Country Intelligence Report 2

Country Intelligence: Report
Italy
REPORT PRINTED ON 01 MAY 2013
Created on 01 May 2013
Page 1 of 33
Page 2 of 33
This information was last updated on 30 APR 2013, 12:02 PM EDT (16:02 GMT)
Outlook and Assumptions: Outlook

With political chaos likely to be the prevailing wind in the next few months after the inconclusive election in late February 2013, our view that Italy could be in play in again with regards to the sovereign debt crisis remains a risk. As expected, the general election has thrown up a substantial no-confidence vote on the current austerity plan and the need to reform further. Nevertheless, with Italy having to tap the sovereign debt markets for at least EUR420 billion in 2013 to cover debt redemptions and any fiscal shortfall, the country will have to respond to rising market tensions, namely the increasing disquiet about the complete loss of the recent and welcome united political front with regards to austerity and structural reforms to deflect the Eurozone sovereign debt crisis. We have already seen an initial spike in bond yields, and the markets are likely to ratchet up the pressure on Italy to find a stable and working political solution to allow a resumption of its economic liberalization reform agenda. Ultimately, Italy has very little room to maneuver, still locked into a severe and prolonged economic downturn alongside still-deteriorating fiscal metrics, with the public-debt ratio climbing to an estimated 126.4% of GDP in 2012. The fear remains that political gridlock coupled with entrenched economic downturn begins to deconstruct demand for Italian sovereign demand while pushing up borrowing costs at a time when Italy faces another tough financing cycle in 2013. We suspect the Italian political classes will be under considerable pressure to take the actions needed to push away intensifying sovereign debt pressures. We cannot rule out another technocratic government being formed in the second half of 2013, though. The recession continues to deepen. Economic activity shrank for a sixth successive quarter in the fourth quarter of 2012 and at an accelerated pace. Furthermore, recent indicatorsnamely the purchasing managers' surveyssignal further contraction in real GDP in the next few quarters. With domestic spending shrinking aggressively during 2012, the near-term recovery prospects remain very bleak, with a further sharp fall in activity expected in the first half of 2013. Since we now expect Greece to exit the Eurozone in mid-2014, as opposed to our previous call of no later than the third quarter of 2013, Italy will be spared a more traumatic second half of 2013 than earlier anticipated. We still expect further real GDP losses in the latter half of 2013, though, which are likely to be at their sharpest in the third quarter, in the wake of the VAT hike from July 2013. A delayed Greek euro exit event is likely to be less damaging to the Italian economy in light of the greater regional supports being in place, namely progress towards fiscal and banking union. Nevertheless, we still expect some contagion to fall on Italy during the second quarter of 2014, which could lead to a period of some uncertainty engulfing Italy around the exit event. Overall, real GDP is expected to shrink by 1.9% (revised from a 1.7% drop) in 2013 and 0.4% in 2014, according to the April 2013 forecast. The markets blame Italy's poor growth prospects on its dismal productivity performance and declining competitiveness since the adoption of the euro, and the resulting erosion in Italy's export share in world markets. Apart from weak labor-productivity performance, Italy's ability to compete both at home and abroad has also been hampered by a lack of competition in several key services sectors. These include the banking and legal sectors as well as others, which are able to transfer their low productivity onto their selling prices, representing a burden for the whole economy, particularly the traded goods sector. The ex-technocratic government had attempted to tackle some long-standing structural impediments, namely a segmented and rigid labor market, excessively regulated business climate, and high levels of inefficient public spending funded by one of the largest tax wedges in the Eurozone. The reforms under the previous government will help to improve the business climate in Italy, which will help to produce a modest boost to the country's growth potential. Nevertheless, deeper labor reforms will be needed to reverse Italy's woeful productivity performance.
Outlook and Assumptions: Domestic Assumptions

Greece is expected to leave the Eurozone in the second quarter of 2014 (we put a 30% chance of it happening within the next 12 months and a 60% probability that it will happen within the next five years). We assume that by the
Page 3 of 33
time the Greek exit occurs, the overall impact will be limited by policymakers, countries, and banks having had ample time to prepare for such an eventuality, with Eurozone policymakers in particular stepping up progress towards increased banking and fiscal union as the event looms. Fiscal policy in Italy will remain tight, as the government strives to improve the poor state of country's public finances. Strong pressure from international investors and European Central Bank (ECB)/EU policymakers will force Italy to pick up the pace of structural reforms in the next few years. The European Central Bank (ECB) will cut interest rates from 0.75% to 0.50% by mid-2013 and then keep them at this level through to 2015. The euro will largely trade around USD1.30 until late-2013, when it will start to weaken amid a renewed heightening of concerns over Greece. The euro is seen trading as low as USD1.22 in 2014 as the Greek exit occurs, but it is then seen recovering. .
Outlook and Assumptions: Alternative Scenarios

Policymakers fail to build a strong enough policy framework in place in the Eurozone to deal with the expected Greek exit around mid-2013. Contagion would be much deeper and longer, and there is an increased danger that more countries would end up leaving the Eurozone. The expected Greek exit from the Eurozone occurs in 2013 rather than 2014 (we put a 30% probability of a Greek exit within the next 12 months). This scenario would likely lead to a larger, as well as earlier, negative impact on Eurozone economic activity, because policymakers would have had less time to make progress on banking and fiscal union, and to prepare for a Greek exit. Italy fails to kick starting its growth-boosting reform agenda after the next general election in early 2013, encouraging sovereign debt markets to take a more negative outlook on Italy's debt sustainability. The situation is made more urgent, with Italy needing to tap heavily into the sovereign debt markets against a backdrop of an uncertain investor sentiment, not helped by a likely Greek euro exit and the increasing risk that Spain will need a full sovereign bailout. A renewed firming in oil prices means that consumer price inflation is stickier than forecast in Italy, keeping a significant squeeze on consumers' purchasing power. Renewed high oil prices would also squeeze companies' margins. This could weigh markedly on Italian growth prospects over the second half of 2012.
Economic Growth: Outlook

