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Authorized for public release by the FOMC Secretariat on 2/3/2021



April 20, 1976


Federal Open Market Committee


Arthur L.


Attached for your information is a memorandum by
Mr. Lubitz of the Board's staff entitled "Recent Italian


Authorized for public release by the FOMC Secretariat on 2/3/2021


Office Correspondence

Mr. Reynolds


Raymond Lubitz



19, 1976

Recent Italian Developments


The Italian lira has continued to show weakness in the past
few weeks and has fallen to new lows.

On February 27,

the last market

day before the Bank of Italy resumed official exchange-rate quotations
and began a policy of limited intervention, the lira traded at 771 per

(On January 19 before the Bank of Italy withdrew from the market,

the rate was 685).

The lira was subjected to substantial downward pressure

because of large capital outflows during March (when official quotations
resumed and at the time of the franc crisis) and to extreme pressure in
April, reaching a low of 912 per dollar on the European exchanges on
April 12.

(By April 19 it had recovered to 877.)

The effective

depreciation of the lira since mid-January has been about 15 per cent.
The proximate cause for the latest selling pressure is undoubtedly
the political situation and the increasing likelihood of elections in
June, a year earlier than required.

The economic crisis is the underlying

cause for the political crisis, and the capital outflows are probably due
to fears of Communist entry into the Government.
The Current Economic Situation
As the exchange crisis has been unfolding, economic activity
has been showing some signs of improvement. The industrial production

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-2index in the last quarter of 1975 was at 109.5 after having reached a
low of 103.6 in the previous quarter.
1974 Q-II).

(Its previous peak was 122.9 in

In the first 2 months of 1976 industrial production continued

to grow and the index averaged 111.9 in January and February; if such an
improvement is sustained (but there are reasons to doubt it will be), it
would indicate that recovery was quite strong.
The recovery in activity has shown up in the worsening of the
balance of trade. The balance had actually moved into surplus in mid-1975
but recorded an average monthly deficit of 322 billion lire, about $470
million, (customs basis, NSA) in the fourth quarter of 1975 and an average
monthly deficit of 390 billion lire, about $530 million, for January-February
of this year.

Since the recorded trade accounts do reflect illegal capital

outflows (via overinvoicing imports and underinvoicing exports), part of
this worsening trade deficit may reflect an intensification of capital
outflow; but it is very likely that a good part of it reflects the
improvement of activity and restocking.
The real causes for the gloom about the prospects for the Italian
economy cannot be found so much in the above figures but in the course of wages
(and unit labor costs) and prices, the public sector deficit and the political
situation. As far as the political situation is concerned, the Christian
Democrats are presently governing in Italy without a majority in Parliament
and are dependent on the abstention of the Socialists.

Because of a fight

over the abortion issue, but more fundamentally because of disagreement
over economic policy, the Socialists are unwilling to maintain the existing

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arrangements and have decided to push for early elections.

The Communists

are expected to make substantial gains in these elections, and the
Christian Democrats may be forced to accept them in the government.


if early elections are not held, the great political uncertainty now
existing is likely to be harmful to confidence, discouraging investment
and leading to capital flight.
Inflationary forces have begun to strengthen again.

The WPI,

which had been nearly flat during the second half of 1975, began to
accelerate in December; it rose 6.3 per cent for February over December,
and by 3.1 per cent in February alone.

The CPI which decelerated from an

annual inflation rate of 25 per cent (end-1974/end-1973) to about 10 per
cent, has begun to accelerate again, although not yet as sharply as the
WPI. Wage increases have outstripped the CPI, and wage rates rose by
about 20 per cent in the 12 months ending in December 1975.

The wage-

escalator, which offsets about 90 per cent of cost-of-living increases,
puts a floor under wage increases for 1976.

The recent depreciation of the

lira will also feed back on to prices, directly and through the wage
escalator; (the IMF Staff estimates that for every 10 per cent depreciation
of the lira prices rise, at a minimumby 4-1/2 per cent).

In addition,

major wage negotiations covering a large part of the labor force, have been
dragging on since the end of last year and may give another substantial
boost to wages.

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The Treasury cash deficit increased last year to about 14.2
billion lire (GDP was 112.3 trillion lire), and was perhaps appropriate
in view of the weakness of aggregate demand.

However, the central bank

financed 8.8 trillion lire of this deficit, and this was the major cause
of the large increase in monetary base which rose about 19 per cent in
the 12 months ending December 1975.
nearly 24 per cent).

(For the same period,M 2 increased

The Italian authorities have since January


a series of steps to reduce the public sector deficit and liquidity of
the economy.

Fiscal measures (mostly indirect tax increases), which

are expected to raise about 1.5 trillion lire, have been announced.
Monetary policy has been continually tightened; discount rate has been
raised in 3 steps from 6 per cent to 12 per cent and reserve requirements
have been increased.

