‘Honeymoon is over’: Giorgia Meloni’s budget to test rocky relations with investors

Italy’s prime minister Giorgia Meloni was notably absent from a star-studded economic forum at Lake Como this month. Instead of sharing her vision for tackling the country’s pressing challenges with the influential audience, Meloni joined the crowds at the Formula 1 Italian Grand Prix.

Her decision to skip the prestigious Cernobbio Forum — whose attendees she courted last year — compounded the growing disquiet among companies and investors over the ability of Italy’s rightwing government to steer the heavily-indebted country through a European economic slowdown.

When she came to power last year, Meloni reassured global investors with promises of fiscal prudence. But markets were jolted this summer by her government’s surprise announcement of a windfall tax on banks, which was quickly watered down after bank stocks tumbled.

Meloni’s three-party coalition now faces its biggest test as it prepares to unveil Italy’s next budget, attempting to strike a balance between dwindling government resources and meeting some of its election promises to cut taxes and help struggling families.

Investors are watching closely to determine whether Meloni will stick to her pledge of fiscal discipline — even as Italy’s economy falters — or be tempted into expansionary fiscal policy or other unorthodox measures.

“There has been a refocusing on Italy,” said Filippo Taddei, chief economist for southern Europe at Goldman Sachs. “People are asking where the country is going . . . they want to make sure there are no more policy surprises.”

Lorenzo Codogno, a former finance ministry official who now runs a macroeconomic consultancy, said a spate of recent interventionist moves had raised serious doubts about the government’s policy orientation.

The European Central Bank criticised the windfall tax last week, warning it could impede banks building up additional capital buffers, making them “less resilient to economic shock” and limit their ability to lend. Fitch, the credit rating agency, warned of potential disruption and uncertainty from a proposal by Meloni’s party, the hard right Brothers of Italy, to allow defaulting borrowers to buy back their own distressed debt at a deep discount.

“The honeymoon is over,” Codogno said. “Business is turning against the government . . . There are forces within the coalition that are not really attuned with markets or the interests of investors.”

In her first months in power, Meloni won accolades for adopting a fiscally prudent budget, which reassured jittery investors of her ability to make the transition from populist opposition antics to responsible governance. Yet that budget was largely prepared by the team of her predecessor, Mario Draghi, thanks to the timing of her victory in a rare autumn election.

But the upcoming budget, to be unveiled in the coming weeks, will bear Meloni’s imprint, giving both Italian voters and investors greater insight into her coalition’s own economic vision.

“This is the first budget where Meloni’s government has to take full responsibility for the measures — and face a potential reaction from public opinion,” said Lorenzo Pregliasco, founding partner of YouTrend, a political polling agency.

The circumstances are hardly auspicious. Italy’s current official growth projections of 1 per cent this year and 1.5 per cent next year are widely seen as over-optimistic, given the wider slowdown in the eurozone.

Italy’s gross domestic product contracted 0.4 per cent in the second quarter, reflecting the malaise in European manufacturing and a sharp slowdown in construction after Rome cut back an incentive scheme that had fuelled a home improvements boom.

Weakness has continued through the summer. Italy’s industrial output contracted by a greater than expected 2.1 per cent year on year in July, and nearly 73,000 jobs were lost, pushing unemployment to 7.6 per cent. Surveys have indicated that the previously resilient services sector contracted slightly in August.

“It looks like the situation is worsening fast,” Codogno said. 

As growth falters, investors question whether Italy can still meet its target of reducing its fiscal deficit to 4.5 per cent of GDP in 2023, and 3.7 per cent in 2024, or whether Meloni’s government will increase the deficit target this month.

The Italian economy should receive a boost from the EU-funded €191.5bn Covid recovery plan, given that Italy is the largest beneficiary of the programme. But implementation has faltered, and Rome is now seeking Brussels’ approval for an overhaul of the plan that would help it unlock outstanding funds.   

Any significant upward revision of next year’s deficit target would point to Rome’s lack of confidence in its ability to meet all the conditions and fully access the EU funds, Taddei said.

“There is some tolerance for fiscal slippage this year, but next year is a different game,” he added. “The government has repeatedly said that it is committed to making the recovery fund work, and markets will look to the fiscal deficit decision as evidence.

“If they push the fiscal deficit up, it suggests that they don’t really believe in the recovery fund,” he said. “Market participants would look at this as an indication that the government is more committed to using the domestic fiscal lever.”

Meloni has acknowledged that her promises to cut taxes, raise pensions and increase healthcare spending will be difficult to keep in the current economic slowdown.

“My idea is to concentrate the resources on a few big measures — that offers the biggest multiplier in economic terms — rather than distributing it among many small measures likely to have less impact,” she said last week.

Meloni will probably be reluctant to fully abandon fiscal caution given how market turmoil could come back to hurt her image at home. “If they get a bad reaction from the markets, this becomes news and can also hurt the relationship with the electorate,” Pregliasco said.

The drop in bank stocks triggered by the chaotic windfall tax announcement will probably increase her caution, Pregliasco added, as polls now show that public confidence in the coalition has eroded somewhat since that episode.

He said: “It slightly reinforced the perception that the government was not fully aware of the consequences of what it was doing.”