The weaker-than-expected GDP performance in the final quarter of 2012 provides further evidence that the economy has become too reliant on net exports to lift activity in the wake of the collapse of domestic spending both at the residential and firm levels. This remains a significant risk with exports likely to face a sustained squeeze on domestic spending across the Eurozone during 2013. To make matters worse, the euro appreciating to a 15-month high above USD1.37 early in February before settling back to USD1.28 by end-March represents unwelcome news for Italian firms, making it even more challenging to protect their fragile export market shares in highly competitive markets outside the Eurozone. This implies that an export-led recovery is even more unlikely to come to Italy's rescue in the near term, as happened in 2010/11, particularly with the Eurozone economy expected to shrink by 0.6% in 2013. Indeed, the latest forward-looking data remain well short of the levels required to herald even a modest upturn in the business cycle, and continue to point to further declines in output in first-half of 2013. The economy is locked into a perennial slump, underpinned by entrenched consumer and business gloom, not surprising given the tougher tax regime, tighter credit conditions, and rising unemployment.
Page 4 of 33
With exports under acute pressure, the other sectors of the economy, damaged by a tough tax-heavy austerity plan, remain too weak to pull Italy out of recession. With consumer confidence still close to record lows in early 2013, fragile household spending is expected to remain intact in the first half, and will serve as a major obstacle to any recovery in economic activity during in 2013/14. Despite the smaller value-added tax (VAT) increase now planned for July 2013, IHS Global Insight remains downbeat about the near-term consumer-spending outlook. The main drags are likely to be household disposable income retreating for a sixth successive year in 2013, as well as a steadily rising unemployment rate, which hit 11.7% in January. Clearly, household demand conditions are expected to remain tough in Italy, not helped by the government having to maintain aggressive fiscal tightening, underpinned by a tougher tax regime, to keep the intensifying sovereign debt crisis at bay. Indeed, the latest consumer confidence survey provides compelling evidence that households continue to refrain from non-essential spending. Since we now expect Greece to exit the Eurozone in mid-2014, Italy will be spared a more traumatic second half of 2013 than earlier anticipated. We still expect further real GDP losses in the latter half of 2013, though, which are likely to be at their sharpest in the third quarter in the wake of the VAT hike in July 2013. A delayed Greek euro exit event is likely to be less damaging to the Italian economy in light of the greater regional supports being in place, namely progress towards fiscal and banking union. Nevertheless, we still expect some contagion to fall on Italy during the second quarter of 2014, which could lead to a period of some uncertainty engulfing Italy around the exit event, resulting in higher bond yields, financial-market disruption, and a hit on sentiment. The economy faces a prolonged slump, which is now expected to spill into 2014. Overall, real GDP is projected to contract by 1.9% (revised down from 1.6%) in 2013 and 0.4% in 2014, according to the April forecast. The 2013 downward adjustment reflects a poorer outlook for the Eurozone, in conjunction with a steady stream of still deteriorating forward indicators in Italy suggesting significant output losses in the first half of 2013.
Page 5 of 33
Economic Growth Indicators 2010 Real GDP (% change) Real Consumer Spending (% change) Real Government Consumption (% change) Real Fixed Capital Formation (% change) Real Exports of Goods and Services (% change) Real Imports of Goods and Services (% change) Nominal GDP (US$ bil.) Nominal GDP Per Capita (US$) 1.7 1.5 -0.4 0.5 11.2 12.3 2011 0.5 0.1 -1.2 -1.4 6.6 1.1 2012 -2.4 -4.3 -2.9 -8.0 2.2 -7.8 2013 -1.9 -2.7 -1.5 -3.8 1.5 -2.4 2014 -0.5 -0.9 -0.7 -1.2 0.6 -0.5 2015 0.5 0.2 0.4 0.2 1.9 2.3 2016 1.4 1.3 1.0 1.8 3.5 3.6 2017 1.2 1.2 1.0 1.3 3.2 3.1
2,053.7 2,195.8 2,012.4 1,987.5 1,943.4 2,108.4 2,305.0 2,467.9 33,916 36,121 33,010 32,535 31,769 34,427 37,610 40,253
Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the 15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release of the GIIF bank. Download this table in Microsoft Excel format
Economic Growth: Recent Developments

The economy remained locked into a severe downturn when real GDP contracted for a sixth successive quarter during fourth-quarter 2012, according to a final estimate from the Statistics Bureau. Specifically, seasonally and calendar-adjusted real GDP contracted by 0.9% quarter on quarter (q/q), the steepest decline since early 2009. This was preceded by drops of 0.2% q/q in the third quarter and a sharper-than-originally reported 0.8% q/q in the second. The annual comparison remained weak, with real GDP tumbling by 2.8% year on year (y/y) at end-2012, the fifth successive
Page 6 of 33
fall on a y/y basis. This implied that the economy shrank by 2.4% in 2012, a notable turnaround from gains of 0.5% in 2011 and 1.7% in 2010. The breakdown of fourth-quarter GDP by expenditure component reveals that a diminishing but still important growth impulse from net exports was offset by a further acute slump in domestic demand. The domestic economy continues to be dragged down by a profound collapse in business and consumer confidence in line with the fallout from the painful austerity measures required to repel the Eurozone sovereign-debt storm. The main components of domestic spending (excluding a change in stocks and government consumption) retreated during the quarter, curtailing the q/q change in real GDP by 0.6 percentage point. Conversely, an acute fall in the level of stocks (plus statistical discrepancy) represented a drag on activity, lowering the q/q percentage change by 0.7 percentage point in real GDP during the fourth quarter. This was expected with companies paying greater attention to their level of stocks given the poor economic outlook both in Italy and abroad. This, coupled with deteriorating domestic demand conditions, appeared to be an important factor behind a further drop in imports during the fourth quarter, alongside a modest rise in exports during the quarter, allowing net exports to contribute 0.4 percentage point to the q/q change in real GDP. Consumer spending is squeezed again. Private consumption retreated by 0.7% q/q in the final quarter of 2012, compared with drops of 1.1% q/q in both the third and second quarters and 1.5% q/q in the first, the sharpest fall since the first quarter of 1993. The annual comparison was disappointing, with overall spending plummeting by 4.4% y/y and 4.3% in the final quarter and 2012 as a whole, respectively. Other spending indicators also provided a gloomy picture of consumer spending in the latter stages of 2012. First, the average number of new car registrations dropped by 18.1% y/y in the fourth quarter after a 22.8% y/y plunge in the third quarter. Second, nominal value of seasonally adjusted retail sales contracted by 3.8% y/y in December, the ninth successive fall on a y/y percentage basis. Third, the purchasing managers' survey reveals that the inflow of new business in the services sector continued to contract alarmingly during the final months of 2012. The investment activity slump deepened. Gross fixed capital formation shrank 1.2% q/q during the fourth quarter of 2012, suggesting that it has fallen in eight of the last nine quarters. Therefore, the y/y percentage change was -7.6% in the fourth quarter, which was preceded by drops of 8.5% y/y in the third quarter, 8.6% y/y in mid-2012, and 7.2% y/y in the first. The slump in machinery and equipment spending continued during the fourth quarter, when it contracted by 2.1% q/q and 8.7% y/y. Industrial investment intentions have shrunk steadily, which began after the government withdrew its temporary tax break to encourage firms to replace obsolete machinery at the end of June 2010. Furthermore, the investment climate has become tougher, with companies enduring uneven profitability, shrinking output, uncertain economic outlook, still difficult access to credit markets, and lower-than-normal capacity utilization. More encouragingly, investment in transport equipment moved up by 1.9% q/q but was still 9.4% lower than a year earlier. Finally, construction investment took another large hit, falling by 1.1% q/q and 6.6% y/y in the fourth quarter, implying it fell by 6.4% in 2012 as a whole, the fifth successive year to register a decline. Clearly, the sector is under a cloud, with restricted channels to credit while construction activity has been curtailed by falling state infrastructure spending alongside weak demand for new housing. Government spending was flat between the third and fourth quarters and was 2.5% lower than in the fourth quarter of 2011. This was in line with expectations, given that the government is under considerable pressure to contain expenditure and improve underlying public finances. Further net export gains are seen as import demand remains under a cloud. Exports of goods and services expanded by 0.3% q/q in the fourth quarter, preceded by a 1.2% q/q gain in the third quarter. In addition, the annual rate of growth slowed to 1.9% from 2.5% in the third quarter and was up by 2.2% in 2012 as a whole. This was a better-than-expected outcome in the fourth quarter but Italian exports of goods were still under pressure by disrupted regional trade flows with real GDP falling back in Germany, France, the Netherlands, Spain, and the United Kingdom. Finally, import demand also registered a pronounced drop in the fourth quarter, down 0.9% q/q and 6.6% on a y/y percentage basis, probably hit by weak capital spending. Overall, imports of goods and services contracted by 7.8% in 2012, a sharp reversal from gains of 1.1% in 2011 and 12.3% in 2010.
Page 7 of 33
Economic Growth: Consumer Demand - Outlook

