BRUSSELS (Reuters) - EU officials will probably not do much to enforce their borrowing rules on Italy’s new government, but they are hoping they won’t have to because financial markets will do the job for them.

FILE PHOTO: European Union flags flutter outside the European Central Bank (ECB) headquarters in Frankfurt, Germany, April 26, 2018. REUTERS/Kai Pfaffenbach/File Photo

A new government is expected to take office in Italy next week, a coalition of the anti-establishment 5-Star Movement and far-right League, who have jointly promised a bonanza of tax cuts and spending increases that would burst through the EU’s limits on borrowing by member states.

Slovak Finance Minister Peter Kazimir on Thursday called the policy mix a “suicide mission”. Markets have already responded: yields of the benchmark 10-year Italian bonds have jumped 0.7 percentage point since the start of May to 14-month highs above 2.46 percent.

Morgan Stanley warned this week that sustained yields that high could spark contagion by hitting the profits of banks which hold a big chunk of their assets in government debt. Shares in Italian banks hit 11-month lows on Friday, having fallen almost 14 percent so far this month. Economists say that is only a taste of what could come: the rise in rates would be much steeper if markets believed that Italy was actually prepared to go through with the plans.

“If they do what said they want to do, the reaction of the market will be much more than what we have seen so far,” said Francesco Papadia, a senior fellow at the respected Brussels-based Bruegel think-tank.

The spread of the Italian benchmark paper over comparable German bonds hit 200 basis points this week, still a far cry from the 550 basis points spread at the peak of the sovereign debt crisis in 2012.

“So far (the market reaction) has been clear, but not extreme. Maybe the market still has a hope they won’t do at least the most extreme version of what they said they would do,” Papadia said.

Italy’s increased spending against EU rules “would likely be met by aggressive Italy underperformance versus other markets”, investment bank J.P. Morgan said in a note for investors.

EU UNLIKELY TO INTERVENE

As an EU member, Italy is obliged seek a balanced budget in structural terms and have debt below 60 percent of gross domestic product. Instead, its structural deficit has been rising since 2015 and its debt has been close to 132 percent of GDP since 2014. But most Brussels-watchers do not expect Europe to take political action to enforce its rules.

The European Commission, the guardian of EU laws, has the task of disciplining profligate governments through what is called an excessive deficit procedure that could end in fines.

But it has repeatedly declared that punishment is not the way to deal with budget rule-breaking, and showed leniency to repeat budget offenders like France, Portugal and Spain.

The Commission is also held back by concern that enforcement action would only strengthen eurosceptic sentiment in Italy, the euro zone’s third biggest economy, where many people are already ambivalent about the euro currency.

“In the end, crazy countries are always disciplined by markets. Rules can be broken. But you cannot replace market funding with wishful thinking,” one senior euro zone policy-maker said, expressing a widely-shared view.

MARKET PRESSURE WOULD HURT VOTERS QUICKLY

League leader Matteo Salvini brushed off market pressure.

“The more they insult us, the more they threaten us, the more they blackmail us, the more desire I have to embark on this challenge,” he said.

But analysts point out that only 36 percent of Italy’s massive 2.4 trillion euro debt is held by foreigners, meaning a fall in asset prices would hit Italians hard.

The rest is held domestically by banks, funds, investment vehicles and individuals, who now benefit from demand created by a European Central Bank bond-buying program.

The ECB scheme is likely to wind down this year and rate hikes are expected in mid 2019. Faced with profligate policies that undermine Italy’s ability to repay debt, foreign investors are likely to sell Italian paper. As yields rise, Italian voters would quickly see the value of their assets shrink.

“In Italy, quite a percentage of bonds is held by families directly. So when people see the statements from their banks on the value of their financial wealth, their savings, they would see the consequences,” Papadia said.

Another factor likely to limit the Italian government’s fiscal plans is the threat of a credit rating downgrade. Italy is now just two notches above junk with a BB from Standard & Poor’s and Fitch, and Baa2 from Moody’s. Fitch has already said the plans outlined in the coalition agreement would add risk to Italy’s fiscal position.

If Italian debt were to fall below investment grade, its banks would find it much more difficult and costly to get daily liquidity from the ECB -- a constraint that could have serious consequences for the whole sector and the country.