Inflation fears turn investors towards Italy

International investors have given an unprecedented thumbs-down to Britain's economic policy.

Following the Bank of England's warning this week that base rates would have to rise, the gap between the interest rate the British government has to pay on its debt and the German government's borrowing costs widened yesterday to nearly two full percentage points.

In addition, the yield on long-term Italian government bonds fell below the yield on benchmark 10-year gilts for the first time. In recent weeks both Spanish and Swedish government bonds have seen their yields dip below those on gilts.

"It's a good thing the Greeks do not issue these bonds or there would be one last milestone," said Stephen Lewis, chief economist at London Bond Broking. "The Bank of England is being vindicated."

Kevin Adams, gilts analyst at BZW, said gilts were very good value, yielding a third more than German bunds. "But international investors just won't hold gilts at the moment," he said.

The negative sentiment in the financial markets reflects the prospect that UK inflation will pick up as the economy moves into top gear. The buoyant retail survey reported by the Confederation of British Industry on Thursday reinforced this concern.

The fact that investors now find Italian government bonds more attractive represents a remarkable turnaround. Italy has almost always had higher inflation and weaker government finances than the UK.

Mr Lewis said that Italy's inflation could be lower than the UK's during the next few months, which would make the UK inflation rate the highest among the G7 industrial countries. He said Italy was planning to halve its budget deficit to the equivalent of 3.3 per cent of GDP in 1997, while the UK borrowing requirement was likely to be 3.5 per cent of GDP.

The financial markets have also taken into account Italy's enthusiasm for the single European currency.