The fallout from the Eurozone sovereign debt crisis will continue to constrain consumer confidence during 2013. Household confidence continues to bounce around record lows, while overall private spending fell by 4.3% year on year (y/y) during 2012. In addition, consumer confidence surveys continue to signal the near-term outlook will remain challenging with households expressing continuing reluctance to undertake major purchases as they struggle to cope with significant headwinds. First, consumers are enduring shrinking real household disposable income, partly resulting from slower nominal wage growth alongside higher-than-expected consumer price inflation when placed alongside dismal domestic demand conditions. Second, the unemployment rate has risen notably, and hit 11.7% in January. Third, painful revenue-raising measures passed during December 2011 have led to a rising tax burden on struggling households. The outlook for consumer spending remains bleak, with households likely to remain cautious about non-essential spending. Indeed, overall household spending is projected to contract by 2.7% in 2013 and 0.9% in 2014 after a 4.3% drop in 2012, according to the April 2013 forecast. To make matters worse, the government has retreated from its initial promise to provide immediate support to struggling low-income households by cutting income tax rates from early 2013, and will now plan to take action from 2014, which could entail higher tax deductions for young workers. Therefore, the outlook for consumer spending is even darker in 2013, not helped by the planned VAT increase from 21% to 22% going ahead in July 2013. This could encourage a temporary spurt in private consumption in the second quarter of 2013 as consumers bring forward major purchases to avoid the tax rise. Nevertheless, this will be a drag on spending intentions in the second half of 2013 and early 2014. The cut in payroll taxes planned for 2014 is a rare piece of good news for households, but they could be tempted to save a significant slice of the additional disposable income when faced with still-volatile employment prospects and tight personal finances. Overall, consumer spending is set for a bumpy ride during 2013 and 2014, providing a major obstacle to Italy pulling clear of the current recession.
Economic Growth: Consumer Demand - Recent Developments

More recent indicators point to continued weak consumer spending in the first quarter of 2013, with new car sales continuing to fall at a sharp pace, while spending on other consumer durables appeared to be sluggish. The average number of new car registrations dropped by 13.2% year on year (y/y) in the first quarter, after an 18.1% y/y plunge in the fourth quarter. Finally, the purchasing managers' survey reveals that the inflow of new business in the services sector continued to contract alarmingly during the first three months of 2013.
Page 8 of 33
Retail sales continued to struggle in early 2013, in line with dismal consumer confidence. According to the National Statistical Office, Italy's nominal value of seasonally adjusted retail sales fell by 0.5% month-on-month (m/m) in January, from a downwardly revised 0.1% m/m drop in December 2012. This was also preceded by falls of 0.4% m/m in November and 1.3% m/m in Octoberthe sharpest fall since April 2012. On an unadjusted basis, retail spending in January fell by 3.0% year-on-year (y/y), the seventh successive fall on a y/y percentage basis. This also implied that retail sales fell by 1.7% in 2012 as a whole, the sharpest decline since 1995. Furthermore, retail sales were considerably weaker during January when adjusted for consumer price inflation, which averaged 2.2% during the month. A breakdown by type of goods reveals that spending on food items was down by 0.6% over the month and was 2.3% y/y lower in January in nominal terms. Spending on non-food items fell by 0.4% between December and January, and was 3.3% lower y/y. According to the National Statistical Office (ISTAT), repeated consumer confidence surveys reveal households remain very downbeat in early 2013. According to the National Statistical Office (ISTAT), repeated consumer confidence surveys reveal households have become increasingly downbeat since early 2011. They continue to express acute concerns about the economy and their personal finances, resulting in a major reversal in consumer spending in 2012 and early 2013. ISTAT reported that the seasonally adjusted consumer confidence index fell back in March, but was still just above a new survey low recorded in January. The overall index stood at 85.2 in March, compared with 86.0 in February and 84.6 in January, the poorest level since the monthly series began in early 2009. A breakdown by subcomponent reveals consumers are struggling to cope with the dire current economic climate, with the sub-index for this slumping to a nine-month low of 68.8 on March, compared with 72.7 in February and a survey low of 60.7 in June 2012. Households also remain concerned about their personal situation in March, with the sub-index standing at 91.4, against 91.7 in February and a survey low of 89.3 in January. Clearly, high unemployment, squeezed real incomes, and a tougher tax regime are taking a toll on households' financial health. Finally, households expressed deep pessimism about their outlook, with the sub-index measuring an aggregate view on the future economic situation and personal finances at a poor 80.2 in March, against 79.9 in February and 77.2 in January.
Economic Growth: Capital Investment - Outlook

Overall fixed investment is likely to remain modest in 201314. Total fixed gross investment is projected to fall 3.8% in 2013 and 1.3% in 2014 after an 8.0% drop in 2012, according to the April 2013 forecast. The recovery in business fixed investment weakened steadily during 2011 and 2012, and capital spending is now projected to fall at a notable pace in 2013. Specifically, according to our first-quarter 2013 detailed forecast round, we estimate industrial capital expenditure (excluding general government investment) will fall 5.3% in 2013 and 2.9% in 2014 from an estimated 10.9% drop in 2012, with the balance of risks on the downside with Italy stuck in a deepening recession. The slump in business investment appeared to bottom out in late 2009 and was lifted by the introduction of tax breaks to encourage firms to replace obsolete machinery for one year from July 2009. Indeed, machinery and equipment investment had dropped to its lowest level relative to GDP since 1999. Nevertheless, the recovery has stalled, with firms continuing to face substantial excess capacity, tight financials, and heightening fears of a prolonged recession. Specifically, increasingly uncertain assessments of both the domestic and global economies remain obstacles to a sustained and strong recovery in business confidence. Consequently, IHS Global Insight believes business confidence is likely to remain uneven during the latter stages of 2012 and 2013 as these factors persist, not boding well for investment during the period. The outlook from 2013 is uncertain, with the prospect of still-fragile demand and tough credit conditions helping to limit the upside in business investment. Furthermore, the risks remain on the downside because of the lagged effect of the robust austerity measures planned from 2012 to 2014, and the potential impact of our baseline assumption that Greece will exit the Eurozone no later than the third quarter of 2013. Construction activity deteriorated in 2012 but will improve modestly in 2013. Restraining factors, including still-disrupted access to mortgage loans, a recovering but still fragile property market, and the prospect of muted growth in real household incomes are expected to restrain residential investment after it fell for a sixth successive year when it fell by 6.0 in 2012. It is likely to shrink by a further 0.5% in 2013 but should recover in 2014, rising by a projected 1.7% on the
Page 9 of 33
back of the reconstruction of the earthquake-damaged Emilia-Romagna region. The government has put aside EUR1 billion in both 2013 and 2014 to assist the reconstruction efforts, with the rest being obtained from the European Union.
Economic Growth: Capital Investment - Recent Developments

