Italy finances slipping as political crisis brews

ROME Thu Sep 5, 2013 12:58pm EDT

Italy's Prime Minister Enrico Letta attends a meeting with Russia's President Vladimir Putin (not pictured) at the G20 Summit in Strelna near St. Petersburg September 5, 2013. REUTERS/Dmitry Lovetsky/Pool

Italy's Prime Minister Enrico Letta attends a meeting with Russia's President Vladimir Putin (not pictured) at the G20 Summit in Strelna near St. Petersburg September 5, 2013.

Credit: Reuters/Dmitry Lovetsky/Pool

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ROME (Reuters) - Italy, which three months ago got off the European Union's blacklist of countries with excessive fiscal deficits, may be put straight back on it next year unless it can reverse a worrying trend in its public finances.

Enrico Letta's government has been forced to respect the tax cutting promises of Silvio Berlusconi's People of Freedom Party (PDL), a vital part of the ruling coalition, while a deeper than expected recession is also weighing on state accounts.

Yet with Berlusconi's allies now threatening to bring down the government, growing political instability and wayward public finances risk creating a toxic combination that puts Italy back at the center of financial markets' attention.

Data this week showed the state sector borrowing requirement amounted to 60 billion euros at the end of August, almost twice as large as the 33 billion euro deficit in the same period of 2012.

The SSBR does not fully correspond to the broader "general government" deficit the EU uses to assess countries' fiscal performances, but it still suggests there may be a need for significant belt-tightening before the end of the year, something a fragile government may find hard to deliver.

Italy is targeting a general government deficit of 2.9 percent of output, just a fraction below the EU's 3 percent ceiling after the deficit was bang on 3.0 percent in 2012.

On the basis of this target, set in April, the EU Commission removed Italy from its Excessive Deficit Procedure, allowing it some extra leeway for public spending.

However, since April Italy's economy has gone from bad to worse and the contraction then forecast at 1.3 percent is now seen at close to 2 percent, hurting tax revenues and pushing up the deficit as a proportion of gross domestic product.

Citigroup analyst Giada Giani said the last time the SSBR was so high at the end of August was in 2009, when the general government deficit came in at 5.5 percent of GDP.

"Even to reach 3.5 percent the government will have to take some emergency tightening measures," she said.

State payments of several billion euros of outstanding bills in arrears to private suppliers are included in the SSBR but not in the general government deficit.

However, after months of a steadily swelling SSBR, August's statement by the Treasury was the first which did not include the reassuring line that the data was still consistent with meeting the general government deficit goal.

COSTLY DELAYS

Last month Letta finally bowed to Berlusconi's demand to scrap the unpopular housing tax IMU with a cost to state coffers of around 4 billion euros. But he only did so after months of wrangling and delays, meaning any measures to plug the shortfall will have little time to take effect.

A similar story regards sales tax. A one percentage point hike in the main rate of 21 percent was slated by Letta's predecessor Mario Monti to take effect in July, but Letta delayed it to October.

Letta says he will do his best to scrap the increase altogether, but in the meantime every three months of delay pushes up the deficit by 1 billion euros.

Economy Minister Fabrizio Saccomanni inserted a "safeguard clause" when IMU was eliminated, stating that if the deficit is overshooting there will be an automatic hike in advance payments of corporate tax before the end of the year.

However, advance payments are based on estimates of the following year's tax bill, so any hike will be compensated by smaller payments in the next installment in June 2014.

So far markets have shown little concern for Italy's public finances, despite the fact that its debt, the second largest in the euro zone after Greece at 130 percent of GDP, is still on a steadily rising trend.

Investors have been calmed by the European Central Bank's pledge to buy potentially unlimited amounts of debt of countries in difficulty and by an improved global growth outlook.

Yet that could change if Berlusconi acts on his threats to sink the government and fiscal targets overshoot badly.

A return to the excessive deficit procedure may also prompt ratings agencies to downgrade Italy's creditworthiness, and the EU would force Rome to adopt tougher deficit-cutting goals.

Agencies Standard & Poors and Moody's both have a negative outlook on Italy.

Saccomanni will have his work cut out to respect Italy's targets and resist political pressure for more expansionary policies ahead of the 2014 budget to be presented next month.

(Writing by Gavin Jones; Editing by Toby Chopra)

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