ROME—Italy’s populist government is looking for a route out of a fight with the European Union over its budget, as the financial fallout from the clash pushes the economy to the brink of recession.
Italy’s governing coalition of the antiestablishment 5 Star Movement and the nativist League is searching for ways to avoid a sharp rise in the government’s budget deficit, after its bold spending plans led to a confrontation with EU authorities, spooking bond investors and leading to tighter credit for businesses.
It isn’t clear that they are finding any outs, however. The two EU-skeptic parties are struggling to identify enough savings to comply with the EU’s strict rules on fiscal discipline while also sticking to their popular promises to raise welfare and pension spending and trim taxes.
Meanwhile the closely watched Purchasing Managers Index survey indicated that Italian business activity contracted in November, raising the likelihood that Italy is slipping into recession. Italy’s gross domestic product fell by an annualized 0.5% in the third quarter, due largely to a steep drop in business investment as well as more hesitant spending by consumers.
The growing risk of recession is putting pressure on Italy’s new government, which took office in June, to change course and comply with EU fiscal rules that the two parties have previously attacked. “I have no interest in a clash with Europe. It’s in nobody’s interest,” the League’s leader Matteo Salvini said on Tuesday. “We will find an agreement in the end. We are working on it with alacrity.”
As recently as October, the combative Mr. Salvini said if EU authorities “insist on slapping us in the face, I will want to give even more money to Italians.”
The confidence shock to bond markets, Italian banks and the country’s business sector illustrates the constraints facing financially fragile nations in the eurozone—even if voters choose a government devoted to breaking with EU fiscal orthodoxy.
Italy’s €2.3 trillion ($2.61 trillion) national debt, equivalent to about 131% of GDP, is seen by markets as riskier than most other euro nations’, especially if Italy’s economic policies don’t have the support of Europe’s powers-that-be, including the European Central Bank.
Italy’s economic recovery has been losing momentum this year anyway, part of the broader growth slowdown in eurozone amid global trade tensions, higher oil prices and a downturn in the car industry. Most other eurozone economies continue to expand, as Wednesday’s PMI survey confirmed. Italy’s overall PMI measure, in contrast, stood at 49.3% in November for the second month. A PMI score below 50 points to a decline in activity.
But Italy has compounded its weakening outlook by triggering financial tensions with its fiscal plans, according to the ECB, the International Monetary Fund, and many private-sector economists.
The yield on Italy’s 10-year bonds rose to nearly 3.7% in October, compared with levels of around 1.7% before the government was formed. Rising yields have particularly hurt Italy’s banks, which are heavily exposed to the national debt.
Yields have eased in the past month, reaching 3.07% on Wednesday, according to Tradeweb, as the government has toned down its rhetoric and signaled that it was seeking a compromise with the EU’s Brussels-based executive, the European Commission.
The difficulty for Rome is that the Commission is tasked with upholding EU fiscal rules that require a continual cutting of countries’ budget deficits on a “structural” basis, stripping out the effects of economic swings and one-time fiscal measures. Estimates of the structural deficit depend on often contentious guesses about spare economic capacity and growth.
The Commission says Italy’s budget plan would increase the structural deficit by around 1.2% of GDP, or about €22 billion, and is demanding a deficit reduction instead. That would imply spending cuts far in excess of the roughly €8 billion of savings that Italy’s government is currently trying to find.
“I can’t see that happening without affecting the implementation of the key planks of the budget,” said Francesco Daveri, an economics professor at Milan’s Bocconi University. “That would mean losing face with their voters.”
One problem for the EU is that its Italian interlocutors, Prime Minister Giuseppe Conte and Finance Minister Giovanni Tria, are politically weak appointees. Rome’s dominant players are the two party leaders, the League’s Mr. Salvini and the 5 Star’s leader Luigi Di Maio, who don’t negotiate directly with the EU.
Failure to bridge the wide fiscal differences between Rome and Brussels is expected to lead to the EU opening disciplinary proceedings against Italy for breaking the fiscal treaty that is meant to keep the eurozone stable.
Italy’s leaders say they want to avoid that step, which could further unsettle markets, while still delivering their costly fiscal promises to voters. These include allowing retirement as early as the age of 62 instead of around 67 and introducing a “citizenship income” or basic welfare level of €780 a month for the poor and unemployed.
“Those measures are still in the budget,” Mr. Di Maio told reporters on Wednesday. “We will bring home the budget measures, avoiding the disciplinary proceedings and keeping the promises.”