Italy fights to prove that budget recovery will last

Date: 02/10/1997

By Tim Jones

AS THE long-reluctant UK edges tentatively towards signing up to a single European currency, Italian plans may be about to unravel.

Within the next three weeks, Premier Romano Prodi's government will have to prove to the monetary decision-makers in Germany and France that it is worthy of swapping the lira for the euro in January 1999.

On the face of it, Italian chances are good. The behaviour of the financial markets suggests Italy has all but made it. The interest rate which Rome pays investors to hold on to its debt - the surest sign of macroeconomic 'convergence' with Germany - has collapsed. Rates are now only 1&percent; above those in Germany, compared with nearly 7&percent; two years ago.

The budget deficit, which must be cut from 6.6&percent; of gross domestic product last year to 3&percent; this year if Italy is to qualify for EMU, looks as though it may even dip below the key threshold.

The problem for Prodi is that his EU colleagues have made it clear they are equally concerned with the 'sustainability' of Italy's improved performance: something they are required to consider by the Maastricht Treaty.

This means the country's hugely expensive welfare system must be overhauled before the German financial establishment and Europe's central bankers will take Prodi's convergence seriously.

Massimo Russo, a top official at the International Monetary Fund, made it clear last week that true sustainability was essential if Italy's membership application was to be considered in May next year when the short list of EMU members is drawn up. “If Italy fails to introduce such measures, the EU partners will have their doubts,” he said.

The key to pleasing the critics is the 1998 budget, which is currently the subject of tortuous triangular talks between Prodi, his far-left ally in parliament Communist Refoundation and the labour unions. While most of the plans for slicing 13 billion ecu from next year's budget appeared to have been approved, the three sides cannot agree on pension reform and Communist Refoundation plunged the government into crisis this week by announcing it would vote against the budget.

This, combined with scepticism that the government can recover as much as it claims from fighting tax evasion, is giving rise to serious questions about allowing Italy into the euro-club.

The French, on the other hand, have almost assured entry with publication of the government's 1998 budget. While acknowledging again that meeting the 3&percent; budget deficit target this year would be impossible - it will be 3.1&percent; of GDP instead - Finance Minister Dominique Strauss-Kahn played the sustainability card by promising to hit 3&percent; in 1998.

At the same time, he managed to keep some of the government's Socialist credentials intact. Although public spending will be kept to a tight 1.4&percent; growth level, expenditure on job creation schemes will rise by 3.5&percent;, of which 1.2 billion ecu has been earmarked for youth employment programmes. The bulk of the 2-billion-ecu worth of tax increases will be borne by companies rather than people with votes.

Even the UK is getting in on the act. The stock market rocketed and the pound fell late last week after a member of the cabinet planted a story in a newspaper indicating that the government was becoming more favourably disposed towards joining EMU in time for the appearance of euro notes and coins in January 2002.

The anonymity of the source allowed the government to deny it, but the story achieved its aim. The markets and the people now believe it is true, and this has succeeded in pushing down sterling and taking some of the heat off hard-pressed exporters.