By Francesco Guarascio and Giuseppe Fonte
BRUSSELS/ROME (Reuters) - The European Commission on Wednesday reached a deal with Italy over its 2019 budget, avoiding disciplinary steps against Rome, ending months of verbal sparring and buoying Italian bonds and shares.
The Commission in October rejected the budget which included a deficit of 2.4 percent of gross domestic product, up from 1.8 percent this year, saying it would not cut Italy's large debt and was an "unprecedented" breach of EU fiscal rules.
The ensuing row worried investors, pushed up Italy's borrowing costs and depressed bank stocks.
Under the compromise announced by Commission Vice President Valdis Dombrovskis in Brussels, Italy cut its deficit for next year to 2.04 percent of GDP. It also lowered its economic growth forecast for 2019 to 1.0 percent from 1.5 percent.
On the more important structural fiscal gap, which excludes one-off items and business cycle swings, the two sides reached what Dombrovskis called a "borderline" deal by which there would be no structural adjustment next year.
Under recommendations from EU finance ministers in July, Rome was supposed to reduce the structural deficit by 0.6 percent of GDP, but instead made plans to increase it by 1.2 percent, according to Commission calculations.
In Rome, Prime Minister Giuseppe Conte hailed the deal which he said allowed his government to honour its main policy commitments and support the economy.
"At the end of tough negotiations, conducted with tenacity, we have reached a point of sustainable equilibrium, sticking to a higher deficit figure than was deemed appropriate by Europe," he told the upper house Senate. "It is good for Italians and it is also satisfactory for Europe."
Luigi Di Maio and Matteo Salvini, the leaders of the ruling anti-establishment 5-Star Movement and the rightist League, congratulated him for the way he had conducted negotiations.
Speaking to reporters in Brussels, Dombrovskis was less enthusiastic.
"The solution on the table is not ideal. It does not yet deliver a long-term solution to Italy's economic problems. But it allows us to avoid an excessive deficit procedure at this stage," he said.
The deal relieves pressure on Italy's populist government and allows the Commission to focus on other pressing matters such as Britain's departure from the European Union and France's plans to increase its deficit in the face of street protests.
Italian benchmark 10 year bond yields IT10YT=TWEB fell sharply to 2.79 percent at 1214 GMT from 2.833 before the announcement.
The compromise marks a climbdown by both sides. Until last week Rome was insisting it would not backtrack "by a millimetre" from its 2.4 percent target, while the Commission is now accepting a deficit which rises next year instead of falling, and is far above Italy's previous commitments.
The previous centre-left government which lost power in March had promised a deficit of just 0.8 percent in 2019.
Dombrovskis said the Commission would monitor closely whether Italy voted through the changed budget draft, as agreed with the EU. If not, Brussels was ready to resume disciplinary steps against Rome, which could eventually mean fines.
The Italian parliament must now approve the amended budget in both houses by the end of the year.
Under its new plan, the government cut its 2020 deficit target to 1.8 percent from 2.1 percent and lowered the 2021 goal to 1.5 percent from 1.8 percent.
Opposition parties attacked the government over its sudden retreat, but there are no signs the ruling parties are losing popularity.
Surveys have shown most Italians were in favour of a compromise with Brussels and a poll by the SWG agency on Monday showed higher support for both the League and 5-Star, who together were backed by almost 60 percent of voters.
Analysts welcomed the end of hostilities with Brussels but remained sceptical that Rome, faced with a weakening economic growth outlook, could meet its new deficit target.
"A rather uncertain policy agenda and still overly optimistic growth forecasts remain two key risks for debt sustainability," Morgan Stanley said in a research note to clients.
It forecast Italian GDP growth next year of just 0.5 percent, while Barclays Capital projected 0.4 percent.
Conte stressed the lower deficit would have no impact on the government's flagship policies of a new income support scheme and a lower retirement age, but Dombrovskis said the deal would mean 10 billion euros ($11.42 billion) of extra cuts from Rome.
He said Conte had agreed that this would come partly from higher taxes on companies and cuts in planned investment "which are not growth friendly steps."
The Italian government has agreed to cut more than 4 billion euros from planned investments in 2019, though this could be partly offset by a better use of EU structural funds.
($1 = 0.8760 euros)
(Additional reporting by Jan Strupczeweski; Writing by Gavin Jones; editing by Andrew Roche and Jon Boyle)
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Updated Date: Dec 20, 2018 00:06:18 IST