already res­po­nded: yields of the benchmark 10-year Italian bonds have jum­ped 0.7 percentage point since the start of May to 14-month highs above 2.46pc.

Morgan Stanley warned this week that sustained yields that high could spark contagion by hitting the profits of banks which hold a big chunk of their assets in government debt. Shares in Italian banks hit 11-month lows on Friday, having fallen almost 14pc so far this month.

Economists say that is only a taste of what could come: the rise in rates would be much steeper if markets believed that Italy was actually prepared to go through with the plans.

“If they do what said they want to do, the reaction of the market will be much more than what we have seen so far,” said Francesco Papadia, a senior fellow at the respected Brussels-based Bruegel think-tank.

The spread of the Italian benchmark paper over comparable German bonds hit 200 basis points this week, still a far cry from the 550 basis points spread at the peak of the sovereign debt crisis in 2012.

“So far (the market reaction) has been clear, but not extreme. Maybe the market still has a hope they won’t do at least the most extreme version of what they said they would do,” Papadia said.

Italy’s increased spending against EU rules “would likely be met by aggressive Italy underperformance versus other markets”, investment bank J.P. Morgan said in a note for investors.

As an EU member, Italy is obliged seek a balanced budget in structural terms and have debt below 60pc of gross domestic product. Instead, its structural deficit has been rising since 2015 and its debt has been close to 132pc of GDP since 2014. But most Brussels-watchers do not expect Europe to take political action to enforce its rules.

The European Commission, the guardian of EU laws, has the task of disciplining profligate governments through what is called an excessive deficit procedure that could end in fines.

But it has repeatedly declared that punishment is not the way to deal with budget rule-breaking, and showed leniency to repeat budget offenders like France, Portugal and Spain.

Published in Dawn, May 27th, 2018