Markets: Italy diets hard to stay in the Club Med sun

Italy is finally coming out of denial on its chances of being in the first group of countries joining the single European currency at its start date in 1999.

With fewer than 415 business days remaining until Europe is scheduled to adopt a common currency, Italian Prime Minister Romano Prodi is beginning to acknowledge something investors have been trying to tell him in the bond market - Italy's European neighbours aren't going to allow it to join the EMU club when it opens for business.

Earlier this week, Prodi tacitly entertained the possibility his country won't make the grade, threatening that "if Italy were to be the object of a negative decision, it would be determined to use all the political instruments at its disposal" to disrupt the process.

While there's not a lot Italy could do to force its fellow Euro-enthusiasts to let it in, the fact Prodi feels the need to mutter threats shows he's starting to get more rattled as the date for membership applications to be decided approaches.

The countries allowed to join EMU will be chosen in April or May 1998 in a vote by EU heads of government, ostensibly based on whether they meet the economic targets laid out in the Maastricht Treaty, including limits on budget deficits, inflation and interest rates.

To be selected, a country must win 70 per cent of the votes cast. Each nation's vote is proportionate to its population, with Germany, France, the UK and Italy carrying 10 votes each - more than other EU nations.

The unspoken concern of EU leaders is that while Italy, Portugal and Spain - dubbed "Club Med" by economists because their economies are perceived to be closely linked - are all striving to meet the targets, Italy won't be able to sustain its recent economic performance.

If Italy gets in, and then its budget deficit soars, it would undermine the newly born euro, and the whole project could come crashing down.

With Prodi talking tough on what he'll do if only Italy is barred, EU leaders could face a tough choice - let Italy in, or exclude Club Med altogether even though Spain and Portugal are much stronger candidates.

"If Spain completes the criteria and Italy doesn't, there will be no argument to keep Spain out," said Alfredo Fernandez, fixed income fund manager at Sogeval, the fund management unit of Spain's Banco Popular. "The treaty doesn't contemplate the possibility that a country completes the criteria and stays out."

The bond market remains highly sceptical of Italy's chances. Fund managers currently demand a yield premium of more than 150 basis points to invest in 10-year Italian government bonds rather than German bonds, Europe's benchmark. That's almost double the 80 basis point premium demanded by investors in Spanish and Portuguese bonds - both of which are at record lows.

Differences in the debt yields of countries joining monetary union should disappear, because they'll all be denominated in the same currency, reducing the risk of currency movements wiping out value.

Among shorter-dated securities, those closer to being repaid at the EMU start date, three-year Italian bonds yield 250 basis points more than German debt, well above the 135 basis point premium on three-year Spanish bonds.

Forward rate curves, which analyse what today's bond yields indicate future bond yields will be, show three-year Spanish bond yields moving to within 60 basis points of German yields by the beginning of 1999.

Italian yields, however, are expected to remain more than 150 basis points higher.

"The market at the moment certainly reflects that Spain is more in than Italy," said Banca di Roma economist Alfredo Granata. "If Spain gets in and Italy doesn't, then clearly the spread between the two will widen greatly. The spread will go to whatever the spread is between Germany and Italy."

In its April forecasts, the European Commission said it expects Italy to have a 1997 budget deficit of 3.2 per cent, rebounding to 3.9 per cent in 1998. Countries adopting a single currency are required not only to meet a 3 per cent budget deficit target, but to be able to keep it there.

Prodi told the French La Tribune newspaper earlier this week that he believes the EC forecasts are an attempt by Germany and other Northern European countries to keep Italy out of the monetary union project.

Italy's problem, whatever the truth of its conspiracy theory allegations, is that it doesn't have a good economic track record.

"Italy may be able to cut its deficit having been on a crash diet, but really it needs a constant regime of weight training and careful eating," Steve Major, head of European bond research at Credit Lyonnais said. "The problem with a crash diet is you tend to balloon afterwards."

Prodi conceded he's "willing to understand" scepticism about Italy's ability to reduce its deficit to 3 per cent this year, and admitted that German public opinion "had doubts about Italy's financial stability". Nevertheless, he repeated his assertion that Italy will meet the economic targets for 1999 membership.

With doubts remaining about whether even Germany will meet the budget deficit target, and Belgium likely to be allowed in even though its debt- to-gross-domestic-product ratio is more than double the 60 per cent limit laid down in the Maastricht treaty, analysts and investors say it'll be tough to keep the door closed on Italy, especially if Prodi starts to hammer harder in the months ahead.

"At the end of the day, it's a political decision," said Banca di Roma's Granata. "I think it would be very difficult to exclude Italy and allow in Spain." Copyright: IOS & Bloomberg