Flags of Italy and the European Union. Photo: iStock
Flags of Italy and the European Union. Photo: iStock

Italy has agreed to reduce its budget deficit target to 2.04% of gross domestic product, down from the originally proposed 2.40%, as part of an agreement to avoid European Union fines.

Italian government bonds rallied on the news, with the yield on 10-year notes reaching a three-month low.

The deal, however, only kicks the can down the road. The fundamental disagreement between the Italian ruling coalition and Brussels centers on a promised massive expansion of government social-welfare programs, which has only been postponed under this arrangement.

“A substantial part of the amount [saved] stems from the delayed entry into force of the two main expansionary measures – the citizens’ income and the rolling back of pension reforms,” said Valdis Dombrovskis, a European Commission vice-president. “This means that when these measures will fully come into force, they will result in higher costs for the years to come.”

Key parts of the deal, per The Financial Times:

Postpone the launch of a “minimum basic income program”, a priority for Deputy Prime Minister Luigi Di Maio and his Five Star movement. It will be rolled out during 2019 rather than in January.

Delay unwinding part of previous pension reforms by a year: cuts that were introduced during the euro area economic crisis are highly unpopular and were heavily criticized during this year’s election.

A safeguard clause to increase VAT: tax rises would kick in if Italy’s budget numbers are worse than expected in 2020 and 2021.

An additional safeguard: Italy will freeze €2 billion of planned expenditure in the 2019 budget. The money will be released if the deficit target is on track.

Flexibility from Brussels to allow more spending on roads and flood prevention without falling foul of budget rules.