According to the latest national accounts, the investment downturn activity continues to deepen. Gross fixed capital formation shrank 1.2% quarter on quarter (q/q) during the fourth quarter of 2012; it has fallen in eight of the last nine quarters. Therefore, the year-on-year (y/y) percentage change was -7.6% in the fourth quarter, preceded by drops of 8.5% y/y in the third quarter, 8.6% y/y in mid-2012, and 7.2% y/y in the first. The slump in machinery and equipment spending continued during the fourth quarter, contracting by 2.1% q/q and 8.7% y/y. Industrial investment intentions have shrunk steadily, which began after the government withdrew its temporary tax break to encourage firms to replace obsolete machinery at the end of June 2010. Furthermore, the investment climate has become tougher, with companies enduring uneven profitability, shrinking output, an uncertain economic outlook, still difficult access to credit markets, and lower-than-normal capacity utilization. More encouragingly, investment in transport equipment moved up by 1.9% q/q but was still 9.4% lower than a year earlier. Finally, construction investment took another large hit, falling by 1.1% q/q and 6.6% y/y in the fourth quarter, implying it fell by 6.4% in 2012 as a whole, the fifth successive year to register a decline. Clearly, the sector is under a cloud, with restricted channels to credit while construction activity has been curtailed by falling state infrastructure spending alongside weak demand for new housing. Italian manufacturing confidence rose unexpectedly in March, which was at odds with the ensuing political turmoil that followed the inconclusive general election at the end of February. According to the National Institute for Statistics (ISTAT), the confidence indicator for the manufacturing sector moved up to 88.9 in March, compared with 88.6 in February, 88.3 in January, and 89.0 in December 2012. The manufacturing confidence index is a composite of the sub-indices for current inventory levels, orders, and the production outlook for the next three to four months. The new orders situation still remains fragile, with the sub-index for this standing at a dismal -43 in March, against -42.0 in February and -43 in January. With the poor new order situation prevailing, firms' near-term production expectations remain in negative territory, up slightly to -3 in March. ISTAT's newly launched composite index, which combines surveys of the manufacturing, retail, construction, and services sectors, improved to 78.0 in March from 77.6 February and a survey low of 75.6 in December. This was due exclusively to improved sentiment among manufacturers.
Labor Markets: Outlook

The demand for labor remains very sluggish and is expected to persist throughout 2013, with the economy now entrenched in a more painful and protracted recession than previously anticipated. We believe the private services sector will struggle to generate any new employment opportunities, while public-sector employment at both the central and local government level is likely to fall as a result of the need to curtail public spending. Meanwhile, we expect further notable industrial employment losses, as companies continue to tightly control their workforces amid falling profits and lower-than-normal output. In addition, the government is under increasing financial pressure to rein back the use of the state-assisted "cassa integrazione scheme" in the next few quarters. The scheme allows firms to send workers home temporarily on reduced pay, which has helped to restrict the employment losses during the recession. Italy's seasonally adjusted unemployment rate eased back slightly in February, with marginally firmer labor demand conditions offsetting a modest rise in the labor force. According to the National Statistical Office (ISTAT), total employment edged up by 0.2% month-on-month (m/m) to stand at 22.739 million, the first increase since October 2012. This was preceded by drops of 0.4% m/m in January and 0.3% m/m in December. Despite the rise in February, we continue to argue that employment intentions have weakened progressively since mid-2011, with firms increasingly shaking out labor amid the deepening recession and very competitive trading conditions. Meanwhile, the labor force crept up by 0.1% between January and February 2013, to stand at 25.710 million. With employment rising in February, the seasonally adjusted unemployment rate retreated to 11.6%, down from 11.7%in January, the highest level since the series
Page 10 of 33
began in 2004. Meanwhile, youth unemployment (1524 years) moved down from 38.6% to 37.8% between January and February. Diminishing employment prospects are expected to result in higher unemployment in 2013/14. The unemployment rate is expected to develop more aggressively in the next few quarters given the deteriorating economic climate. Unemployment is projected to climb from 10.6% in 2012 to 11.7% in 2013, and 11.9% in 2014, according to the April 2013 forecast. Furthermore, it stands notably higher than the recent low of 6.1% in 2007, which was the lowest rate since 1975.
Labor Markets: Recent Developments

Demand for labor retreated in the fourth quarter of 2012, with firms facing sluggish markets. According to the National Statistical Office (ISTAT), total employment shrunk 0.3% between the third and fourth quarters to stand at 22,996, after a 0.1% quarter-on-quarter (q/q) drop in the third quarter and stagnating in the first half of 2012. In unadjusted terms, overall employment declined by 0.6% when compared with a year earlier to stand at 22.855 million in the fourth quarter, after stagnating in the third quarter. The demand for labor has been propped up by the " cassa integrazione scheme, with the scheme making up the pay of permanent employees affected by temporary layoffs (who are not considered unemployed) or under shorter working hours for a maximum of two years. During the last recession, the number of authorized hours subsidized by the scheme increased more than 600%, and the Organisation for Economic Co-operation and Development estimates that the share of total employees (full-time equivalent) in short-time work schemes in Italy rose from 0.6 percentage point in mid-2008 to just under 4.0 percentage points by early 2010. Job losses were recorded in industry, falling 2.5% year-on-year (y/y) in the third quarter, while employment in construction continued to shrink aggressively, down by 4.6% y/y. Finally, the number of jobs in services moved up by 0.5% y/y in the same quarter. Unemployment rose during the fourth quarter of 2012 in line with shrinking employment intentions. An expanding labor force alongside falling employment pushed up the seasonally adjusted unemployment rate to 11.2%, the highest rate since end-1998, and up from 10.7% in the third quarter and 10.6% in mid-2012. More labor-market reforms needed to boost employment ratio. Italy continues to endure one of the lowest employment ratios in the Eurozone, particularly among women. The overall employment rate in Italy was unchanged at 56.6% at end-2012, compared with 56.8% at end-2011. It peaked recently at 59.2% in mid-2008.
Inflation: Outlook
Inflation is expected to drift down in the next few months, with downward pressure arising from Italian retailers and service providers under pressure to price competitively to attract new business alongside lower global crude oil prices compared with a year earlier. Nevertheless, some uncertainty remains, given the recent volatile crude oil-price developments in recent months, which surprised on the upside. Brent oil overshot IHS Global Insight's expectations again in January, but slipped below USD110/barrel during March, and is expected to fall below USD100 over the coming quarters. More decisively, core price pressures remain moderate and are expected to remain so in line with the increasingly challenging economic climate. Importantly, wage pressures are projected to remain moderate during 2013. The industrial and service sectors are under pressure to control wage costs due to tight profit margins, as companies are resorting to aggressive pricing to drum up new business against a backdrop of still-high non-wage input prices. Conversely, the consumer price inflation rate will be elevated (and distorted) by the planned 1.0-percentage-point rise in VAT rates from 21% to 22% in the third quarter. In 2014, inflationary pressures will also be limited by our baseline view that Greece will exit the euro in mid-2014 rather than the second half of 2013. This will keep up pressure on Italian retailers and service providers well into 2014 to price competitively to generate new business, while ongoing intense competition on the high street in the face of reluctant consumers will continue to contain the price of some services and durable goods, especially with regard to clothing, footwear, and electronics. Overall consumer price inflation is thus expected to average 1.7% in both 2013 and 2014, according to the April forecast.
Page 11 of 33
Wage inflation is projected to remain moderate during 2013/14 in line with softer labor-market conditions. The industrial sector is under pressure to control wage costs due to tight profit margins as companies are resorting to aggressive pricing to drum up new business against a backdrop of rising input prices. Labor costs must be contained in order to protect competitiveness. The Italian export sector has lost much of its dynamism thanks to a marked fall in price competitiveness with the euro and even slowed more acutely against non-euro countries after the euro recovered. This increase has created problems for Italian exporters, given the price-elastic products in which Italy specializes, notably clothing, footwear, and capital equipment.
Inflation Indicators 2010 Consumer Price Index (% change) Wholesale-Producer Price Index (% change) 1.5 3.1 2011 2.8 5.1 2012 3.0 4.1 2013 1.7 -0.1 2014 1.7 1.2 2015 2.0 1.8 2016 2.2 2.1 2017 2.1 1.8
Inflation: Recent Developments

