By Giovanni Legorano, Avantika Chilkoti and Marcus Walker
ROME -- As Italy's populist government approaches a showdown with the European Union over its budget, financial-market tremors are hurting the country's banking system and threatening the economic growth Rome wants to stimulate.
Italian bank shares and bonds have suffered sharp selloffs in the past week as Italy's government stumbled toward a budget that looks set to break EU rules on fiscal discipline. Rome's new, EU-skeptic governing coalition between the antiestablishment 5 Star Movement and the nativist League has said it aims for a budget deficit of 2.4% of gross domestic product next year, three times what the previous, pro-EU government planned.
Rome's optimistic forecasts for growth and tax revenues are expected to draw tough scrutiny from EU authorities, who fear the true deficit could end up dangerously high for a country with an already worrisome national debt. The 5 Star and League's fiery rhetoric against EU officials have further spooked foreign investors, who fear the European Central Bank -- the ultimate guarantor of bond-market stability in the eurozone -- is unlikely to support a government that defies the bloc's economic orthodoxy.
Despite some stabilization in markets since Wednesday, after the government promised slightly smaller deficits in the medium term, Italian bonds and banks remain under heavy pressure.
"It is almost killing the recovery of the banking sector. And this will be a shock for the economy," said Nicola Nobile, a Milan-based economist for forecasting company Oxford Economics. The danger, he said, is a return of the credit crunch that choked off Italy's recovery after the eurozone crisis earlier this decade.
ECB President Mario Draghi warned last month that credit has become costlier in Italy's economy as a result of market tensions fueled by anti-EU rhetoric emanating from Rome. "Words have created some damage," Mr. Draghi said.
Italy's political leaders continue to lambaste EU officials tasked with enforcing the bloc's fiscal rulebook. Dismissing "threats from Europe," League leader Matteo Salvini on Wednesday quoted an expression from an early 20th-century militant nationalist poet meaning "I don't give a damn."
Higher borrowing costs for Italian businesses and households could counteract the economic boost the government is hoping to achieve via fiscal stimulus. The 5 Star wants to raise welfare spending by introducing a universal basic income for the poor and unemployed, while the League wants to cut taxes and lower the pension age. As the coalition's more radical members from both parties wrestle with cautious officials such as Finance Minister Giovanni Tria, the government has missed its deadline under Italian law for publishing fiscal and economic projections. The country is supposed to submit a detailed budget plan to the EU by Oct. 15.
The eurozone is far more stable now than during its existential crisis of 2010-12, when capital flight nearly destroyed the common currency. Most of its national economies are growing, including Italy's, though with less momentum than a year ago. The region's political strains continue to worsen, however, as voters turn against the old center-right and center-left parties that built today's Europe. Those legacy parties are widely blamed for problems including the economic scars of the crisis years, immigration and security.
Italy's League and 5 Star are two of the many political movements around Europe riding the antiestablishment wave. Their radical spending and tax-cutting ideas and their demands for greater national sovereignty within the EU are testing Europe's existing order -- including its process of financial healing from the crisis era.
Having spent recent years trying to write down their mountain of bad loans, Italian banks this year had started to embark on new lending. But that effort has been hampered by repeated financial turbulence of which last week's was only the most recent. In August total loans to companies and consumers fell to the lowest level for two years, according to data from the Italian Banking Association.
"Banks are restricting credit. They are struggling to deploy their liquidity," said Mario Ravagnan, chief executive of Ravagnan SpA, an engineering company from near Venice.
The market turmoil is hitting banks' funding costs and their capital cushions. Yields on Italian bank bonds have shot up this week. On Thursday, a bond maturing in Jan. 2023 from UniCredit SpA, Italy's biggest bank by assets, yielded 2.67%, compared with just over 1% when first issued early this year.
The cost of insuring against default on $10 million of UniCredit's debt -- like that of Italy's second-biggest lender, Intesa Sanpaolo SpA -- has nearly tripled since the start of the year, in another sign that investors are treating the banks as risky and likely to demand higher interest for future funding. UniCredit and Intesa declined to comment.
Italian banks face heavy borrowing needs in coming months and years. Some need to strengthen their capital buffers to satisfy regulators. The sector also needs to repay some EUR250 billion ($289 billion) of ECB loans that fall due in 2020-21, and funding that can't all be left until late.
Earlier this year, Banca Carige SpA had to scrap a planned bond sale, blaming "market conditions." In July the Genoa-based bank received a warning about its thin capital cover from the ECB, which is pushing it to submit a capital plan or consider a merger.
"Banks need to operate in a stable macro environment, and if the sovereign uncertainty leads to market risk-aversion, the banks will find it more difficult to issue funding at convenient prices -- or even issue funding at all," said Paola Biraschi, an analyst at CreditSights.
The sinking value of Italian government bonds already eroded the core capital of the country's banks over the summer, according to research by Credit Suisse. Less capital makes banks less able to write down bad loans or make new ones.
Analysts at Morgan Stanley say Banco BPM SpA, Banca Monte dei Paschi di Siena SpA and UBI Banca SpA, among Italy's biggest lenders, are the most vulnerable because of the size of their exposure to Italian government debt. MPS and Banco BPM declined to comment. UBI said it was cutting its government-bond holdings and remained relaxed about current market turbulence.
Italy's banking sector holds more government bonds than do its counterparts in Europe's other major economies. Italian sovereign debt makes up over 10% of total assets at the country's banks, compared with around 2% in Germany. Italian banks have increased their purchases of government bonds this year while foreign investors have retreated from the market. That leaves the sector ever more exposed if tensions worsen between the EU and Rome's populist rulers.
"The situation for the banks is really quite dire," said Tom Kinmouth, fixed-income strategist at ABN Amro Bank.
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