BRUSSELS (Reuters) - Italy’s emerging ruling coalition is likely to put deeper euro zone integration on hold and could set the stage for the bloc’s next crisis if it delivers on its tax-cutting and high-spending policies, European policymakers and economists fear.

FILE PHOTO: Anti-establishment 5-Star Movement leader Luigi Di Maio speaks following a talk with Italian President Sergio Mattarella at the Quirinal Palace in Rome, Italy, April 12, 2018. REUTERS/Max Rossi/File Photo

Italy’s anti-establishment 5-Star Movement and the far-right League are nearing a government coalition deal that would bring together two parties which both want to challenge European Union limits on government borrowing and spending.

EU rules limit government budget deficits to 3 percent of gross domestic product and debt to 60 percent of GDP and oblige governments to seek balanced budgets.

With debt of around 132 percent of GDP and slow economic growth, Italy has long been a worry for euro zone policy-makers.

“With the M5S/LN government, the underlying problems of the Italian economy, including low growth, inflexible labor markets, inefficient banking system and public administration will not be tackled, in many cases only worsened,” Nordea Chief Strategist Jan von Gerich said in a note to clients.

“In short, trust towards Italy is bound to face heavy tests under a M5S/LN government, even if the two parties will not be able to implement their program in full,” he said.

Yields on benchmark Italian 10-year debt rose three basis points on Thursday to 2.13 percent, its highest since late-February. IT10YT=RR The rise came after Wednesday's 16 basis point spike, the biggest one-day rise since March 2017.

To make the debt smaller, the League wants to ask the EU’s statistics office Eurostat not to count the 250 billion euros of debt held by the European Central Bank when calculating Italian debt levels for the purposes of EU budget rules.

But EU officials dismissed the idea, saying that since Italy was the issuer of the debt, it did not matter who held it -- private investors or the ECB -- it was still money Italy owed.

“It is totally nuts. It doesn’t make any difference to Eurostat who holds the debt,” one senior EU official said.

BORROW MORE TO REDUCE DEBT?

The likely new government might increase the debt further, as Five-Star’s leader Luigi Di Maio said that “the recipe to lower public debt is by investments and expansionary policies”.

Five-Star’s flagship policy of a universal income for the poor would cost an estimated 17 billion euros ($20 billion) per year. At the same time the League’s hallmark scheme, a flat tax rate of 15 percent for companies and individuals, is to cut tax revenues by 80 billion euros per year.

A plan to scrap an unpopular pension reform would cost 15 billion euros and another 12.5 billion would be needed to head off an automatic hike in sales tax due for next year.

“There is a real danger that the new Italian government could, through its irresponsible economic policies, set the stage for the next euro zone crisis,” a second senior official involved in euro zone policy-making said.

The plans of the emerging Italian coalition are in sharp contrast to those of the outgoing centre-left administration, which promised the fiscal deficit would fall this year to 1.6 percent of GDP from 2.4 percent in 2017, and then decline to 0.8 percent next year with a balanced budget in 2020.

“Everybody is worried that Italy is becoming ungovernable, and that populists will drive the country into another deep crisis,” a third euro zone official said.

Some officials struck a more optimistic note, saying that once in power, the two Italian parties will quickly have to scale down radical campaign promises to fit reality.

“They have already become more moderate and this will probably continue. And even if it does not, they will be disciplined by other means, like financial markets,” a fourth senior euro zone official said.

But League leader Matteo Salvini sounded defiant:

“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.

Nicola Nobile, economist at Oxford Economics, said the coalition’s policies might produce a short-term bounce in growth to 3 percent in 2019 and 2 percent in 2020, versus a baseline of around 1 percent for both years.

But it would also mean that Italy’s borrowing costs would rise sharply on concern about long-term debt sustainability. Nobile said long-term yields would reach 5 percent by 2022, compared to 4 percent in the baseline and a current yield of 1.9 percent on 10-year bonds.

DEEPER EURO ZONE INTEGRATION ON HOLD

Italy is crucial for deeper euro zone integration that is aimed at better preparing the 19 countries sharing the single currency for the next crisis, whatever that may be.

So far, ambitious plans from French President Emmanuel Macron have met with a cool reception in Berlin. With a euro-sceptic government in Italy, the euro zone’s third biggest economy, they could be effectively frozen, officials and economists said.

“If (they) ... agree on a government program for Italy, French President Macron’s EU reform plans are likely to have largely failed once and for all,” Commerzbank Chief Economist Joerg Kraemer said in a note.

“Such an Italian government would appear irresponsible in fiscal policy terms and further reduce the willingness of many voters in the north of the euro zone to support Macron’s plans for more redistribution of risks and income,” he said.

Central to deeper euro zone integration are plans to make the banking sector more resilient. This would involve an obligation to diversify banks’ bond portfolios, setting limits on how much debt of a single sovereign a bank can hold.

It would also for the first time mean rules on how a sovereign debt restructuring in the euro zone would be carried out. Italy’s huge public debt is mainly domestically owned making both issues highly sensitive for Rome.

“I expect it will be extraordinarily more difficult to discuss this with a new Italian government than with the current one,” the fourth EU policymaker said.

ITALY MAY CREATE DILEMMA FOR ECB

Officials said that Italy’s huge public debt was now effectively subsidized by the ECB’s bond-buying program.

But once that ends, Italy’s still high deficit and low growth would mean the premium demanded by markets to lend to Italy would rise sharply.

Because policymakers agree Italy is too big to be rescued by the euro zone bailout fund, the ECB may face a dilemma -- start tightening policy and risk the collapse of Italy and a new euro zone crisis, or keep policy loose to help Rome finance its debt.

“A crisis is not likely in the next 12-18 months, but once the ECB starts to tighten, I would get worried,” the second official said.

“An alternative scenario is that the ECB would feel like it couldn’t raise rates without provoking a crisis in Italy and therefore monetary policy begins to lose its independence. We economists call this ‘fiscal dominance’. Not likely, but still...” the official said.