By Sara Rossi
MILAN, April 13 (Reuters) - Italy's economic vulnerabilities are being laid bare by war in the Middle East, with Rome's heavy reliance on imported energy and the threat of rising government and fiscal instability ahead of 2027 elections taking the shine off its bonds. Italy's two-year borrowing costs surged 75 basis points in March in their biggest monthly rise since 2022 - at least 10 bps more than peers France, Spain and Germany.
And while a two-week ceasefire announcement in early
April has given bond markets some reprieve, Italian yields at around 2.76% remain well above levels traded before the United States and Israel attacked Iran at the end of February.
Even after the fragile ceasefire, Italian debt financing costs rose at an auction nL8N40S0RU on Friday to the highest level since July 2024. In addition, an extended honeymoon period for Italian Prime Minister Giorgia Meloni, who had won markets' favour since she took office in 2022 thanks to her government's stability and a relatively cautious budget policy, appears to be souring. RECESSION FORECAST
Italy is Europe's most gas-reliant economy, accounting for 38% of its energy supplies, according to the London-based Energy Institute. It is also the European Union's largest importer of liquefied natural gas through the Persian Gulf. "With prospects for prolonged energy price increases, investors are very concerned about Italy's growth outlook," said Commerzbank rate strategist Hauke Siemssen. The bank forecasts that in the first half of this year the euro zone's third largest economy will suffer two consecutive quarters of falling gross domestic product, the technical definition of recession. Italian 10-year benchmark BTP yields rose around 80 basis points in March following the start of the Iran war, well above the roughly 60-bps increase for equivalent French OATs and a 45-bps rise for German Bunds.
The closely watched premium, or "spread" investors demand to hold Italy's 10-year bonds over Germany's, briefly widened over 100 basis points, its highest level in nine months. That makes it more costly for Rome to finance its public debt, which rose last year to 137% of gross domestic product and is proportionally the second largest in the euro zone after Greece's. Italy's 10-year benchmark bonds are the highest yielding in the 21-nation bloc.
Analysts say the Iran conflict has served as a reminder that, despite Rome's claims of improved economic fundamentals, Italian debt remains the most vulnerable in the euro zone to bouts of "risk off" market sentiment. "To me, BTPs are like a global risk proxy," said Steven Major, global macro advisor at the global brokerage Tradition in Dubai.
With growth seen at just 0.4% this year and 0.6% in 2027 Italy is the most sluggish economy among the Group of 20 advanced nations, according to the spring forecasts of the Organisation for Economic Cooperation and Development. NOT JUST THE ECONOMY Meloni's problems are not just economic. She suffered a resounding defeat last month in a referendum on judicial reform nL8N40B1GV and in the following days sacked three government officials nL8N40D2A8, two of whom were caught up in financial or mafia-related scandals. Italy's political stability of the last three years is now looking more fragile, as is the previously widespread assumption that the premier will win a second term at 2027 elections. "Meloni's position is becoming more precarious," Eurasia Group said in note to clients. "The (referendum) defeat robbed the government of a rare policy win on a flagship issue and demonstrated that a sizeable majority can coalesce against it," the political risk consultancy said. In this context Italy's fiscal discipline is also likely to waver, some analysts said, noting that both Meloni and Economy Minister Giancarlo Giorgetti are calling on Brussels to suspend European Union budget rules nL8N40M07F if the Iran war continues. So far the EU is turning a deaf ear to the appeals. "I think the combination of the justice reform vote, the approach of the 2027 election and the rise in energy prices increases the incentives for the government to loosen fiscal policy to shore up popular support," said Franziska Palmas, senior Europe economist at Capital Economics. However, Meloni's scope for largesse has been crimped by news last month that Rome's 2025 deficit stood at 3.1% of GDP, missing a 3.0% target nL8N3ZQ0QY and meaning Italy cannot exit an EU disciplinary procedure this year for its "excessive deficit". Despite the EU constraints, Capital Economics estimates this year's deficit will rise to 3.5% of GDP instead of falling to 2.8% as the government has targeted.
Commerzbank's Siemssen forecast that investors' previously positive perception of Italian bonds will probably not be fully restored even when the Middle East turmoil ends.
"I expect BTP-Bund spreads to return to tighter levels, although likely not as tight as before the Iran war," he said.
(Additional reporting by Amanda Cooper in London, editing by Gavin Jones)