According to a final release, Italian consumer price inflation fell back in March. This was in line with expectations, retreating to a 33-month low of 1.6% (national definition), compared with 1.9% in February, 2.2% in January, and 2.4% at end-2012. It has been trending downwards steadily from 3.2% in September 2012, after the value-added tax (VAT) increase in September 2011 fell out of the index. A breakdown of March's consumer price index data by goods and services reveals a diminishing but still significant inflationary impulse from essential goods, namely domestic energy, and to a lesser extent, food prices. This puts an additional burden on gloomy households, eroding their ability to spend on major consumer durables. Indeed, the March data confirm a still significant rise in energy-related prices, with transport and housing, and electricity and fuel prices rising 1.7% year-on-year (y/y) and 4.3% y/y, respectively. Countering this, other goods and services reported more moderate price developments across the economy. Communication costs fell by 5.6% y/y, while the health-care and recreation and culture sectors reported muted price developments y/y in March.
Page 12 of 33
Finally, underlying price pressures remained moderate in March, restrained by sluggish domestic demand conditions and large output gap. Core inflation (excluding fresh food and energy prices) edged down to 1.4%, compared with 1.5% in February and 1.7% in January. Wage inflation remained moderate in December, signifying a continued fall in real wage income. Hourly wages edged up 0.1% between November and December, with the annual rate of wage inflation edging up for the third successive month to stand at 1.7% in the final month of 2012. Nevertheless, it has slowed from 1.8% in 2011, 2.2% in 2010, and 3.0% in 2009. Despite the rise in nominal hourly wages, real wages fell when compared with December 2011, given that the annual rate of consumer price inflation was 2.3% during December 2012. A breakdown by sector reveals that nominal hourly wage growth in December was strongest in industry, recorded at 2.7% y/y. Meanwhile, private services and public administration revealed weaker growth in hourly wages, at 1.9% y/y and 0.0% y/y, respectively.
Exchange Rates: Outlook

We believe that the market got well ahead of itself on the euro early in 2013, notwithstanding the support that the single currency received from an extended easing of Eurozone sovereign debt tensions. So we suspect that the peak rate of USD1.3711 seen in early February will not be seen again in 2013, or for some considerable time to come. Indeed, the euro has since fallen back markedly from this peak level and we believe it is likely to largely trade in a USD1.251.30 range over the rest of 2013. The Eurozone highly likely suffered further GDP contraction in the first quarter of 2013, and prospects for the second quarter hardly look bright at the moment. As a result, it looks increasingly probable that the European Central Bank will finally cut its key interest rate from 0.75% to 0.50% before long. We now expect the ECB to trim interest rates by June. Furthermore, we suspect that Eurozone sovereign debt tensions are far from over despite the lull in late 2012/early 2013. This suspicion was reinforced by the difficulties in coming up with a rescue package for Cyprus in late March. In particular, tensions over Spain and Italy could well flare up on occasion, which would hamper the euro, while doubts may very well rise anew on Greeces long-term ability to stay in the Eurozone. Heightened concerns over the situation in Italy following the inconclusive general election in late February are now weighing down on the euro. Finally, it should be borne in mind that the European Central Bank was unhappy with the sharp appreciation of the euro early in 2013. Consequently, the euro is seen trading around USD1.25 at mid-2013.
Page 13 of 33
The euro could firm marginally in the third quarter as Eurozone economic activity stabilizes and perhaps even ekes out marginal growth. Nevertheless, the euro is seen coming under increasing pressure towards the end of 2013 from a renewed marked heightening of concerns about the situation in Greece. Consequently, the euro is seen trading around USD1.29 at the end of 2013. The euro is expected to come under further pressure during the early months of 2014 as Greece continues to struggle markedly to meet its fiscal targets and enact reforms. We suspect that Greece could very well end up leaving the Eurozone around the second quarter of 2014. This is seen sending the euro down to a low of USD1.22 around mid-2014. The euro is seen stabilizing and then starting to recover in the third quarter of 2014 on the assumption that European policymakers and the ECB make strong policy responses to the Greek exit and contagion is both short-lived and limited. Such developments would increase markets confidence in the longer-term future of the Eurozone. It would also provide a more settled and stable environment that would hopefully significantly boost business and consumer confidence, and lift their willingness to invest and spend. On this basis, the euro is seen recovering to USD1.27 at the end of 2014 and then continuing to firm in 2015. Exchange Rate Indicators 2010 Exchange Rate (LCU/US$, end of period) Exchange Rate (LCU/US$, period avg) Exchange Rate (LCU/Euro, end of period) Exchange Rate (LCU/Euro, period avg) 0.75 0.76 1.00 1.00 2011 0.77 0.72 1.00 1.00 2012 0.76 0.78 1.00 1.00 2013 0.78 0.78 1.00 1.00 2014 0.79 0.80 1.00 1.00 2015 0.73 0.75 1.00 1.00 2016 0.70 0.71 1.00 1.00 2017 0.68 0.69 1.00 1.00
Exchange Rates: Recent Developments

