It appears that all is well in the state of Italy for now. The Italian government has changed its rhetoric with regards to its budget and its spending plan for 2019. They will present a new plan to the EU to hopefully placate the EU Commission. Bloomberg writes;

Italy’s two powerful deputy premiers, Matteo Salvini and Luigi Di Maio, are ready to back down on their hard-line deficit target demands, newspaper Il Messaggero reported, while Prime Minister Giuseppe Conte has taken over as budget negotiator with the European Union.

The markets have reacted positively to the new lines. Yields on Italian bonds have dropped to a 2 month low.

Source: Bloomberg

All of this might be premature as no party knows exactly what type of new proposal the Italians are going to present and if that will be enough for the EU Commission. CNBC notes;

Florian Hense, a euro zone economist at Berenberg, told CNBC via email that even if Rome brings its deficit target down from 2.4 percent to 2 percent, that “doesn’t seem to be to the EU’s liking yet.

Furthermore all market exuberance might be in vain due to recent changes in European Stability Mechanism (“ESM”), EU’s rescue fund. In effect the changes are meant to make it easier for countries to access to shield themselves from outside turmoil. These changes are specifically made to hinder Italy to blackmail the rest of the EU. Bloomberg outlines;

Euro zone finance ministers now say they want to make it clearer which countries can use a precautionary line. Conditions include meeting certain debt and deficit benchmarks, as well as not suffering from excessive macroeconomic imbalances.

Interestingly enough, the new criteria are too stringent for Italy to be able to meet. A country’s debt need to be below 60%, or it needs to reduce the difference between their current debt level and this level by 5% yearly for 2 years before requesting access ESMs credit-line. Finally the budget deficit needs to be below 3% but also be maximum 10% higher of average deficit of Spain, Portugal and France. This is currently at 1.1%. In another words, it would basically be impossible for Italy to access any of ESMs credit-lines considering what the populist government of the Five Star and the League have promised.  

In addition, the new rules makes it more difficult for ECB to buy Italian bonds would it end up in a more stressed situation. Furthermore, ECB’s new “Capital Key” rules means that it will buy less Italian Bonds come 1st of January 2019. ECB would buy EUR780m less bonds between Jan-Oct 2019 compared to previously.

It could end up being a game of chicken between EU and Italy. Now that EU have actively changed its rules to make it more difficult for Italy to blackmail the Union, the populists in Italy might feel cornered. In a situation with further market turmoil and Italy loses market access for its bonds things could get ugly fast.  It is hard to imagine that Five Star Movement and the League would be ok of fully complying with EU rules as that would go 100% against their platform and promises to their voters. They could again try see if they can challenge the EU with threatening bringing everyone down with them unless EU again makes special accommodations for Italy.