ROME (Reuters) – The Italian government cut its growth forecasts for this year and next and raised its budget deficit targets as rising interest rates weighed on the economy while incentives costly energy renovation costs weigh on public finances.

Italy, whose debt is, in relation to GDP, the second largest in the euro zone, worries investors.

The deteriorating economic outlook poses a major challenge for Council President Giorgia Meloni, who must find a way to finance the tax cuts promised in the 2024 budget, expected next month, without triggering a massive sell-off of Italian securities.

The yield spread between Italian and German 10-year bonds, which reflects market sentiment on Italy, exceeded 195 basis points on Wednesday, its highest level since the start of May.

In its economic and financial document (DEF), which sets out the economic framework for the budget, the Treasury forecasts that the GDP of the third economy in the euro zone will increase by 0.8% this year, down from the projection of 1 % made in April.

The growth target for next year was reduced from 1.5% to 1.2%.

“The outlook has changed due to two factors: the restrictive monetary policy of the European Central Bank (ECB) and the war in Ukraine,” Economy Minister Giancarlo Giorgetti told reporters after the cabinet approved the new forecasts.

The government raised its deficit target for 2023 from 4.5% to 5.3% of GDP, with the effect of the economic slowdown on state accounts exacerbated by costly incentives for energy renovation of homes.

These incentives, which take the form of tax credits, were introduced before Giorgia Meloni took office last year and have contributed to a strong rebound in growth in 2021 and 2022.

These measures nevertheless cost 54 billion euros, 2.8% of GDP, last year alone, while the deficit far exceeded its target of 8% of GDP.

The deficit target for 2024 was raised in the DEF to 4.3% of GDP, compared to 3.7% previously.

Public debt is expected to remain stable at around 140% of GDP until 2026.

ROOM FOR MANEUVER IN EXPENDITURE

According to current trends, next year’s budget deficit is expected to amount to 3.6% of GDP, Giancarlo Giorgetti said, well below the target of 4.3%.

The difference represents headroom of more than 14 billion euros that Giorgia Meloni can use to finance tax cuts for low and middle earners, as well as other stimulus measures in the budget.

“All the resources we have will be used to support low wages, reduce taxes and help families,” Giorgia Meloni said on Facebook.

The target of a deficit of 5.3% of GDP in 2023 provides room for maneuver of 2 billion euros, with this year’s budget deficit expected to reach 5.2%.

Italy is one of the euro zone countries most reluctant to heed the ECB’s calls to end expansionary fiscal policies.

Rome must present its budget plan before October 15 to the European Commission, which wants to reintroduce modified public finance rules next year, the old ones having been suspended in 2020 due to the COVID-19 pandemic.

The government said in a statement that it believed its new, higher deficit targets would not break new EU rules.

The DEF predicts that the deficit will only fall below 3% of GDP in 2026.

Italy’s public debt is expected to reach 140.1% of GDP next year. The surge in inflation over the past two years has helped reduce the debt-to-GDP ratio because it inflates nominal GDP.

“The debt has stabilized considerably, because from 140.2% of GDP in 2023, we should arrive at 139.6% in 2026,” said Giancarlo Giorgetti.

(Reporting by Giuseppe Fonte, Gavin Jones, with contributions from Angelo Amante, Federico Maccioni, Antonella Cinelli, Sara Rossi; Corentin Chappron, edited by Kate Entringer)

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