Having largely traded in a USD1.301.35 range during the first half of 2012, the euro sank to a 25-month low of USD1.2040 in late July. This was largely the consequence of heightened Eurozone sovereign debt tensions related to Italy and Spain as well as Greece, weak Eurozone economic activity, and the European Central Bank cutting interest rates from 1.00% to a record low of 0.75% in early July. The euro stabilized and then edged up from its lows after ECB president Mario Draghi said the bank would do "whatever is necessary to preserve the euro." The ECB followed this up by announcing plans at its 2 August policy meeting to make future Eurozone bond purchases (under certain conditions) in order to reduce the risk premium on the yields of pressurized countries. In addition, German Chancellor Angela Merkel and French President Francois Hollande issued a joint statement saying that they are "determined to do everything to protect the Eurozone." The euro's rise from its late-July low gained momentum in September as it was helped by the ECB fleshing out its bond-buying plans and by the German constitutional court giving the go-ahead for the European Stability Mechanism.
Page 14 of 33
Meanwhile, the dollar was pressurized by the US Federal Reserve announcing further aggressive quantitative easing to support the US economy and indicating that it was unlikely to raise interest rates before mid-2015. Consequently, the euro reached a four-month high of USD1.3173 in mid-September. The euro then moved below USD1.30 on occasion, influenced significantly by uncertainty over Spain's situation and intentions. The euro was further hit in November by increased concerns over Greece's adoption of austerity measures and the disbursement of further aid; this caused it to trade as low as USD1.27. On the other hand, the euro was only modestly pressurized by the expected news that Eurozone GDP fell 0.1% quarter-on-quarter in the third quarter, thereby putting the single currency area officially into recession. The euro enjoyed a firmer end to 2012, though. Agreement in late November among Eurozone policymakers and the IMF on measures to cut Greece's debt over the long term and to release loans needed to stop Greece defaulting in the near term saw the euro move back above USD1.30 in early December. The euro then extended this upward move to reach an eight-and-a-half month high close to USD1.33 in mid-December. The euro was helped by some signs that Eurozone economic activity may have bottomed out while it also benefited as the dollar was hurt generally in mid-December by the US Federal Reserve (Fed) expanding its quantitative easing (QE) measures. The euro extended its gains at the start of 2013 to hit a 14-month high of USD1.3711 in early February. In addition to ongoing reduced Eurozone sovereign debt tensions following the ECBs policy actions in September 2012 and the Greek debt bailout, the euro was boosted by the ECB indicating at its 10 January policy meeting that there had been a unanimous vote to keep its key interest rate at 0.75%. This vote contrasted with the December 2012 meeting when some governing council members had favored an interest-rate cut. Nevertheless, the euro came off its highs after the ECB indicated at its 7 February policy meeting that it was concerned about the single currencys strength. This fueled speculation that a further marked appreciation of the euro could prompt the ECB to cut interest rates. The euro was also pressurized by the news in mid-February that Eurozone GDP contracted by a larger-than-expected 0.6% quarter on quarter in the fourth quarter of 2012 and concern over Eurozone economic activity was then further fueled by the purchasing managers reporting a relapse in manufacturing and services activity in February after recent improvement. With the euro also being weighed down by heightened political uncertainty in Italy following the inconclusive general election in late February, and the dollar benefiting from some decent US economic data, the euro dipped below USD.1.30 for the first time in 2013 in early March. Concerns over the situation in Cyprus and some disappointing Eurozone economic news saw the euro trade as low as USD1.2843 on 20 March. The euro failed to benefit from the agreement on a bailout deal for Cyprus on 25 March, largely because of market concerns that bank depositors could be hit in any future country rescue deals. The euro hit a new four-month low of USD1.2778 in late March. The euro was little affected by the ECB indicating at its 4 April policy meeting that it could cut interest rates from 0.75% to 0.50%, and it is currently trading around USD1.30.
Page 15 of 33
Economic Policy: Monetary Policy and Outlook

With Eurozone economic activity clearly still weak after GDP highly likely contracted again in the first quarter of 2013, and with inflationary pressures muted, we now suspect that the ECB will take interest rates down from 0.75% to 0.50% during the second quarter. A move as soon as May looks very possible. Admittedly, there are clearly some members of the ECBs Governing Council who remain reluctant to take interest rates any lower due to concern about the longer term inflationary risks potentially stemming from extended very low interest rates as well as all the liquidity the ECB has made available. There are significant doubts within the Governing Council that cutting interest rates would have a beneficial impact in the near term at least given current fragmented conditions in credit markets. There is a risk that this fragmentation could be magnified by the recent events in Cyprus. The case for the ECB to cut interest rates from 0.75% to 0.50% looks ever more compelling and the evidence from its April policy meeting suggests that the banks governing council is increasingly coming around to this view. While there were signs in late 2012/early 2013 that Eurozone economic activity could be coming off its lows, these signs of improvement have not been sustained. Business confidence relapsed in March, while the purchasing managers surveys indicated that overall Eurozone manufacturing and services activity contracted at deeper rate in February and March after improving between November and January. The Eurozone is still being buffeted by major headwinds, notably including increased fiscal tightening in many countries, very high and rising unemployment, and tight credit conditions. Consumers are under additional pressure from muted wage growth and in some countries, a need to deleverage. On top of this, relatively muted global growth is limiting export orders. Meanwhile, the Eurozone inflation situation and outlook is extremely benign. Eurozone consumer price inflation retreated sharply to a 38-month low of 1.2% in April, while core inflation was limited to 1.6% in March. The chances are high that consumer price inflation will remain clearly below 2.0% through 2013 and likely through much, if not all, of 2014 because of the constraining effect of extended weakened economic activity and high unemployment. The European Commission's business and consumer confidence survey showed that consumers' inflation expectations across the Eurozone fell to a 28-month low in April and were well below the long-term average. Furthermore, any renewed spikes in inflation expectations would be highly unlikely to feed through to lift current muted wage growth in most Eurozone countries anytime soon, given appreciable job insecurity and persistently high and rising unemployment across the single-currency area. Significantly, companies pricing power appears limited. The composite output prices index of the manufacturing and services purchasing managers surveys indicated that prices fell for a 13th month running in April and at the fastest rate since February 2010. Meanwhile, the European Commission survey showed that selling price expectations among manufacturers, service companies, and retailers were all well below long-term norms in April and were largely weaker compared with March. Further supporting the view that underlying price pressures will be limited, the adjusted three-month moving-average growth rate for annual Eurozone M3 money supply fell back to just 3.0% in March (and was only 2.6% in March itself), which is well below the ECBs targeted rate of 4.5%. Given this backdrop, we expect the ECB to take interest rates down from 0.75% to 0.50% in either May or June. Latest Eurozone economic news certainly justifies an interest-rate cut in May, but it is possible that the ECB may prefer waiting to June before acting. By then, the ECB will likely have had confirmation that the Eurozone continued to contract in the first quarter of 2013 and will probably be in little doubt that a return to growth is still proving difficult. The ECB will also have available the new Eurozone GDP and consumer price inflation forecasts produced by its staff, which are likely to be fully supportive to lower interest rates. On the assumption that interest rates do come down to 0.50% by June, we expect them to then stay at that level through to 2015 before starting to rise gradually. We believe the ECB would have a crucial role to play in Eurozone policymakers efforts to contain the fall-out from a Greek exit from the Eurozone if such an event occurred in 2014. ECB action could well include: (1) providing substantial liquidity to banks; (2) stepping up its own bond-buying activity, effectively setting a cap on bond yields of Spain, Italy, and other vulnerable countries; and (3) providing assistance in recapitalizing Eurozone banks.
Page 16 of 33
Monetary Policy Indicators 2010 Policy Interest Rate (%, end of period) Short-term Interest Rate (%, end of period) Long-term Interest Rate (%, end of period) 1.00 0.81 3.99 2011 1.00 1.39 5.29 2012 0.75 0.62 5.37 2013 0.50 0.20 4.70 2014 0.50 0.22 4.62 2015 1.50 1.21 4.06 2016 3.00 2.60 5.03 2017 3.75 3.72 5.25
Economic Policy: Monetary Policy - Recent Developments

