Lira aims for stamp of approval

Date: 09/05/1996

By Tim Jones

FINANCIAL markets are fickle things.

In Italy last month, a motley crew of former and current Communists, Christian Democrats and a brand new party founded by the outgoing prime minister won a majority in both houses of parliament.

In normal circumstances, the Olive Tree coalition led by Bologna University economics professor Romano Prodi is just the kind of wobbly alliance that markets hate.

A creaky centre-left grouping would usually have them selling their lire and Italian securities pronto.

This time, they loved it. The Milan stock market added 4&percent; to its value in a day, while the lira rose by almost 2&percent; against the deutschemark.

Much of the currency's gains could be put down to the real prospect that the lira will be brought back into the Exchange Rate Mechanism (ERM) that it left, together with the British pound, back in September 1992.

Prodi, a true enthusiast for ERM membership, advocated “serious, rapid re-entry” for the lira within 48 hours of his election victory.

The idea has got currency dealers terribly excited. But what does it actually mean when a currency rejoins a system that allows it to fluctuate within a 30&percent; band?

Between 1979 and 1993, the prospect of a currency joining the ERM caused a frenzy in the foreign exchange markets. But that was when the currency grid really had a bite.

In those days, most currencies were assigned a central rate against the Ecu and - through the Ecu - with every other member in the mechanism, and were allowed to fluctuate by 2.25&percent; either side of this (6&percent; for the Spanish peseta, Portuguese escudo and the pound).

If a currency fell to its floor against any other, both relevant central banks were guaranteed buyers of the weak unit and sellers of the strong one to any market participant. Credit was passed on to these central banks so that they could (theoretically) buy unlimited amounts of the weak currency.

The weak currency authorities might be expected to raise interest rates as well to defend their parities, while the strong currency central bank could also loosen its monetary policy.

This was a mechanism with teeth. The so-called 'speculators' could be defeated (once again, in theory) by the determination of monetary authorities.

In practice, market pressure against currencies was seen off by the combination of interest rate changes and foreign exchange intervention. But, while the authorities won the battle, they lost the war.

In 1992, the Italian authorities simply lost the confidence of the people who kept them afloat.

In July, a rise in German interest rates was met with a hanging-tough 1.25&percent; increase in rates from the Bank of Italy, but unfortunately this had a perverse effect. Instead of instilling confidence, it simply highlighted Italy's perennial problem: its gigantic public debt worth more than 120&percent; of gross domestic product.

While the government of Giulio Amato was pushing through huge and politically difficult budget cuts of more than 40 billion ecu, the central bank was effectively wiping out these gains with an interest rate rise.

This was because Rome was paying for the errors of its predecessors. While current state revenues were outstripping spending, more than 8&percent; of national income was going straight into the pockets of the country's creditors through interest repayments on old debt.

If sustaining a parity of 748 lire per mark meant adding billions to the public debt, then it was not worth the effort. Dealers sold their lire 'short' - in the hope of buying them back later once the currency had devalued to a cheaper rate - and Rome's 13-year membership of the ERM came to an end.

When the speculative contagion spread right across the currency grid a year later, the authorities chose to widen all the bands to 15&percent; either side of the central rate - bands so wide as to be flotation by any other name. The good old days of heavy Bundesbank intervention to protect a currency's ERM parity were over.

So why all the debate about whether and when the lira will come back? With a full 30&percent; band and no intention on the part of the big boys to defend the parities, what difference does it make? The lira has been trading well within 890-1,200 per mark bands since last summer (see chart) - and this is what the 15&percent; bands will be if Prodi gets his way and the lira is given a central rate of around 1,050 per mark.

The answer is appearances. If Italy is to escape from its debt cycle - and incidentally qualify for monetary union - the Prodi government must keep down the cost of financing it. That means long-term interest rates must fall and, crucially, the Bank of Italy's high short-term interest rates must also be cut.

To achieve this, Prodi needs credibility with the Bank of Italy and its independently minded governor Antonio Fazio, with the EU and, through it, with international investors.

Rejoining the ERM would be a stamp of approval. Even though the lira would have huge scope for volatility, it would not be expected to use it.

“It's like getting married,” says Alison Cottrell, economist at investment bank PaineWebber International. “By joining, you are making a public commitment and while you might stray, you fully intend not to.”

But first, Prodi and Olive Tree will want to get a few victories under their belts. Despite this year's stringent budget cuts, everybody now accepts that higher than expected interest payments will cause the 1996 budget to overrun by 5 billion ecu.

Prodi has already promised a supplemenary budget, coinciding with an early round of spending cuts and tax increases for 1997. The earliest this can be done is June. It will be the first real test of the alliance and how much it needs to rely on the unreformed Communists in the lower house.

But if Prodi tries to rejoin the ERM without sorting out the budget first, it is just possible that Fazio will stamp his feet and not deliver the much-needed interest rate cuts.

The choice of central rate will depend as much on Germany and France as on Italy. The lira is widely believed to be undervalued at its current rate and fundamental analysis suggests 950 per mark is a fairer value.

As much as two-thirds of Italy's staggering trade surplus - 20 billion ecu last year - is thought to result from the lira's undervaluation. The last thing the Germans and the French will want is even to give the appearance of locking in this competitive advantage for the Italians.

They need not worry of course. If Prodi manages to stay a five-year course and gets the budget deficit to 3&percent; of GDP by 1998-99, the lira could well be testing the higher regions of its ERM bands.