Euro zone’s budget pact passes first test

Date: 03/06/1999

The flexibility shown last week by the EU's finance ministers in letting Italy off the budgetary hook provoked hysterical headlines.

Tim Jones explains why the decision has in fact boosted the single-currency area's credibility

LAST week, the Italians reneged on their single currency commitments, widened their budget deficit, tore up the EU's budget rulebook and undermined the credibility of the fledgling euro.

Alternatively, common sense prevailed; Italy stuck to the spirit of the stability and growth pact, kept public spending under wraps and had next-to-no impact on the exchange rate of the world's newest currency.

Based on evidence rather than instant punditry, last week's decision by EU finance ministers to let the Italian government miss its budget deficit target easily qualifies for the second interpretation.

The fact is that Italy is stuck in a trough of slow growth. So much has been written about Rome's public debt problem that the sclerotic economic growth suffered by the euro zone's third largest economy has hardly elicited comment outside the Italian capital.

Under Romano Prodi's stewardship in 1996-98, the annual growth of Italian gross domestic product never exceeded 1.5% - compared with the euro zone's 2.3% average - following an average 1.1% growth rate in 1991-95. Growth in the other two continental giants, France and Germany, averaged 2.4% and 2.1% respectively.

Last autumn, as economic and monetary union approached, Italians thought they could kick this habit.

They knew that euro-zone membership might, in the long term, hurt manufacturers used to devaluing their way into competitiveness. But for now, it meant a growth-catalysing cut in the cost of short-term borrowing to 3% from an average 5% last year and 9% as recently as 1996.

Like a good boy, Italian Treasury Minister (now President) Carlo Azeglio Ciampi drew up his 'stability programme' - laying out the government's targeted reductions in the budget deficit from 2.7% of GDP last year to 2.0% in 1999 and 1.0% in 2000.

Within months, it was obvious that circumstances had changed. Tumbling interest rates were not enough to offset the impact on Italian exporters of the parallel slowdown in Germany or the collapse of Asian markets, while consumers refused to go out and spend.

The coverage of last week's débàcle was full of Italy's "sudden" and "out of the blue" request. In fact, only some journalists were shocked. Back in January, Ciampi wrote to Economics Commissioner Yves-Thibault de Silguy and warned him that the 2%-of-GDP 1999 deficit target would be too ambitious.

He wrote again in March, promising to stick to cabinet-approved caps on public spending and pledging to stick to the totemic 1%-of-GDP deficit target for 2001 but asking permission for the economy's 'automatic stabilisers' to be put to work right now.

It is often forgotten that a budget deficit is not a figure but a relationship between two figures: revenue and spending. When growth slows down, company profit margins narrow and corporate tax revenues fall. By failing to compensate for this shortfall in revenue through tax increases or spending cuts, governments can 'automatically stabilise' overall demand.

Before the Maastricht Treaty was turned into holy writ, this was standard macroeconomic policy practice and was all Ciampi wanted to do.

De Silguy and his staff felt this would undermine the credibility of the stability and growth pact, and restated Italy's old 2%-of-GDP target for 1999 in their draft 'broad economic guidelines' for the EU.

But Ciampi and his Treasury Director Mario Draghi refused to play dead, and called repeatedly in the EU's Economic and Financial Committee for their EU counterparts to recognise reality. The 2% target was prepared on the basis of 2.5% economic growth, they said, and now even 1.5% looked optimistic for this year.

When newly reappointed Treasury Minister Giuliano Amato came to Brussels last week, he had no choice but to demand a change to the broad guidelines text.

To meet the 2% target, he told his fellow ministers, his government would have to raise taxes or slash public spending to the tune of 0.4% of annual GDP by December. This would amount to sucking more than €5 billion out of the economy at a time when confidence is already sapped.

Still, that is what De Silguy demanded and German Finance Minister Hans Eichel, who chaired the meeting, declined twice to reflect Amato's request for latitude in his formal presidency conclusions.

During pre-lunch cocktails, Amato finally convinced Eichel and they concocted a statement which declared that "implementation of budgetary policy in 1999 should aim at limiting any slippage from the target for the total deficit of 2% of GDP which, in any event, will stay below 2.4%".

The Netherlands' Gerrit Zalm, who was the biggest ministerial sceptic regarding Italy's entry to EMU in the run-up to the euro-summit in May last year, wanted one last safeguard. He reminded Amato of a promise contained in Ciampi's letters that Rome would stick to its 1%-of-GDP deficit target for 2001. No problem, said the treasury minister, and a deal was struck.

It was then that the real problems began.

When the Financial Times landed on Asian currency dealers' desks in the middle of Europe's Tuesday night with the front-page headline "First Cracks Show in Euro Pact after Italian Deal", local traders indulged in their now customary euro sale and took the currency to its lowest level since January at $1.0420.

We all knew those Italians could not be trusted, said newspaper commentators, lamenting the craven weakness of the other finance ministers for letting Rome have its way.

The markets, on the other hand, begged to differ. When big-time investors lose faith in the willingness of governments to keep public spending under control or bear down on inflation, this is reflected in interest rates.

Since investors receive a fixed income from holding bonds, inflation can do nothing else but eat away at their real returns, while a slackening of public spending controls means more bonds have to be issued and dilutes the value of existing holdings.

Yet, at the same time as the euro was 'collapsing', bond yields hardly moved. On the same day that the euro fell to its new low, the benchmark German ten-year bond yielded 4.09%, the French equivalent 4.24% and the long-term US treasury bond a spanking 5.83%.

As opinion-formers opine about the Italian discrediting of the euro, polls among dealers, strategists and fund managers tell a different story. They are keener to hold dollars than euro because the American economy continues to grow apace, the US/euroland interest rate differential is certain to widen and they do not believe the European Central Bank is interested in raising interest rates to push the currency up.

They are right. The ECB is not enjoying the speed of the euro's fall because monetary authorities like variables to vary as little as possible, hence recent comments from the Bundesbank's chieftains. But, what these central bankers are certainly not worried about is importing

inflation.

Even assuming prolonged euro weakness - keeping it at around $1.02 for most of the year - rising oil prices and a rally in other commodity prices, investment houses are still expecting euro-zone inflation to stay below 1.5% over the next 18 months.

Given this fact, the ECB is unlikely to sanction the sale of foreign currency reserves to support the euro: the equivalent of a bombing campaign without the implicit threat of a ground war.

This fact was acknowledged by Bundesbank President-designate Ernst Welteke is a non-headlined section of his euro-supporting comments late last week, when he said that the success of such reserve sakes was "very doubtful when the markets are going in a certain direction".

Italian exporters can only hope that the ECB's 'benign neglect' goes on.

Major analysis.