Arrivederci Italia: The new government will have to upset a few allies if it is to shore up the economy. James Ball reports

THE LAST 10 days have been wretched for Italy. Acclaimed in the Eighties for an economy that worked despite crazy politics, the country is finally suffering as profound structural faults begin to show.

The Friday before last, members of Milan's financial community opened their papers to find three stories jostling for space: Salvatore Ligresti, one of Italy's leading property developers and contractors, had been arrested; the Bank of Italy was engaged in an interest rate battle against the mark; and the entire board of Efim, the third- largest state holding company, had resigned.

The markets were already jittery but nobody was expecting the next revelation. At lunchtime the same day, the unthinkable was announced: Efim was not going to pay its debts. It was no less of a shock to Efim's bankers, who were sitting on exposure of nearly dollars 4bn ( pounds 1.9bn) - more than half of it to foreign banks.

'It was all done in the typical Italian way - by leaks,' said one. 'Not even a phone call to say 'Oh, by the way, we're not paying you'.' For a government desperately seeking cash to control a voracious budget deficit, it was scarcely a wise move. Moreover, it may well tip Italy another notch down in the credit ratings.

On Sunday came the bloody murder of magistrate Paolo Borsellino, the country's leading anti-Mafia fighter, and his five bodyguards in Palermo. The assassins were undoubtedly employed by the octopus of organised crime.

When the markets opened the next day, the lira, shares and bonds all came under heavy pressure. The central bank managed to support the currency - just - but bonds and equities started to slide.

Since then, the stock market has continued to slide, and on Thursday the government produced another shock - the abandonment of its proposal to group state holdings into two vast new companies in preparation for privatisation.

The Efim saga and the violence of organised crime are just the most obvious symptoms of Italy's woes. Even the Governor of the Bank of Italy, the widely respected Carlo Azeglio Ciampi, called a section of his 1991 review of the Italian economy 'The contradiction of Italy's existence'. During the 1980s the state didn't work but the economy did; now even the economy seems in trouble.

The root of the trouble lies with the government or, more accurately, with the country's myriad political parties, each disproportionately powerful because of Italy's extreme system of proportional representation. Since the last war, Italy has averaged a new government coalition every year. Each party has its own sectional interests which barter favours for each other and trust the state to pay.

But now Italy is running out of money and time. The budget deficit this year, originally projected to be 128,000 billion lire (pounds 60.8bn), is expected to verge on L180,000bn (pounds 85.5bn). At the end of last year, total government debt was L1,446,360bn (pounds 687.1bn), more than the GDP for the year. Despite repeated pious exhortations, no political party has ever grasped the nettle of controlling public expenditure and clamping down on the black economy. Too many special interest groups - all with votes - stand in the way.

Hopes were raised that the elections earlier this year could signal a new and determined direction for Italy. The demise of the Communist Party and the rise of the separatist regional leagues promised a completely new political balance: one in which a strong prime minister could undertake the necessary structural changes to streamline government and bureaucracy. The emergence of Giuliano Amato, a Socialist technocrat, encouraged the optimists.

Amato was a bold choice. He made his name as a minister with a reorganisation of the sprawling banking sector and had emerged untainted from the corruption which had enveloped his party. Moreover, he was ready for bold moves and put privatisation of the vast state sector at the top of his agenda, moving at a speed that shocked observers more used to snail-paced zigzags.

One of his first moves was to announce his intention to merge and restructure the huge holding companies. They would be turned into limited companies and subsequently privatised. Ente Nazionale Idrocarburi, the state petro- chemical group, was to be merged with the electricity utility, Ente Nazionale per l'Energia Elettrica, to create an energy giant with a turnover of nearly L80,000bn (pounds 38bn), sales of L32,000bn (pounds 15.2bn) and 240,000 employees. The new company would have been profitable, making L1,300bn (pounds 618m) on 1991's figures.

Mr Amato also proposed to bundle most of the state's manufacturing industries into a new super-group. It would have been dominated by the Istituto per la Ricostruzione Industriale (IRI), the whitest of government elephants. Established in 1933 as a vehicle to acquire the industrial holdings of the troubled banking sector, IRI had been used in the 1960s to give a strategic direction to the developing Italian economy and exploited to take over an increasingly diverse range of bankrupt companies.

Perched on a mountain of debt - IRI's is a total of some L60,000bn (pounds 28.5bn) - the company has some winners (the country's three big banks of national interest and Stet, a telecommunications company) and some losers (Alitalia and steel). IRI would have been joined in the super-holding by a number of financial institutions including Banca Nazionale del Lavoro, the bank at the centre of the arms for Iraq scandal. The resultant colossus would have had revenues of nearly L250,000bn (pounds 118.7bn) and 438,000 employees. With more than L300bn (pounds 143m) in losses for 1991, it would have been a challenge to sell.

That, however, is no longer an issue - the Efim affair has put paid to the plans.

The government's solution for the smallest of the three state conglomerates - which had a ragbag of largely loss-making companies - was radical: it decided the conglomerate was bankrupt. Gaetano Mancini, the firm's socialist head, decided that a gun was being placed to his head and wanted to pull the trigger first. He resigned, then the government closed the company.

Foreign lenders were horrified, claiming they had lent to Efim on the basis of Italian sovereign risk. They could not understand why the government should threaten Italy's credit rating at such a sensitive time, and so accelerate the country's spiral of debt. The authorities meanwhile implied that Efim was straight corporate risk and that lenders should have been aware of its difficulties.

After five days, the treasury said that interest would be paid on Efim's debts, although payment would be frozen for up to two years. This did little to change sentiment. 'Nice of them to tell us,' a foreign banker said. 'But the damage has been done.' It seems to have been partly pressure from bankers worried about the status of other state company debts that forced the government to abandon its plans. In addition, senior management from the state companies made it quite clear that they did not relish losing their power: although the government is still paying lip service to privatisation, it is difficult to see how it can be pushed ahead.

But if the government bears the biggest responsibility for Italy's current plight, private industry must also accept that its recent performance has been none too bright.

The Italian economy had been phenomenally successful in the 1980s. By the middle of the decade it had overtaken the United Kingdom to become the world's fifth-largest economic power. Foreign investors flocked to buy shares in the big industrial groupings such as Fiat, Pirelli and Olivetti.

Yet these companies' successes were more a result of a recovery from the dismal years of terrorism and the ability to sell into a booming world export economy while being protected from competition domestically than anything else. In a recessionary climate and with the single European market to come, they will face keen competition both abroad and at home.

An even bigger problem for the Amato government is the gradual loss of a dynamic small- and medium-sized company sector, traditionally the engine of growth for the Italian economy. A generation of entrepreneurs who built their companies after the war is now finding that few of its children want to follow in their fathers' footsteps: their companies need professional managers to compete.

Whether a new managerial dynamism can emerge will depend on whether Italy has a well-managed economy. At the moment, businessmen have a prime minister determined to use the honeymoon period of office to force through some unwelcome reforms even at the cost of upsetting his reluctant political allies. But, as the Efim affair illustrates, they also have a prime minister whose methods are not as slick as they should be.

Last week's events have crystallised for Italy the real problems it faces within a single European market. Mr Amato has shown he can display the courage to deal ruthlessly with his country's problems. But does he have the political support and the practical ability to get it right?

(Photographs omitted)