If French voters reject the Maastricht Treaty on 20 September, few observers are willing to bet that the lira will escape devaluation. And although the lira is not the most important currency in the EMS, there is more than an outside chance that a devaluation would cause general upheaval.
For decades, rampant political corruption and unstable governments spurred unparalleled fiscal profligacy. But rarely did it seem to hurt the country's economic standing, or affect the credit rating of Italian bonds.
Today, however, Italy is caught in a debt trap. Only the threat of a financial crisis has driven parliament to support the new reformist government of Giuliano Amato, which has a potentially unstable majority of just 16 seats.
The country has reached the point where the financial community is no longer willing to tolerate increased budget deficits, which boost Italy's horrendous national debt even further.
The annual deficit stands at 10.8 per cent of national output and Italy's public debt is a record 104 per cent of output. On some estimates its total public debt accounts for about one-third of all European debt.
This spring, political and financial events conspired to signal that the party was over and that Italy was approaching bankruptcy.
First, the three-month political hiatus after the April elections focused world attention on Italy's fiscal crisis. Then the Danish rejection of the Maastricht Treaty removed the assumption that the Italian government would meet the treaty's guidelines on national debt - reducing it to about 60 per cent of national output by 1996. Italian interest rates jumped, reaching almost 18 per cent at one stage, and added the equivalent of pounds 700m for each additional percentage point to Italy's debt-servicing costs.
According to Giorgio Radaelli, Italian economist for Shearson Lehman: 'The Danish rejections of Maastricht cost Italy about pounds 1.4bn. Can you imagine how much a French 'no' would cost?' No wonder talk about devaluation, increasingly prevalent in Italy these days, is so expensive.
Inevitably, leading credit-rating agencies began to downgrade the status of Italian debt - the first G7 country to be ejected from the triple-A rating club. Italy was stuck in a vicious circle of mounting debt, higher interest rates, boosting the stock of debt once more.
The new government must transform this increasingly unstable situation into a virtuous circle; if the budget deficit is reduced loan rates will fall, cutting interest payments in their wake and curtailing the growth of the national debt. But the task is enormous.
Debt interest accounts for virtually all of Italy's budget deficit. Excluding interest payments, the country boasts a small budget surplus. So the obvious route to adjustment lies in reducing the stock of debt.
In practice that means cutting deeply into Italy's public spending on pensions, health care, public sector pay, local authority spending and subsidies to the South. This is difficult, because so many jobs are the result of patronage, and because so much money disappears into kickbacks.
The powerful upward pressures on spending - in pensions because of demographic change, in local authority spending because of corruption and the absence of caps - are at the root of Italy's fiscal crisis.
But reducing the stock of debt would also mean embarking on a massive privatisation programme.
To restore revenues, effective measures are needed to curb tax evasion. Several attempts to widen the tax net have proved ineffective because of widespread evasion. And while the government wants to raise taxes, several Italian economists believe the tax burden - already more than 40 per cent of national income - should be redistributed towards those who do not pay, rather than increased.
Stefano Micossi, research director of Confindustria, the Italian employers' association in Rome, said: 'Our economy is the Polish economy of the West; a very rigid, subsidised and protected economy.'
Mr Amato's government, heavily influenced by the independent Bank of Italy which stands out as beacon of financial sanity, has taken the first tentative steps towards change. The 1992 budget deficit was originally projected at L128,000bn ( pounds 60bn), but threatened to balloon to between L180,000bn and L190,000bn.
So Mr Amato introduced an emergency package of tax increases and spending cuts. As a result, the deficit should be L160,000bn to L170,000bn.
Much more significantly, he secured the agreement of unions and employers to scrap the infamous scala mobile system, in force since 1947, which indexed wages to the rate of inflation.
The achievement has raised hopes that Mr Amato will prove even braver in his ultimate demands for spending cuts. 'What was considered unthinkable was feasible,' said Mr Micossi. 'Amato should try again.'
By scrapping the scala mobile the government strengthens its hand in securing public sector wage awards no higher than the 3.5 per cent 1993 inflation target. Many private economists now regard as credible the government's forecast that inflation will ease to 2.5 to 3 per cent from about 5.5 per cent in the next two years.
Lower inflation should lead to reduced interest rates and a lower debt servicing burden, to say nothing of gains in competitiveness.
The government hopes that this measure will help to drive down the budget deficit. But, while lower inflation will ease the burden considerably, it does nothing to reduce the stock of debt.
Mr Amato has secured umbrella 'decree laws' which will enable the government to make detailed spending cuts. But on the evidence of preliminary plans for the draft 1993 budget, which will go to parliament next month, little will be done to curb the growth in pension spending. The stress on tax increases sidesteps the problem of underlying spending pressures.
Even worse, initial efforts to embark on privatisation have run into trouble. Mr Amato wanted to bundle the wide array of state companies into two superholdings, turn them into limited companies and privatise them. But when Efim, the third largest state holding company, announced it would not pay its debts, the plan ran into trouble.
Although the Efim decision was hastily reversed, bankers objected that it could downgrade the status of publicly owned corporate debt, which had hitherto enjoyed the status of government paper.
Since then, Efim has been liquidated. But the government has gone ahead with the conversion of Italy's four largest public sector groups - IRI, ENI, ENEL, and INA - into limited joint stock companies. Their boards have been significantly reduced and stripped of political appointees.
It is an important first step. But the hurdles to privatisation are immense. Many of the state companies are saddled with big debts which make them unsuitable candidates for early privatisation.
But as with everything in Italy, politics offers the biggest obstacle. Support for privatisation in Italy's two biggest parties, the Christian Democrats and the Socialists, is fragile and resistance to change is entrenched.
But if Mr Amato is brought down in the autumn there will be new elections in which the Christian Democrats and the Socialists could lose seats. As one senior Bank of Italy official remarked, 'Mr Amato's weakness is his strength. That is why we think he has a chance.'
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