Matter of life or debt in Italy

Date: 19/02/1998

The Italian authorities have sweated for five years to lick the economy into shape in readiness for the single currency. Tim Jones examines how money markets and politicians might react in the 'unthinkable' event of Italy being locked out of euro-land ITALY is in a classic state of denial. The idea that the country might not qualify for first-wave membership of European economic and monetary union on 1 January 1999 has become literally unthinkable.

People will never love the single currency like football, yet a staggering 1.5 million people phoned into RAI's popular Domenica television show a fortnight ago to vote for their choice of design for the national side of the new euro and cent coins.

It seems nothing can shake the inner belief of Italians, and particularly the Roman and Milanese establishments, that they will soon be rid of the lira and the bad memories associated with it.

Like most cases of severe denial, its cause is a reluctance to face what failure would mean. Italy is unique among the borderline applicants for EMu membership, in that the consequences of rejection at the crucial 2-3 May Union summit when euro-zone participants will be chosen would be immediate and severe.

Worse still, the hard work carried out over the past five years to lick a dangerously unstable political economy into shape could unravel at an alarming speed.

Looming behind the discussion of Italy's membership is its public debt.

Totalling around 1.2 trillion ecu and worth 122&percent; of the total wealth the economy produces every year, the debt has to be continually refinanced simply to pay interest to creditors. This, in turn, makes the debt grow and so the cycle goes on.

The Italian authorities could not let this continue so, by cutting public spending and increasing taxes over the past five years, governments have finally got to the point where they are running a substantial 'primary surplus'. Public sector revenues are outstripping spending once interest payments on old debt have been removed from the equation.

At the same time, the growing belief in the financial markets that Italy will be signing up for EMU from day one has performed miracles for the costs of servicing the debt. The rate the government has to pay investors for taking the risk of buying its IOUs in the form of short-dated bills and long-maturity bonds has dropped sharply.

Two years ago, ten-year Italian government bond yields were 11&percent; compared with 6&percent; for similar securities in Germany, the Netherlands and Austria.

Today, they have halved to 5.4&percent; and the yield differential with German bonds has narrowed to a mere 0.4 percentage points - an amazing achievement.

As for short-term interest rates - those set by the Bank of Italy to cap inflation and stabilise the lira - the effect has been similar. The 'repo' rate at which the Bank of Italy provides funds to the money markets and so influences short-term interest rates is now 6.2&percent;.

Although this is still well above the 3.3&percent; rate operating in Germany, France and the Netherlands, the stated aim of Bank of Italy Governor Antonio Fazio is to push rates lower towards the average which will operate in the euro-zone from next year. If the markets continue to believe that Italy is in EMU bar a little Dutch shouting at the May summit, this should be achievable.

Once inside euro-land, the future for Italian fiscal policy could be extraordinarily rosy. Short-term rates controlled by the European Central Bank are likely to drop to at least 4&percent;, while the German/Italian bond yield gap (or 'spread') should narrow further.

Because of Italy's long history of high and volatile inflation, governments have tended to borrow from the capital markets only for short periods rather than the long 'maturities' favoured by most other developed countries.

With the prospect that inflation would slow, the treasury was reluctant to sell bonds to investors in return for cash at a fixed rate over a long period, if it could refinance the debt within a few years at a lower rate.

As a result, two-thirds of fixed-income Italian public debt has a life of less than five years or has - in the case of their certificati di credito del tesoro - a span of seven years at a floating rate. This means that falling short-term interest rates alone will wipe billions of ecu off the government's bills.

But what if the unthinkable happens and Italy is voted out at the Brussels summit? What if the faction typified by the 155 German economics professors gets the upper hand and compels Italy to serve a short apprenticeship outside the euro-bloc?

Ask Italy-watchers this question and they will always preface their answers with the same rider: well, it will not happen. But if it did, the immediate reaction would be dramatic.

If Italy is excluded, market participants would probably sell the bonds and short-term lira deposits they have stocked up over the past year on the expectation that the country would join EMU, short and long-term interest rates would rise, and the lira and share prices would fall.

“There would be a widening of bond yield spreads at the ten-year mark, which would stabilise around 1.5-2 percentage points,” says Jose Alzola, an economist at investment bank Salomon Smith Barney. “That is narrower than it was before the market started to believe Italy would be in EMU, and that is largely because of real improvements that have been made in the domestic economy.”

Riccardo Barbieri, an economist at Morgan Stanley & Co International, spells out the consequences. “A conservative estimate would put short-term rates two percentage points higher - that is to say they would not fall to the 'core' level of 4&percent; but stay closer to 6&percent; - adding to the budget deficit by at least 0.5&percent; of gross domestic product. Progress after that would depend on how quickly the Bank of Italy was ready to cut rates again.”

Exclusion from EMU would be an enormous blow to the centre-left Olive Tree coalition of Prime Minister Romano Prodi. Since his election two years ago,

Prodi, his Treasury Minister Carlo Azeglio Ciampi and Foreign Minister Lamberto Dini have staked everything on the euro.

Spending cuts and tax increases worth more than 50 billion ecu have been pushed through a coalition dependent on the erratic support of the left-wing Rifondazione Comunista, the reformed Communist Party.

Prodi once said he would resign if Italy were left in the cold. However, this truly is an unthinkable scenario. Whatever some members of the Bundesbank directorate or the Dutch government might think about Italian fiscal trickery over the past two years, they certainly do not want to kick Prodi while he is down.

If Italy is asked to stay outside the first wave, it will be with a cast-iron guarantee that membership will follow in time for Botticelli's Venus to grace the 50-cent coin in January 2002. If Prodi is prepared to accept a face-saving solution, then this could hardly be bettered.

“The coalescence of the government would be tested,” says Barbieri. “Those who are wanting to return to the old ways could win the upper hand and the opposition could reunite. They would say: this government has imposed a lot of fiscal sacrifice and it has failed.”

However, Prodi could use the disappointment of failing to qualify for the first wave of EMU to accelerate the kind of thoroughgoing reforms of the pensions system and the structure of publicly owned companies which the Germans and the Dutch have been demanding.

The unthinkable might be a feasible proposition after all.