Italy is set up for a showdown with the European Union

Reuters/Giampiero Sposito

The gap is widening between Rome and Brussels. The reasons are both diverging interests and increasing domestic pressure on the government. But how far will this fight go in 2016?

A year ago, Italy was widely thought to be on the right path by EU leaders.

Matteo Renzi, a member of the Democratic Party appointed as Prime Minister, was going forward with his reformist agenda, including a labor reform and an overhaul of the Italian electoral and constitutional laws to put an end to political instability in the country.

Results are starting to show: the economy grew by 0.8% in 2015 after three years of recession and is expected to grow by 1.5% this year. The country’s deficit should be reduced to 2.4% this year — more than previously hoped but below the Commission’s 3% limit — and unemployment has fallen from a peak of 13% to 11.3%. Skeptics feel that these figures are mostly repercussions of a combination of the ECB’squantitative easing program and cheap oil, but positive indicators like rebounding business and consumer confidence show clear signs of economic improvement.

However, after spending his first year in power as a EU champion and receiving praises for his policies in Brussels, Renzi has now grown critical of EU policies and the German leadership.

Diverging interests

This is particularly true on the thorny issue of refugees. Renzi has become a vocal critic since the EU relocation plan has proved ineffective and failed to stop the overflow of refugees on Italy’s shores. But what made the Italian government even more upset was the successive criticisms from Brussels on Italy’s incapacity to fingerprint every asylum seeker entering the country and the need to build more reception centers in Italy.

In the ultimate stage of opposition, Rome is blocking EU funds to Turkey, which Brussels hopes would help reduce the flow.

Rome has also been frustrated by Berlin’s leadership on the Russian question and energy routes, which it considers drastically opposed to its national interests. Berlin keeps calling for an extension of sanctions on Russia, whereas Italy is feeling the economic cost of counter-sanctions from Russia on its economy.

Additionally, Germany convinced the EU to build Nord Stream II instead of the South Stream project, when the latter would have taken gas directly on Italian shores as opposed to going through Ukraine — a route Rome deems to be unsafe.

In another field of opposition, Rome has been calling for new EU policies — particularly measures promoting growth — and an end to German hegemony. Renzi regularly denounces a double standard in European politics, notably on fiscal rules by pointing at the excessive German trade surplus (currently 8%). He has recently claimed that, “Europe has to serve all 28 countries, not just one”.

Domestic politics prevail

Moreover, the leader described a direct link between this double standard and the rise of populist parties in several European countries — namely Greece, Poland, Portugal and potentially Spain.

His Democratic Party now fears a similar push at home. Once major supporters of European integration, Italian’s enthusiasm was trimmed by years of economic stagnation and high unemployment. Now the PD has to face a rising 5-Star-Movement, a populist and anti-EU party and the threat of an alliance between another populist party, the Northern League, and Forza Italia, former PM Silvio Berlusconi’s party that had disintegrated after many scandals.

Reuters/Giampiero Sposito

With municipal elections (including in Rome and Milan) in March and a referendum on constitutional reforms that the prime minister has staked his political future on due for October, Renzi has to build a new momentum. If he loses the referendum, he will quit. This will throw Italy back into immediate instability. If he wins — a likely outcome — he will probably call for general elections to be held in Spring 2017.

In this context, the government’s harsh rhetoric on the European scene is an attempt to convince Italians it is resisting Brussels, and thus to temper the populist drive. Rome also just introduced popular measures for the middle-class like property tax cuts, and used the migrant crises and Paris attacks to justify more spending on areas such as security and culture.

This vote-winning strategy will raise eyebrows in Brussels. But EU leaders feel the threat of Italian populists too, so they are unlikely to voice their concern when they next review Italy’s budget in the spring.

Banks an immediate test for Renzi

The current government will face another immediate test in 2016 that could undermine its credibility and generate a populist surge.

Italian banks have been in the spotlight in the past weeks after steep share price declines which served as a reminder of their struggle to sell off non-performing loans to the markets. The issue is structural: Italy has seen a constant surge in non-performing loans since 2007 (see chart below). The country did not receive a bailout from the EU, and thus while Ireland or Greece were able to create a bad bank to buy these loans, Italy was not.

Reuters/Giampiero Sposito

As of the beginning of 2016, bailouts will first be felt by bank shareholders, bondholders and depositors with more than €100,000. Under the rules, which are part of new EU rules and were adopted by the Italian Parliament last Summer, 8% of a bank’s liabilities have to be wiped out before public money can be used.

The new rules combined with the Italian banking system’s structural flows and weak markets globally could test the government’s credibility rapidly, especially if a number of banks fail and Italians start pulling their money out in a move of panic.

A worst case scenario that would end in a banking crisis with Rome calling for rescue from Brussels cannot be ruled out.

In the meantime, pressure has built up since last November and the €3.6bn rescue of four small banks that saw thousands of retail investors losing money in the deal, and caused a retiree to commit suicide shortly after. After the recent turmoil, a poll released by Ipsos showed 60% of Italians believe the government is handling the situation poorly.

Renzi hopes a deal with Brussels on the creation of a bad bank (negotiations have been ongoing for years) could help restore confidence and give his governmental team some relief.

It is quite ironic that the PM now finds himself in need of Brussels to resolve a domestic issue that could cost him his position. But on the other end, if things go wrong he will probably use failing negotiations with Brussels to condemn the EU once again, and move from a Euro-critic stance to conspicuous Euroscepticism.

Brussels cannot afford to make a new enemy, especially the fourth largest economy in Europe, at a time when it needs support on several crises. As a result, EU leaders should show leniency to Rome’s increasing bellicosity, at least until the next general election.

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