What's at stake as Italy plays chicken with markets, EU

MILAN (AP) — Italy's government is playing a game of chicken with European authorities and financial markets over plans to spend big — and it's unclear whether the country can avoid a collision that would spread wreckage throughout Europe and the rest of the world.

Financial markets have been falling in Italy and the risk is the dispute could revive investors' dormant concerns about the country's stability and the future of the euro.

Italy is Europe's fourth-largest economy and integrated in the global financial system. Serious trouble there could roil business around the world.

Here's a look at the risks posed by Italy's budget clash with the European Union's executive commission.

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Q: HOW DID THE FIGHT START?

A: Italy's new government decided to increase spending dramatically, pushing the deficit to 2.4 percent of GDP — three times higher than earlier planned. The Commission rejected the budget under an EU review process. It warned the higher spending would keep Italy from lowering its debt, as promised. At 133 percent of GDP, it's the second-highest in Europe after Greece.

Italy's populists are refusing to back down. Matteo Salvini, leader of the anti-immigration, EU-skeptical League party, pledged that "not one euro" would be removed from the 2019 budget.

The tensions are already having an impact on Italy's economy. Ratings agency Moody's has lowered its credit rating for Italy to the lowest investment grade level — a move that has cost Italy's fragile banks dearly as they own a lot of the public debt in the form of government bonds.

On Friday, Standard & Poor's lowered its outlook on Italy to "negative" from "stable" but maintained its rating unchanged. The lowering of a country's outlook, however, can precede a rating downgrade.

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Q: WHY IS ITALY SPENDING SO MUCH?

Italy's populist 5-Star Movement and League note that Italy has lagged Europe's economy, and they blame austerity, the limits on spending observed as part of being in the euro.

Their recipe: Get money into the hands of Italians through social welfare programs that will benefit mostly young job seekers while restoring pensions that had been slashed by a previous government. They say spending and investments will mean growth that would later help bring the deficit back down. But many analysts say Italy mainly needs to change the way the economy works — by reducing red tape, for example.

And much as the populists insist they don't want Italy out of the EU or the euro, a confrontation with Brussels is electoral candy, reinforcing their anti-establishment credibility. Their popularity is rising, with surveys showing they would take 60 percent of the vote in an election today. Both parties have their eye on elections to the European parliament in May.

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Q: WHAT CAN THE EU DO?

A: The European Commission is aware that throwing the book at Italy could only make matters worse by fueling a populist backlash against the EU. But a more lenient response would upset more rule-abiding states, particularly in northern Europe, and challenge the credibility of the bloc's fiscal rules.

The commission has been keen to point out Italy has the right to choose its spending priorities and backs the need to tackle poverty. And they have underlined Italy's role as a founding EU member.

Italy has three weeks to respond to the EU's rejection. If it fails to revise its budget, the EU could invoke a formal procedure to bring Italy in line that could eventually result in a fine. That would likely only sharpen the dispute and worry markets more about Italy's commitment to the EU and the euro.

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Q: WHAT HAPPENS IF ITALY GETS DOWNGRADED?

A: Ratings downgrades mean the bonds are riskier, and their price falls. That hurts the banks, which hold a lot of those bonds. The downgrade stresses their finances and restricts their ability to lend. Interest rates would rise. Rates on government bonds influence rates for other lending, so businesses and consumers would pay more to borrow. The economy would suffer.

And if the bonds are downgraded to below investment grade, Italian banks could no longer use them as collateral to tap cheap credit from the European Central Bank. They'd lose their reliable source of cheap funding to keep doing business. Troubled banks are a frequent part of broader economic crises — like the Great Recession a decade ago — because of the key role banks play in the economy.

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Q: WHY SHOULD ANYONE OUTSIDE ITALY CARE?

A: Although much of Italy's debt is held by Italian investors, a default or sudden drop could hurt other financial markets as fears spread. For example, French banks have 316 billion euros ($360 billion) in exposure to Italian debt, meaning losses in a crisis could hop the border quickly.

If Italy seems unable to pay its huge debts, investors could start betting the country will default, and that could raise questions about the euro breaking up. That would likely have a big impact on the global economy by depressing confidence, disrupting commerce and making banks wary of lending money needed for finance and businesses to run.

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Q: CAN'T ITALY BE BAILED OUT LIKE GREECE?

A: It would be much more difficult because Italy is far bigger. The eurozone's bailout fund has 410 billion euros ($465 billion) in spare lending capacity. Italy will need 240 billion this year alone in financing. So the bailout fund has barely enough for two years — and Greece was on life support for eight years. Also, other governments might balk at taking on Italy's troubles.

That leaves the European Central Bank. The ECB has a backstop: a promise to buy unlimited amounts of bonds issued by a country facing extreme borrowing costs. But that comes on condition the country signs a deal promising budget cuts and tax increases. It's unlikely Italy's populists would do that.

So an ECB rescue would probably first require the collapse of the current government.

That might come too late to halt a crisis.

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McHugh reported from Frankfurt, Germany.

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This story corrects the figure for French exposure to Italian debtors to 316 billion euros.