Market interest rates have responded dramatically

to the monetary tightening -- the 3-month interbank rate has risen from
7.7 per cent in January to 18 per cent in late March, and was 16.75 per cent
on April 15.
Official Reserves
The Italian external position as of the end of 1975 is shown
in Table 1. While comparable details for 1976 are not available, major
recent developments affecting the Italian reserve position can be

Since the beginning of the year Italy has drawn $500 million

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Table 1
Italian Net Foreign Position

($ Million)

Net Official Reserves
Gold ¹
Convertible Currencies
Short-term Liabilities
Net Medium and Long-term Position


IMF Stand-by ²


IMF Oil Facility ²
EC Credit
German Gold Loan
Other (Incl. Exch. Adj.)


Total(Bank of Italy/Italian Exchange Office)
Commercial Banks Net Foreign
Total Position(Bank of Italy/Italian Exchange
Office and Commercial Banks)
Compensatory Euro-currency





e/ Estimate.

Details may not add to totals because of rounding.
¹ Valued at official price of 242.22 per ounce.
² Valued at $1.20 per SDR.

³ Borrowing by Italian state-controlled corporations for balanceof-payments purposes.


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-6on the Federal Reserve swap, the $500 million of the German gold loan
that was previously repaid was reborrowed, and $450 million from the
$1 billion EC loan has been received.

Also during this period, the

Italians have spent about $1.5 billion in exchange market intervention.
Presently, we estimate that Italy's foreign exchange holdings amount
to about $1.2 billion.
While Italy is due to receive the remaining part of the
$1 billion EC loan soon, these funds will be needed to repay the
outstanding drawings on the Federal Reserve swap.

The other source of

official credit that appears to be available is approximately $520
million from the IMF stand-by.¹

But negotiations between the IMF

and the Italian authorities have not been concluded, and it is not
clear whether the Italian authorities will be able to agree to the
terms that the IMF staff thinks necessary concerning limits on the
public-sector deficit and wage increases.

We have received reports that European countries are putting together
a $1.9 billion swap line for Italy, of which $750 million may be made
available immediately.


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It is extremely difficult at the present time to determine
the likely development of the Italian economy this year.

The Italian

authorities had made economic projections in March 1976 based on the
conditions laid down by the EC.

These conditions (which refer to the

12 months ending March 1977) and data for 1975 are shown below.
Table 2
Italian Financial Indicators: 1975 Actual and 1976 EC Conditions
Accepted by Italian Authorities
(Trillions of lire)

Central Government Expenditures
Treasury Cash Deficit
Domestic Credit Expansion
Bank of Italy financing of Treasury Deficit
Nominal GNP


EC conditions
March 1976



Estimated by FRB staff.
Italian officials had estimated that these conditions would imply

for 1976:

1 per cent real growth, a 15 per cent increase in the GDP

deflator, a 5 per cent fall in real investment and a $500 million current
account deficit.

However, according to IMF staff members who participated

in the Fund mission to Italy that is negotiating the new stand-by, there
is a great deal of doubt concerning these estimates; the political situation
and the uncertainties surrounding the labor negotiations make any forecast
highly uncertain.

The IMF staff also thinks that while it is not


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-8inconceivable that the Treasury cash deficit limit in the EC conditions
can be met,

it might only be done at the expense of a greatly enlarged

deficit in 1977.

(The Fund's desire for assurances that the 1976 deficit

will not be at the expense of the 1977 deficit is a major stumbling
block in the negotiations).
Although hard forecasts cannot be made, it appears very likely
that the EC conditions would impose a substantial degree of tightness on
the Italian economy and might eliminate the chances for any real growth
this year.

The domestic credit expansion (DCE) target had already implied

a rate of monetary expansion which, with the GDP deflator increasing 15
per cent,would produce 1 per cent real growth; the current Fund staff
guess for the deflator for 1976 (year-over-year) is 23-25 per cent and
perhaps 30 per cent on an end-year basis!

With the same DCE target this

rate of price increase would imply that the degree of tightness would
be greatly increased.
The Fund staff does not think that the Italian estimate for
a $500 million current account deficit is unreasonable, although it might
be a little too low. The lira's depreciation ought to stimulate exports;
however, the Bank of Italy staff finds it difficult to make forecasts
because of the great uncertainty whether wage increases will offset the price
advantages of the depreciation.

However, the real issue for the balance

of payments is not current account but capital account, and here the
political and economic uncertainties are the major determining factors.

Authorized for public release by the FOMC Secretariat on 2/3/2021
The great fear now is that the Italian economy is caught in a
cycle of depreciation and inflation.

Lira depreciations feed back onto

the price level making further depreciations necessary.
The economic case for substantial further assistance to Italy
depends on the Italians' ability to set-up a credible economic program.
Such a program would include limits on the public sector deficit and
monetary expansion and a reduction of wage increases.

The latter is

essential if Italy is to avoid a cycle of wage and price increases and

The Italian authorities realize that wage restraint

is essential and are trying to face up to the problem, particularly in
regard to reducing or freezing the wage escalator.

Success in this

area and a more stable political situation are central to achieving
economic stability.

Without a credible program, there is a great risk

that additional assistance to Italy used to support the lira would be