The European Central Bank (ECB) kept its key interest rate unchanged at a record low of 0.75% at its 4 April policy meeting. The ECB had previously trimmed interest rates by 25 basis points from 1.00% to 0.75% at its July 2012 meeting. Prior to this, the ECB had cut interest rates by 25 basis points in both December (from 1.25% to 1.00%) and November 2011 (from 1.50% to 1.25%). These interest-rate cuts at the end of 2011 had marked a quick, full turnaround in the Eurozone interest-rate cycle amid a markedly weakening economic environment, as the ECB had previously raised interest rates to 1.50% from 1.25% in July 2011 and to 1.25% from 1.00% in April 2011. The ECB also cut its deposit rate to 0.00% from 0.25% at its July 2012 meeting. This acts as the floor for money market rates and by cutting it to 0.00%, the ECB hoped to encourage banks to lend more to each other, and to the private sector, rather than just park the money with the ECB. Cutting the ECBs key interest rate to 0.75% in July could be seen as a significant change of tack as the bank notably did not take interest rates below 1.0% even at the height of the 2008/09 recession. The previous lack of a cut had implied that there was a significant core of ECB Governing Council members who had a strong aversion to taking
Page 17 of 33
interest rates below 1.00%. The ECB has appeared more flexible and pragmatic in its policy since Mario Draghi replaced Jean-Claude Trichet as ECB President in November 2011. While the ECB made no policy changes at its 4 April policy meeting, the overall tone of its statement and ECB President Mario Draghis comments were markedly more dovish compared with March, and an interest-rate cut from 0.75% to 0.50% now looks highly likely. It is very possible that the ECB could trim interest rates to 0.50% as early as at its May policy meeting. Significantly, Draghi revealed that there had extensive discussion within the Governing Council at the April meeting on interest rates. Furthermore, he reported that the decision to keep interest rates at 0.75% was by consensus, so it was not unanimous. While the decision for unchanged rates had also been a consensus one in March, the indications are that the discussion on whether to lower them or not was much more intense in April. Also significantly, Draghi stated that the ECB will monitor very closely all incoming data and stands ready to act. He indicated that this related to both standard and non-standard policy measures. However, Draghi pointedly refused to pre-commit on interest rates when asked in the press conference if the ECB would act in the near term should the Eurozone see further poor data over the coming weeks. The ECB has recently seemed reluctant to cut interest rates due to concern that fragmented credit markets would mean that the effectiveness of such a move would be limited, particularly in those countries where help is most needed. While this clearly remains a concern, the indications are that the ECB increasingly believes that an interest-rate cut is warranted anyway given the weakening economic environment. The ECB noted that the weakness in Eurozone economic activity seen in the fourth quarter of 2012 (when GDP contracted by 0.6% quarter-on-quarter) has extended into the early part of 2013. The bank acknowledged that the signs of economic weakness had recently become more widespread across countries, and was extending to the core Eurozone. While the ECB indicated its belief that gradual recovery should start in the second half of the year, it acknowledged that the risks to this outlook are to the downside. Meanwhile, it is clear that the Eurozone inflation situation is compatible with the ECB cutting interest rates. Eurozone consumer price inflation at 1.7% in March was essentially just beneath the ECBs target rate of below, but close to 2%, while a flash estimate released since the ECBs last policy meeting shows that inflation plunged to 1.2% in April. Furthermore, the ECB sees medium-term inflation expectations as firmly anchored and believes that price developments over the medium term will be limited by weakened economic activity. The ECB is clearly also keen to try and find other measures that it can come up with to help ease the fragmentation in Eurozone credit markets and facilitate lending to companies, but it is clearly struggling to come up with suitable initiatives that are consistent with its mandate and that can be effectively implemented. Meanwhile, the ECB made no further announcements at its October 2012April 2013 meetings on its bond purchase (Outright Monetary Transactions, or OMT) program. The ECB has repeatedly stressed that it is ready to buy the bonds of pressurized countries once all the prerequisites are in place. The ECB had previously fleshed out its bond-buying plans at its September policy meeting after announcing the introduction of such a program in August. This followed Draghis statement in late July 2012 that the ECB will do whatever it takes to preserve the euro. And believe me, it will be enough. It is very clear it will be the success of governments in problem countries in undertaking structural reforms and other measures that lift their competitiveness and improve their underlying fiscal positions and in Eurozone policymakers ultimately taking major steps towards greater fiscal and banking integration that will be key to the Eurozones survival in its current form over the long term. Having said that, the risk premia in bond markets that have periodically sent the yields of Spanish and Italian bonds to dangerously high levels is a major threat to the stability of the Eurozone that needs to be tackled urgently. So the ECB is treading a fine line by trying to put in place a strong enough bond-buying program that impresses the markets and results in a sustained, marked reduction in problem countries risk premia while at the same time keeping major pressure on the problem countries to commit to structural reforms and see them through.
Page 18 of 33
In many respects, the OMT program seems to satisfy these conditions. The markets appear to have been impressed by the fact that there are no ex ante size limits to the ECBs buying of a countrys bonds and that the ECB will accept the same (pari passu) treatment as private creditors in the case of a default. While there had been some speculation that the ECB could indicate a targeted ceiling for a countrys bond yields or a maximum spread differential, the unlimited size of the bond buying should be a powerful measure. The bond buying will be focused on sovereign bonds with a maturity between one and three years. It will be fully sterilized. To keep pressure on countries to commit to, and see through, major structural reforms and corrective measures, the ECB is imposing strict conditionality on its bond-buying program. The ECB will not buy a countrys bonds until its government has requested assistance from the European Financial Stability Facility (EFSF)/European Stability Mechanism (ESM) and then signed up to either a full macroeconomic adjustment program or a precautionary program. Critically, the ECB will only consider bond purchase if a country fully respects its program. If non-compliance occurs, the ECB may terminate or suspend its bond buying. The ECB will also ask the IMF to help countries monitor compliance with the programs. The ECB has undeniably gone a long way towards providing an effective backstop and bond yields have come down appreciably overall in the problem countries since July 2012. Ultimately, the success of its actions will depend critically on whether or not problem countries are prepared to first of all approach the EFSF/ESM for assistance, agree to specific corrective actions, and then see them through over a sustained period.
Economic Policy: Fiscal Policy and Outlook

The Italian Stability Law for 201315, passed by parliament in late November, retreated from the previous promise to lower the tax burden on struggling low-income households. After a prolonged cabinet discussion, the government has decided against its initial promise to provide immediate support to struggling low-income households by cutting income tax rates from early 2013, and will now plan to take more significant action from 2014. This will entail a cut in payroll taxes, while tax deductions for workers under 35 will rise from EUR10,600 to EUR13,500 from 2014. In addition, the government has confirmed the planned value-added tax (VAT) hike in July 2013 from 21% to 22%, but the reduced rate of 10% will remain unchanged. This was preceded by a VAT hike from 20% to 21% on 17 September 2011. Finally, the new stability law paved the way for a new Tobin Tax of 0.5% on the purchase and sale of equities and derivatives. Later administrations are required to consider broadening the base on this taxable income. The government made no announcement about new spending cuts, which had been expected to fall mainly on the health budget.
Page 19 of 33
Economy Minister Vittorio Grilli of the outgoing technocratic government has admitted that the recession is likely to linger throughout most of 2013 and will result in a larger fiscal slippage than previously anticipated. The economy is projected to contract by 1.3% in 2013, a marked downward revision from the previous official projection of 0.2% drop. In 2014, the economy is expected to recover, with real GDP growth estimated at 1.3%, replacing the current projection of 1.1%. The gloomier near-term economic outlook has been reflected in a softer public-sector budget deficit target for 2013, which is now expected at 2.9% of GDP, revised up from 1.8% of GDP. In addition, Grilli raised the 2014 budget deficit target from 1.5% of GDP to 1.7%. According to official calculations, the higher budget deficit targets for 2013/14 suggest that the government borrows an additional EUR40 billion over the next two years. Not surprisingly, Grilli defended the softer fiscal targets by arguing that the less aggressive fiscal consolidation stance is in response to the still deteriorating economic outlook alongside a plan to pay money currently owed by the government to private businesses for goods and services. However, the government will need parliamentary approval for the new fiscal plan as its represents higher public sector budget deficits than previously agreed. With regards to the public debt position, Grilli refused to offer a new general government debt to GDP target for 2013 to replace the current goal of 126.1% in 2013. However, he argued that the plan to pump additional liquidity into the economy would help to stir activity, and help to "curb potential increases in the debt to GDP ratio," which is the second highest in the single currency region after Greece. IHS Global Insight predicts the public-sector budget deficit will widen slightly from 3.0% of GDP in 2012 to 3.2% (revised up from 2.4%) of GDP in 2013 and 2.5% (up from 1.8%) in 2014, according to April's forecast update. We are expecting significant fiscal slippage in the first half of 2013 and now accept Italy will face a real challenge to keep the deficit below the EU target of 3% of GDP in 2013. This acknowledges the increasing pressures on the multiyear budget deficit reduction plan from the compelling signs that the recession is likely to linger throughout 2013 and is now projected to spill into 2014 as Italy endures some contagion from our baseline view of a Greek euro exit in mid-2014. Finally, we expect to produce more downbeat public debt projections in the next detailed forecast update, because of a sharper squeeze on nominal GDP than previously anticipated in conjunction with the government's higher borrowing requirements (if approved). According to our first-quarter detailed forecast, the public debt ratio is projected at 125.0% of GDP in 2013 and 123.7% in 2014, but this will be lifted significantly by two to three percentage points in both years in the next update.
Economic Policy: Fiscal Situation - Recent Developments

