Italy set for after-shock: The interest rate rise last week has added to Berlusconi's headaches, writes Peter Torday

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The Independent Online
NOT for the first time an Italian political crisis has shaken financial markets around the world. For months there were high hopes that the fractious coalition government of Silvio Berlusconi would act to curb the country's ballooning public debt. Yet today the mood is pessimistic.

Mr Berlusconi's high-profile fence-mending talks last weekend with Umberto Bossi, his main coalition partner, have replaced financial turbulence with uneasy calm.

That is unlikely to last. Unless the deficit-cutting package sails through parliament late next month, there is at the very least a risk of another bloodbath in the Italian financial markets.

Initially, the Italian Prime Minister's targets for raising revenue and cutting spending were welcomed as stringent, even if criticised for being slow in coming. Then came the threat of a split in the centre-right coalition.

Unnerved at the prospect that the budget promises might fall by the wayside, the largely independent Bank of Italy unexpectedly announced an 'emergency' half- point rise in the Italian discount rate to 7.5 per cent. It was meant to be a warning shot across the Italian government's bows. But it sent the lira tumbling to record lows last week and prompted a sell-off in bonds.

In other ways, too, it proved counter-productive. The rate hike added roughly L5,000bn (pounds 2bn) to the government's debt service bill because debt is financed through short-term bills as well as long- term bonds. Higher short-term rates also resulted in higher bond yields as prices fell, something that raised the cost of servicing debt of all maturities.

As a result, the government is under pressure to boost its deficit- cutting package from the current proposal of L45,000bn.

Brian Mullaney, of Morgan Stanley, said: 'We were very concerned about the rise in interest rates. It was addressing the problem with the wrong remedy.'

Come September, Mr Berlusconi must define the details of his spending cuts and revenue-raising measures in parliamentary negotiations.

The July package proposed cuts of L45,000bn to reduce the deficit to L139,000bn. Many of the details have still to be worked out, which is why the cohesion of the coalition is so important to the financial markets.

Public spending cuts are to account for two-thirds of the package and should come from pensions and healthcare spending. The remaining third of the package is to be financed through higher revenues.

The axe must fall chiefly on heavy pensions spending but already some ministers are murmuring their opposition.

The government's deficit reduction plan is intended to cut the all- important ratio of government debt to gross domestic product. The government says that if its plans are carried through they will reduce this ratio from 123.6 per cent this year to 121.6 per cent by 1997.

That figure still looks dismal by comparison with the 60 per cent set by the Maastricht accord.

Worries about the government's credibility have thus unsettled the bond markets. Worse, without serious deficit reduction measures the markets will be flooded with bonds. Next year, Italy must redeem (and refinance) L180,000bn of bonds.

Growing concern that global bond markets are being inundated with too much paper has undermined markets everywhere of late, but Italy is one of the worst culprits. One analyst at a leading securities firm described Italian bonds as 'lira-denominated wallpaper'.

Some of the gloom may be overdone. However divisive the political scene, there is a growing consensus that spending must be curbed and indirect tax evasion ended. Direct tax evasion is already coming under pressure.

Moreover, the deficit-cutting process was begun in the midst of recession and succeeded in sustaining a 'primary' budget surplus, that is a surplus excluding debt servicing costs.

More buoyant economic growth today seems set to ensure that process continues.

In addition, the economic background is much brighter than when the fiscal crisis first broke out in 1992. Midland Global Markets thinks the government's growth forecasts of 1.7 per cent this year and 2.7 per cent in 1995 are reasonable.

And the inflation outlook is considerably brighter now that Italy has abandoned wage indexation. Giorgio Radaelli, of Lehman Brothers, says the 3.6 per cent inflation rate, a 25-year low, will fall further because of last year's labour market reforms.

Mr Radaelli argues that the abolition of the scala mobile, as the law indexing wages to inflation was known, has cut structural inflation by 2 percentage points. As a result, interest rates should in theory be falling, not rising.

Analysts believe the Bank of Italy's rate increase was a high-risk strategy ultimately intended to force the government to behave itself. On this analysis, passage of a deficit reduction package will be rewarded with a cut in rates, which would ease the debt service burden and improve the outlook for bonds.

'Tight yet not credible targets are better than lousy but credible ones,' Mr Radaelli says. 'Had Berlusconi chosen the loose option, investors would have surely dumped lira assets as the plan would have shown that this cabinet was fiscally irresponsible.'

All of which is cause to believe that the Italian fiscal situation may not be as dire as it is painted.

But the markets remain to be convinced. Mr Berlusconi is due to present his budget on 21 September. A protracted debate and significant concessions on spending cuts will be greeted grimly in the bond markets.

(Photograph omitted)