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Italian Lira Re-Admitted into European Union

News

On November 23, the European Union’s 15 finance ministers agreed to allow the Italian currency to rejoin the group's currency grid. This raises Italy's hopes of being part of the first wave of European Union countries to adopt a single currency in 1999.

 Graphics: lira vs. D-Mark, Graphics: lira in the last 5 years

Analysis

What is ERM?
The exchange rate mechanism (ERM), or the currency grid, is a system that limits currency fluctuations to a range of 15 percent in either direction. It is one of the Maastricht agreement’s criterion. According to the treaty, countries must show that they have met the criteria by early 1998.

The grid is intended to reduce volatility among European currencies by allowing the currencies of member nations to fluctuate within 15 percent.

Currently, 11 of the 15 European Union currencies are in the grid: the German mark, Austrian schilling, Dutch guilder, Danish krone, Irish pound, Spanish peseta, Portuguese escudo, Finnish markka, and the Belgian, Luxembourg and French francs. The Greek drachma and Swedish krona have never been part of the grid. The British pound was forced out of the mechanism in 1992 during the same crisis that forced out the lira.

Implications
The re-entry of the lira, which fell out of the currency band four years ago, was crucial to Italy's acceptance into the monetary union, or euro, by the starting date of 1999. It is a sign of confidence that Italian authorities are serious about imposing monetary and budgetary discipline, something that several member states have questioned.

Other membership criteria concern inflation, interest rates, public deficits and public debt.

Some analysts indicated that the struggle over the lira was just another sign that the race toward monetary union is getting ugly. Not only Italy, but Spain, France and even Germany are having trouble meeting the guidelines set down by the Maastricht treaty for a single currency, to be known as the euro. A particular problem for governments is the requirement that public deficits be no more than 3 percent of the gross national product.

Set Rate
Italy was forced to settle for an exchange rate that pegged the lira at 990 lire to the German mark (D-Mark), a level that was slightly stronger than the 1,000 lire level sought by many Italian business and government leaders. A high exchange rate might hamper Italy's recent boom in exports, as Italy’s exports become more expensive relative to other countries.

It is widely believed that the rate setting had some political undercurrents caused by French and German resentment over the benefits reaped by Italian exporters after the lira's devaluation in 1992, and, from the Italian point of view, there are grounds for a conspiracy theory.

Italy’s Economic Conditions

Real growth may be less than 1 per cent for 1996, and recovery hopes for 1997 are fading fast. However, inflation has now fallen below the British rate.

Italy’s debt, totaling 125 per cent of Gross Domestic Product (GDP), represents only part of the government’s obligations. The present value of unfunded future pension deficits amounts to much more than another 100 per cent of GDP.

Many investors believe that the government will default on part of these social security promises, but will fully honor the contractual debts. In fact, credit rating agencies are now calculating that, post European union, high-quality Italian private sector borrowers would enjoy a better rating than the government.

Alternatives such as pension cuts anger a lot of voters - and in Italy, they vote often. But so does debt restructuring or default also angers voters, as Italy’s debt has almost entirely been held domestically, and largely by private investors.

Market’s Reaction
On the day following the announcement, November 25, the lira closed in London at L989.8 to the D-Mark, L9.4 higher than the previous day’s close. The market had expected the currency to rejoin the mechanism at about L1,000 to the D-Mark.

The lira has depreciated about 30 per cent since speculative attacks forced it, and sterling, out of the ERM in September 1992. Its central parity was then L802.5 to the D-Mark.

Sources: New York Times (November 25 and 26, 1996), The Financial Times (November 25 and 26, 1996).