1/20/12

Going back to the lira? Why not !

The Monty game: How I hope he is playing.
Massimo Armanini
January 18, 2012
I dont think a lot of readers need to be convinced that, looking at the three European leaders, Merkel, Sarkozy and Monti, the last one is by far the one with the strongest economic background and most experienced in European matters.
It is also difficult to deny that the German position in relation to the Euro crisis and the risk of a meltdown is stubborn, and becoming more and more unpopular with other European nationals.
It is now widely accepted and suggested (see S&P report) that there is a need for growth, in conjunction and alongside, more rigorous fiscal policies.
Until now I guess nothing new..... but

A Modern State
Monti has fully understood that there is an imperative need to reform the Italian social and economic system. Italy is a difficult country, dominated by selfish and corporative interests, prone on one side to communism and on the other side deeply influenced by the Catholic morale. The historical reasons need not to be discussed here. It is a country where nobody, in normal times, could change the pension system, cut bureaucratic jobs, modernise the labour laws, improve the efficiency of the state machine, improve the judicial system or even increase the number of taxis.... It is a country that decided to have Berlusconi as Prime Minister (three times!!!!) and where magistrates decided not to have him. A difficult country to change and innovate.... unless .... There was no other choice.
Now, there is no other choice, because of the raising cost of funding for the Italian Republic, and so Monti is innovating. With amazing speed, doing the simple and right moves. 
Italy might have in few months a totally different set of rules governing its internal operations. Nobody managed to achieve this in the past 40 years. To see changes of this magnitude, you need to go back (God forbid!) to Mussolini.
Monti needs the external European pressure to succeed. Be reassured he has plenty....

A Positive State Budget
Monti will be close to reaching 'self sufficiency'. As we know, Italys deficit is not in a bad position as far as the annual budget before interests is concerned (with a primary surplus). Actually it is doing pretty well and with the new tax initiatives (wealth tax, VAT increase ...) it is at or close to balancing the accounts. The problem is the stock of debt - which is not a small problem - standing at around 130 % of GDP, with the accompanying refinancing risk. 
Imagine Italy did not have the old debt, it would be one of the best positioned economy in Europe (post the implementation of the Monti structural reforms!). It also means that there is little or no need to have capital flows to Italy to finance new debt, only renewal of existing debt.

Who should be worried?
Imagine the structural reforms are done, implemented, accepted by Italians, but the cost of borrowing remains high. Higher than the forecasted GDP growth. It would mean that millions of Italians had given up their democratic rights (after all Monti has not been elected), paid a high price in terms of pension rights, job security, privileges and taxes, to be .... roughly in the same position. We all know that there is no way to pay say 5% on a 130% debt/GDP ratio and decrease the stock of debt, and grow. No way.
So Germans and debt holders should start worrying.
Imagine a scenario where Monti announces that from tomorrow all Italian government bonds will be repaid when due interest and capital in Lira. The official FX rate is the same as the one used in 2002 (for simplicitys sake, lets call it 2000 Lira for 1 euro). After all, Italians gave up liras for euros at that rate.
The Bank of Italy will print as many Lira as it takes. Sorry, but if you want euros, just go to Merkel with your lira and she might change them into euros. All Italian bank deposits, domestic and international, are converted in lira automatically. The FX used is fixed at 2000 for one.

Results
If you are Italian and wealthy: you are not happy. You used to have 1 million euro and now you have 2 billion lira in your account. The FX may go to 3000 per euro and you will end up with 660,000 euro equivalent. Not happy, but you can spend it in Italy. More expensive to travel abroad, sure. De facto you paid a big wealth tax. (but this was likely to have been inevitable...)
If you are a low income average Italian: you are worried, you might be unhappy but ......you won the lottery! The economy is likely to grow fast thanks to a devaluation, job opportunities will increase, inflation will erode away part of the public debt and, this time, the structural changes in the country have been done so there is a good chance of sustainable healthy growth.
If you are an entrepreneur: great! Less taxes in the future, more export, less bureaucraty, more flexible workforce. Back to the 1960s.
If you are young: bless Monti! The old debt burden of years and years of crazy spending by past generations is mostly gone. And a brave new world to conquer!
If you are an international investor in Italian treasury: tough luck, you are not in good shape. You get a lot of liras that you try to sell, but you lose a lot on the FX. Perhaps minus 30% on your investment. De facto you paid a wealth tax to a country where you do not live. Not happy, you promise you will never invest in Italy again! Then the following week you see a promising stock in Italy and here we go ....the animal spirits kick in .... You go long. The red fish market memory strikes again.

Conclusion
Gross of complication, such as lengthy negotiations at the IMF and ECB level, documentation discussion, penalty and whatever it goes into a forced conversion case.... It is in the best interest of future Italian generations to force the conversion of all debt and all deposits into lira. 
That makes sense only after a deep reform of institutions and regulations which is already taking place. The bill will be paid by all investors (domestic and international) and the loser will be wealthy Italians, international investors and .... the German industrial/export machine that will see its currency appreciating against a new competitor.
Please Monti just do it!
Think about this Angela
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