• In an unprecedented move, the European Union has formally rejected Italy’s budget plans.
  • Speaking on Tuesday afternoon, Valdis Dombrovskis, the European Commission vice president responsible for the euro, said that Brussels had “no alternative” but to reject the proposals.
  • Italy has proposed increasing its budget deficit to levels far above those previously agreed.

The European Union on Tuesday formally rejected Italy’s proposed budget, a highly unusual move that threatens to spark chaos in the eurozone.

The budget proposes increasing both Italy’s overall government debt and its deficit in the short run, pushing the deficit as high as 2.4% of gross domestic product over the coming years. This means Italy would fall foul of a previously mandated maximum deficit level of 0.8% of GDP. As a result, the EU decided to reject the proposals.

Speaking on Tuesday afternoon, Valdis Dombrovskis, the European Commission vice president responsible for the euro, said that Brussels had “no alternative” but to reject the proposals, adding that Italy had refused a chance to make changes to the budget.

After a letter was sent to Rome late last week, the Italian government did not “change our earlier conclusions of a particularly serious noncompliance,” Dombrovskis said.

The European Union has never formally rejected a eurozone member's budget plans. The Italian coalition government now has three weeks to make changes requested by Brussels or risks sanctions from the EU.

Yields on Italian bonds rose on the news, reversing a small decline seen over the past few days. The benchmark 10-year bond hit 3.59% soon after the news. The FTSE MIB share index was little changed but remained more than 1% lower on the day as part of a wider sell-off in stocks.

Brussels' rejection of the Italian budget came soon after Goldman Sachs warned that the market turmoil witnessed in Italy in recent months - which has seen the Italian stock market enter a bear market and the country's bonds hit their highest yields since the eurozone crisis - could worsen.

The Goldman Sachs economist Silvia Ardagna wrote this week that Italy's market situation "may need to get worse before it gets better."

Ardagna argued that for the Italian government to back down in its fight with Brussels, it would need a serious motivation. One such motivation, she said, would be a further market correction.

"From this perspective, our view is that market tensions would need to intensify in order to exert sufficient pressure on the Italian political system to trigger a change in the policy path and the political rhetoric around it.

"On that basis - and even if Italy does ultimately remain part of the Euro area - the market situation may need to get worse before it gets better," she added.