Forex

LONDON (Thomson Financial) - The euro's storming run has increased the pressure on Italy's struggling producers, leaving the country a stark choice if it wishes to avoid continued economic decline -- summon enough political consensus to carry out painful economic reform, or abandon the single currency.

Forecasts that Italy could be forced to exit the euro zone have been doing the rounds from the time the euro came into existence. Speculation intensified as the currency began to strengthen -- with former prime minster Silvio Berlusconi even going so far as labelling the single currency 'a disaster'.

His calls came as the euro was trading at 1.30 to the dollar. Now, with the US economy tumbling, the single currency is hitting record highs above 1.50 usd, and the Italian economy is continuing to lose export share against the might of Asia -- against which it competes directly in low added-value products like textiles.

The scale of the economic reforms Italy would need to reverse this situation is vast, making it clear why a switch from the euro to a new, devalued currency seems so tempting. But analysts say in no uncertain terms that the move would be fraught with danger and complications, and prohibitively expensive.

'Italy hasn't had a happy experience with the euro zone... but the costs of leaving could really be enormous,' said Simon Tilford, chief economist at the Centre for European Reform, a pro-European think tank.

Economists point out that Italy's already sky-high debt would rise even further if it left the euro zone, because servicing costs would jump. Spreads on Italian government bonds, already wide to reflect the parlous state of the economy, would likely grow further, and bank customers would pull their deposits out in droves to avoid the mass devaluation that would come with a new, less sturdy currency.

'Even serious rumours of such a move would probably cause a banking crisis, with a massive run on Italian banks,' said Tilford.

But unlikely as a withdrawal from the euro zone may be, the alternatives for Italy are hardly palatable either. What the country needs, analysts say, is an economic overhaul.

'The problem for Italy isn't the euro, it's structural,' said Dario Perkins, chief European economist at ABN Amro.

'You have lots of small and medium-sized companies producing low-value-added goods like clothing and footwear ... the country is struggling to deal with global trends,' he said.

While other euro zone economies - most notably Germany - have adapted to a new economic environment, shifting production to high-value areas like renewable energy and other capital goods that are in high demand in China and elsewhere, much of Italy's manufacturing base remains in low-added-value areas like textiles and ceramics.

This puts it in direct competition with China and other developing nations, but with none of their low-cost advantage.

Furthermore, the predominance of small, family-run firms means Italy's

productivity and competitiveness are severely limited compared with the major corporations domiciled in other countries.

'What Italy has to do is boost productivity growth, as a matter of urgency,' said Tilford at the CER.

The country's fractured political system, though, makes it difficult to gather enough political will to bring about the major economic reform necessary.

While Spain, which is facing comparable economic headwinds, has a fairly strong government to steer the economy, Italy is in a near power vacuum following the resignation of prime minister Romano Prodi in January. His coalition government lasted 20 months before collapsing - making it one of the longest-lasting of the 60-plus governments Italy has had since the second world war.

There are other structural problems. Katrin Robeck at Moody's Economy.com notes that the Italian education system struggles to compete with the likes of Germany or the UK.

The massive complications associated with abandoning the euro zone or carrying out major economic reform make it a real possibility that Italy will do neither, and continue to suffer as its market share of global exports dwindles.

'This wouldn't be great but it's by far the most likely outcome,' said Tilford at the CER. One other source of relief for Italy's exporters, of course, would be a weaker euro. Indeed, the European Central Bank is widely expected to begin lowering the cost of borrowing later this year to protect the economy, leading to a likely drop in the value of the currency.

But it would presumably take a great deal of weakening to ease Italian businesses' concerns.

While economists point out that talking about dropping the euro is entirely different from actually doing it, the pressure for Italy to take drastic action can only grow as its exports continue to suffer.

Gabriel Stein, director at Lombard Street Research, noted that Italy has suffered multiple periods of recession since joining the euro, and its growth outside those periods has been extremely sluggish.

After time, the pressure to leave could tip the country into taking the plunge, he said -- attributing a 'high probability' of Italy quitting the euro zone at some point in the not too distant future.

'It would certainly be very painful and there would be a lot of problems (with leaving), there's no question about that,' said Stein.

'But you might get to the stage where the pain of leaving is simply less than the pain of staying.'