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Italy's election result hits bond prices amid fears of budget clash with EU

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Italy's election result hits bond prices amid fears of budget clash with EU

The victory of the rightwing League party in Italy at the European elections on May 26 has seen the country's sovereign bonds spread widen over Germany as investors demand a premium to hold Italian debt.

Fears of a renewed clash between Italy and the European Union over the country's budget has led to the spread between Italian and German 10-year bonds widening to 2.88 percentage points, its widest since February.

Italian banks hold large amounts of Italian sovereign bonds, a key component in the so-called "doom loop." This can be created when governments come under pressure, leading to a fall in the price of its bonds, so weakening banks which hold them, which in turn heaps pressure on the government.

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Shares in Italy's main banks were all down following the election. UniCredit SpA fell 2.21% as of midday May 28, Intesa Sanpaolo SpA dropped 2.34%, while Mediobanca was down 1.5%.

Matteo Salvini, leader of the League and Italy's deputy prime minister, has said he will use "all my energy" in a confrontation with the EU over the government's budget plans that are set to breach EU rules, according to forecasts from the European Commission. The Italian deficit is expected to increase sharply to 3.5% of gross domestic product in 2020, up from 2.5% this year. This would lead it to breach the EU's limit of 3% of GDP.

Scope Ratings' projection for Italy's 2019 budget balance is more pessimistic than the Italian government's at more than 2.5% compared with the government's estimate of just under 2.5%.

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Italian banks' holdings of Italian sovereign bonds increased sharply in the first two months of 2019, rising €10.7 billion in January and €7.4 billion in February before falling €2.8 billion in March, with the first two months up on the same period in 2018. There are no figures yet for bond holdings in May 2019, but it was in May 2018 that sovereign bond holdings increased by €28.4 billion after Italian President Sergio Mattarella rejected a cabinet minister he feared would lead Italy out of the euro, leading to a political crisis for Italy's new government.

Italy's banks are still struggling to extricate themselves from their high rate of nonperforming loan exposure. Almost of fifth of Banca Monte dei Paschi di Siena SpA loans were deemed nonperforming, while even Unicredit, regarded as one of the strongest Italian banks, has nearly 8% of its loans as nonperforming.

Italy has agreed with the European Commission to delay key spending measures like the introduction of a basic income program, and reduce the deficit to 2.04% this year, so the EC agreed to put on hold disciplinary proceedings against the country. However, the EU is likely to start disciplinary measures against Italy over its debt and deficit measures in June and Salvini has said he expects the country to face a potential fine of €3 billion.

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