Italy's economy has stalled abruptly over the summer and the industrial sector is on the cusp of outright recession, threatening to drive the country's knife-edge debt dynamics into dangerous territory.

The sudden slowdown comes as mounting political alarm pushes risk spreads on 10-year Italian debt to a five-year high of 290, a sign that capital outflows are picking up again.

Markets are increasingly nervous as the insurgent Lega-Five Star government draws up sweeping plans for tax cuts and welfare spending in the 2019 budget, risking a bare-knuckled fight with Brussels over EU fiscal rules.

Italy's debt trajectory is acutely vulnerable to any change in the pace of nominal GDP growth or any shift in the fiscal outlook. Spreads have risen 175 basis points since April, shadowing the pattern before the 2011 crisis.

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Carlo Cottarelli, former head of Italy's spending review and a veteran of the International Monetary Fund, said there are eerie similarities with events in that episode. Once spreads broke through 300, the crisis span out of control within weeks.

"We had better hope that the international outlook remains favourable, because if there is any inflection in the cycle and our debt ratio starts to rise again, nothing will save us from a jump in spreads to 500-600 points," he said.

The surprising new development is the sharp fall in IHS Markit's manufacturing gauge for Italy to 50.1 in August, just above the "boom-bust line".

Business expectations fell to lows last seen in May 2013 during the eurozone banking crisis.

"Unless we see a pick-up in demand - be it from at home or abroad - the recent trends in the data raise the spectre of the sector tipping into technical recession during the second half of 2018," said Markit's Paul Smith.

Bank of America says Italy's GDP growth is "flirting with zero" in the third quarter. It warned that risk spreads could "easily rise to 400 basis points" if the budget breaches fiscal rules. The first draft is to be prepared this month.

Fitch placed the country's "BBB" rating on negative watch last Friday, saying it "expects a degree of fiscal loosening that would leave Italy's very high level of public debt more exposed to potential shocks".

The debt ratio has only just begun to stabilise at 132 per cent of GDP a full nine years into the global expansion.

Leaders of both the nationalist Lega party and the radical Five Star movement responded caustically: policy would henceforth be set in the interests of the Italian people, not for the convenience of rating agencies.

Cottarelli said the fiscal plans of the Lega-Grillini alliance - if enacted - would shatter market confidence.

"It is all very well saying: 'We couldn't give a damn about the rating agencies', but who is going to lend us money?" he said.

The flat tax would cost €50 billion ($87.9b) a year and a basic income for the poor would cost €17b. These two have to go together to preserve the Left-Right coalition. A rollback of pension reform would cost €8b. A suspension of VAT rises costs 0.7 per cent of GDP.

Italy is supposed to be going in the opposite direction with consolidation of 1 per cent of GDP a year under the "preventive arm" of the Stability Pact. The showdown with Brussels comes at a perilous moment.

The European Central Bank is winding down its purchase of sovereign bonds. There will be no buyer-of-last-resort standing behind the Italian debt market in January 2019.

Any further intervention after that requires a full-blown rescue package by the EU bail-out fund (ESM) under draconian terms, endorsed by the German Bundestag.

Giovanni Tria, the technocrat finance minister, said Italy will suffer "repercussions" when QE ends but vowed to win over markets with a responsible budget. What is not yet clear is whether he has any real power.

Matteo Salvini, the Lega strongman, told a gathering over the weekend that Italy would "gently brush" the 3 per cent Maastricht ceiling without punching through it, but the tone was ironic, almost one of mockery. The audience laughed, fully understanding his message.

The Lega's elder statesman (and de facto co-premier), Giancarlo Giorgetti, said the coalition would go above 3 per cent if necessary, citing the need for a blitz of infrastructure spending after the Genoa bridge disaster.

The plan is to invoke the "Golden Rule" that exempts investment from the deficit. It is a way to evade curbs.

The rebel coalition is putting up a smokescreen by talking about the Maastricht limit 3 per cent of GDP as if that had any relevance. The Teutonic post-crisis Stability Pact is much stricter.

"It is deliberate manipulation," said Lorenzo Codogno from LC Macro Advisors.

"They know that 3 per cent doesn't matter. I think they are testing the waters to see how Brussels reacts, and what happens in financial markets."

The EU must move with care. Italy is not Greece. It is a net contributor to the EU budget and is big enough to set off a systemic crisis for monetary union.

Salvini and his inner circle are hard eurosceptics, hoping to engineer circumstances that makes it possible to pull Italy out of the euro.

They argue that the ECB used the spreads as "a weapon of mass financial destruction" to topple Silvio Berlusconi in 2011 and to install a compliant austerity government under a former EU commissioner.

They have been warning openly over the summer that the EU authorities and their allies are conspiring to break the back of the rebel government by the same method. They have inoculated the Italian public in advance.

Claudio Borghi, a Lega economist and head of parliament's budget committee, says the EU elites will not succeed in bringing Italy to its knees a second time by pressure on the bond market.

"They can't play the same trick twice," he said. "Italians know who controls the spreads."

"We're back where we were when the crisis began in 2011. There are only two golden keys to get out of this slaughterhouse: either the ECB agrees to hold the risk spread at 150 points; or we take back our own currency and restore national independence," he told The Daily Telegraph last month.

The risk for the EU is that if it pushes Italy too hard on fiscal rules and provokes a showdown, the Lega-Grillini will retaliate by activating their "minibot" plan for a parallel currency to keep the banks afloat.

This would subvert monetary union from within, leading quickly to the rupture of the euro.

In a sense, the stand-off between Rome and Brussels is like the Brexit drama. The EU has preponderant power but it sits on fragile foundations and has very low tolerance for economic shocks.

Unless the EU authorities yield some ground to the Italians, they risk setting off the existential crisis they most fear.