The European Union could derail Italy's big spending plans this week, with speculation mounting that officials in Brussels are set to reject the anti-establishment government's 2019 draft budget.
Even the Italian government is reportedly expecting the European Commission, the EU's executive arm which checks and approves euro zone budgets before they are adopted by national parliaments, to decide for the first time ever on Tuesday to ask a member state to revise its draft budget.
The Commission has already indicated that it is not happy with the plans, warning last Thursday that the draft is in serious breach of, and an "unprecedented" deviation from, EU spending rules.
On Monday, Italy's populist government is expected to reply to replay to the Commission's concerns, but analysts see little chance that the coalition will change course given its pledges to voters to up welfare spending.
Italy's euroskeptic coalition government, made up of the right-wing Lega party headed by Matteo Salvini and the anti-establishment Five Star Movement, led by Luigi Di Maio, wants to cut some taxes, roll back on pension reforms, introduce a universal income and introduce a tax amnesty to combat tax evasion.
But such measures are expected to raise Italy's budget deficit to 2.4 percent in 2019, doing a U-turn on a target of 0.8 percent promised by the previous government.
The Commission, and investors, are already worried about Italy's large debt pile which is equal to 133.4 percent of its gross domestic product, according to Eurostat, making it the second largest in the euro zone after Greece.
Italian Deputy Premier Luigi Di Maio said Saturday that Italy would explain its financial plans to Brussels. "We recognize the European institutions and we will sit at the table to discuss the reasons (behind) our financial measures," he said, adding the measures are "very important for the Italian people."
If Italy's budget is rejected, a three-week negotiation period follows in which a potential agreement could be found on how to lower the deficit (essentially, Italy would have to re-submit an amended draft budget). If that's not reached, punitive action could be taken against Italy.
Lorenzo Codogno, founder and chief economist at LC Macro Advisors, told CNBC that Brussels' rejection of the spending plans was a "done deal" — but that Italy was unlikely to change course.
"The problem is what's going to happen after that and I think it's very likely that the Commission will, without making a big fuss, will move towards making an 'Excessive Deficit Procedure' which would not be a big disaster but it's a way to put additional pressure on Italy and a way to have much stricter monitoring on future developments," he told CNBC's "Capital Connection" Monday.
"The message will be loud and clear but I doubt the (Italian) government, for now, will change direction."
With analysts expecting that Italy will stand its ground when it comes to its budget, all eyes are on how the European Commission will respond.
Although it has the power to sanction governments whose budgets don't comply with the EU's fiscal rules (and has threatened to do so in the past), it has stopped short of issuing fines to other member states before. The rules states that deficits should not exceed 3 percent of GDP and public debt must not exceed 60 percent of GDP — a far cry for many European countries.
Although Italy's draft budget envisages a deficit within the 3 percent limit, increasing the deficit from a previously lower target has angered the Commission because European member states are meant to work toward adhering to the rules, not deviating from them.
Now, the European Commission could recommend to the European Council (EU heads of state) that an "Excessive Deficit Procedure" (EDP) is launched against Italy. Basically, "the EDP requires the country in question to provide a plan of the corrective action and policies it will follow, as well as deadlines for their achievement," the European Commission states, adding: "Euro area countries that do not follow up on the recommendations may be fined."
Barclays' Senior European Economist Fabio Fois said in a note Monday that "the risk of escalation is rising" and the likelihood increasing of an EDP against Italy. "Tensions with EU authorities are here to stay. Whether they will lead to an unprecedented outright rejection of the Draft Budgetary Plan (DBP) and to the opening of an excessive deficit procedure is hard to tell, but risks are certainly increasing," Fois noted.
"We do not rule out that the EC could be inclined to recommend opening an EDP earlier (by November 30) than we expected (spring 2019)," he said.
The Commission may consider the current budget season as "the last politically feasible window" for action before next May's European Parliament elections, Fois added.
EDPs are nothing new. In 2013, the Commission had ongoing EDPs for 20 EU member states and there is a constant back-and-forth between countries, the European Council and Commission over budgets and so-called "corrective" measures and budget compliance.
But launching one could increase the already significant antipathy between Brussels and a vociferously euroskeptic government in Italy. Against a backdrop of Brexit and rising populism, the Commission could be wary of antagonizing Italy, the third largest euro zone economy. It could also be wary of financial market nerves surrounding Italy from spreading to its neighbors, many of whom are only just back on track after the sovereign debt crisis of 2011.
Financial markets continue to be rattled over Italy's political plans. Government bond yields rose further on Friday on the day a ratings agency downgraded Italian debt.
The 10-year bond yield hit 3.77 percent, while the 30-year bond yield hit a more than four-and-a-half year high of 4.22 percent. This essentially means that investors grew more cautious over lending money to the Italian government. On Monday, Italy's 10-year bond yield had dropped to 3.32 percent showing an easing of concerns, however.
Chiara Cremonesi, a fixed income strategist at Unicredit, told CNBC Monday that the spread between Italian and German 10-year bond yields (this gap is seen as an indicator of how investors perceive fear in the euro zone) could decrease from its current level of around 286 basi s points.
"That said, there are still uncertainties looming so volatility will probably stay high," she told CNBC's "Squawk Box Europe."
LC Macro Advisors founder Lorenzo Codogno was concerned, however, stating that the yield spreads at current levels "can already have an impact on the overall credit to the economy. If that happens, we turn into a sort of quasi-credit crunch as we have seen in 2011. We're still not there but if the situation continues like this for a few additional months, certainly there will be an impact."
He didn't rule out contagion to other euro zone countries, saying: "If the situation deteriorates it's almost inevitable that we'll see some kind of contagion also in other peripherals or even in the quasi-core (economies) so to speak. Clearly now, the European authorities have better tools to respond to such a situation, but the overall construction is fragile so I would expect some kind of contagion at some point."
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