February 15, 2016 / 12:31 PM / 3 years ago

Storm clouds gather on Italy's budget horizon

* Italy’s economic data weakens

* Prospects dwindle for promised cut in public debt

* PM Renzi faces having to make steep budget cuts in 2017

* Seeks concessions from EU, attacks “budget pedants”

By Gavin Jones and Giuseppe Fonte

ROME, Feb 15 (Reuters) - Italy’s public finance difficulties are set to deepen as its economy weakens, and it may be punished by the markets even if Prime Minister Matteo Renzi reaches a compromise with the European Commission over this year’s budget.

Gross domestic product grew just 0.1 percent in the last quarter of 2015, data showed on Friday, as the recovery from a three-year recession petered out.

The official forecast of 1.6 percent growth in 2016 already looks far out of reach. Tax revenues may also disappoint, making it less likely Italy can bring down its huge debt for the first time in eight years as Renzi has promised.

In another blow, officials say privatisations of the state railways and public air traffic control company are unlikely to go ahead this year as planned due to difficult market conditions.

Before these setbacks, Renzi was already locked in an unusually heated row with Brussels over his 2016 budget, which the Commission says risks breaking the EU’s fiscal rules after he raised targets for the budget deficit and public debt.

It will give a definitive verdict in the spring, and may ask for adjustments. Renzi has demanded more leeway in the rules and attacked the Commission’s “budget pedants”.

Experience suggests a face-saving compromise will be reached. But the Commission knows it risks losing credibility.

“Italy has benefited more than any other country from budget flexibility,” its Deputy President Jyrki Katainen said this month. “If we go on with this flexibility of the rules we won’t have any more rules.”

But even if a deal is done, it will only push back the problems for a few more months, and they are getting bigger all the time.

DEBT MOUNTAIN

Having delayed promised debt reductions for four years now, Rome would have to make a much bigger fiscal adjustment to meet its commitments in 2017.

Its public debt ratio of more than 130 percent of economic output is the second-highest in the euro zone after Greece’s, and unless Renzi wins even more concessions he will have to find cuts of more than 15 billion euros ($17 billion) in 2017.

Rome has not seen that kind of entrenchment since the height of the 2011 debt crisis when former prime minister Mario Monti passed draconian measures to save the country from bankruptcy.

But Renzi faces a toxic combination of faltering growth, stalled privatisations and, despite the shield of the European Central Bank’s bond-buying programme, higher borrowing costs.

There is also a growing risk of a full-blown Italian banking crisis. The country’s lenders, burdened with some 200 billion euros of bad loans, have lost almost 30 percent of their value on the Milan stock market this year.

The gap between the yields on 10-year government bonds (BTPs) yields and safer German Bunds has climbed to more than 1.3 percentage points from 0.9 points in December.

Some analysts fear Italy could follow Portugal, whose bond yields posted their biggest weekly rise for more than three years last week as investors fretted over Lisbon’s public finances and the health of the world economy.

“Italy is definitely vulnerable. As long as there is a risk-off environment, there is a risk that the BTP-Bund spread could widen further,” said Daniel Lenz, a bond strategist at DZ Bank.

Renzi must call an election by early 2018 at the latest. He has seen austerity-minded governments in Lisbon and Madrid thrown out of office recently and does not want to follow suit.

His approval ratings have slumped over the last year and domestic hostility to cuts remains high due to the listless economy and high unemployment. He is under pressure from opposition parties eager to cash in on the strong rise in anti-European sentiment among ordinary Italians.

Nevertheless, Italy signed the tougher “fiscal compact” that the euro zone drew up in 2012 in response to the debt crisis, mandating steep annual debt falls. It even made annual balanced budgets a constitutional requirement.

But Rome has yet to put the rules into practice. Its debt has climbed steadily and parliament has voted each year to allow itself a special exemption to the balanced budget law.

SQUARING THE CIRCLE

This year, if the Commission does not force Renzi to amend his budget, the deficit will fall marginally to 2.4 percent of gross domestic product from 2.6 percent in 2015.

After cutting taxes by more than 5 billion euros this year, Renzi has slated deeper cuts to corporate and income tax in 2017. At the same time, he has pledged to narrow the deficit in 2017 down to 1.1 percent of GDP. How he hopes to perform this feat has not yet been explained.

Gustavo Piga, an economics professor at Rome’s Tor Vergata University, urged him to take his dispute with the Commission even further and renege on his budget commitments for 2017.

“Italy needs real fiscal stimulus,” he said. “Renzi should tackle the 20 percent of wasteful spending in the state sector, while launching a programme of public investment and hiking the budget deficit target to 4 percent.”

Renzi is unlikely to follow that advice, even with problems mounting from all sides. Although growth is weakening, Italy has been out of recession for more than a year, meaning that under current rules justification for more EU budget leeway has all but disappeared.

“There is no more room for flexibility, and it wouldn’t be good for Italy either,” said Daniel Gros, head of the Brussels-based economic think-tank CEPS. “Now, with markets more averse to risk, Italy would be well advised to be very prudent.” ($1 = 0.8872 euros) (Additional reporting by Dhara Ranasinghe in London; Editing by Hugh Lawson)

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