Italy faces significant fiscal pressures in line with a struggling economy, while the latest indicators suggest that it has not reached the "turning point" with regard to restoring fiscal discipline. Public finances overshot government targets in 2012, with Italy enduring some fiscal slippage, posting a general government deficit of 3.0% compared with the official target of 2.4% of GDP. This was preceded by wider deficits of 3.8% in 2011, 4.5% in 2010, and 5.4% in 2009. The narrower budget deficit in 2012 was due to the rise in total revenue (at 2.4% to stand at 48.1% of GDP) exceeding the growth in total expenditure (at 0.6% to stand 51.2% of GDP). Worryingly, Italy's fiscal pressure (taxes and welfare contributions as a proportion of GDP) climbed from 42.6% of GDP in 2011 from 44.0% in 2012 and now stands at its highest level since the start of the series in 1990. More encouragingly, the primary budget balance (public-sector budget position adjusted for interest expenditure) posted a larger surplus of 2.5% of GDP in 2012, up from 1.2% in 2011 and balanced in 2010. Meanwhile, the level of public debt continued to rise aggressively in 2012, standing at 127.0% of nominal GDP in 2012, compared with 120.8% in 2011 and 119.3% in 2009. The sharp rise in the public debt ratio in 2012 was partly due to the fall in nominal GDP but also reflected a still considerable general government budget shortfall. Italy's parliament passed an additional EUR4.5-billion (USD5.59-billion) worth of spending cuts for 2012 in early August 2012, with the savings expected to accumulate to EUR10.9 billion in 2013 and EUR11.7 billion in 2014. The new measures will allow the government to postpone and limit the planned increase in value-added tax (VAT) to just the general rate from 21% to 22% from July 2013. In addition, the government needs to raise funds to finance the welfare costs of 55,000 individuals who were left without benefits or pensions after legislation in December 2011 raised the retirement age, and help in the reconstruction of the earthquake-damaged Emilia-Romagna region. The cost of the earthquake aid is estimated at EUR1 billion in both 2013 and 2014. Overall, these new fiscal measures are estimated to
Page 20 of 33
have a neutral impact on net borrowing, lowering it by around EUR600 million in 2012, 16 million in 2013, and 27 million in 2014, according to the Bank of Italy. The fiscal savings will be generated from the following measures: The government plans to reduce the number of public officials gradually, with the bill proposing a 20% and 10% cut in senior servants and standard-level employees, respectively. Ministerial budgets will be cut by EUR1.5 billion in both 2013 and 2014, followed by a further EUR1.6 billion in 2016, with the Ministry of Finance taking the largest hit. The central government intends to cut the cost of regional, local, and provincial government. First, it plans to halve the current number of 110 provincial governments. Second, transfers to regional and local governments will be reduced by EUR2.3 billion in 2012, EUR5.2 billion in 2013, and EUR5.5 billion in 2014. The bill also includes cumulative cuts to the national health fund, estimated at EUR0.9 billion in 2012, EUR1.8 billion in 2013, and EUR2.4 billion. Meanwhile, eight regions that have a shortfall on their health budgets can raise the local income tax to finance the imbalance. The government had passed its third fiscal-correction package since mid-2011 in early December 2011 to bolster its fiscal consolidation plan. According to the Ministry of Economy and Bank of Italy, the December 2012 austerity package will raise EUR32.1 billion in 2012, EUR34.8 billion in 2013, and EUR36.7 billion in 2014. Around EUR20 billion, or 1.3% of GDP, per year will be allocated to reinforce the multi-year budget-deficit reduction plan. The austerity plan announced at end-2011 was weighted towards tax hikes to bolster the budget-deficit plan. This anticipated net revenues to increase by EUR19.4 in 2012, EUR17.0 in 2013, and EUR14.9 in 2014, which will contribute more than two-thirds of the reduction in the deficit. The most important new revenue measure was the property tax reform, which is expected to raise an additional EUR11 billion per year. The other significant measure was the postponement of the planned VAT hike from October 2012 until July 2013. The austerity plan in early December also contained proposed expenditure cuts totaling EUR0.9 billion in 2012, EUR4.4 billion in 2013, and EUR6.5 billion in 2014, and will be sourced mainly from pension changes (EUR0.9 billion in 2012, EUR4.4 billion in 2013, and EUR6.5 billion in 2014). Overall, Italy has adopted a punishing austerity plan. According to official estimates, the fiscal measures passed in July and December 2011 will extract fiscal savings worth EUR28.6 billion in 2012, EUR54.4 billion in 2013, and EUR9.9 billion in 2014. The cumulative impact of all the measures taken since July 2011 should cut the deficit by 3.0% of GDP in 2012 and 4.7% in each of the following two years.
Page 21 of 33
External Sector: Outlook

Italian exports are projected to grow very modestly in the next few quarters in line with softer domestic spending across the Eurozone. Latest industrial-related indicators provide compelling evidence that Italy's export recovery has stalled, highlighted by the Markit/ADACI manufacturing purchasing managers' index survey. A sub-index from the March survey reveals the inflow of overall new export orders was at near-stagnation in the first three months of 2011, which was preceded by it falling back in 10 of the previous 14 months. Italian exporters are struggling to sustain their recent impressive performance, which had helped to lift Italy out of recession. The main factor is likely to be a difficult 2013 for the Eurozone as a whole, with domestic demand conditions expected to be soft. The recent financial turmoilresulting from the region's sovereign debt crisishas hurt consumer and business confidence across Italy's key export markets. Furthermore, economic activity across the Eurozone and the United Kingdom is being be curbed by a restrictive fiscal policy, with several countries having to work hard to keep the sovereign debt crisis at bay. This situation, coupled with ongoing caution from French and German consumers, will weigh down on the Italian export outlook. The export outlook for 2013 is likely to be less challenging, helped by our amended baseline that Greece will leave the Eurozone in the second quarter of 2014 rather than the second half of 2013. Clearly, this will spare Italian exporters an additional headwind in 2013 when they are already facing soft domestic spending across the Eurozone. Indeed, the Eurozone economy (with Greece) is projected to contract by 0.6% in 2013 before expanding by 0.4% in 2014, according to the April 2013 forecast. Nevertheless, Italian exports are likely to suffer some relapse in 2014 with the Greek euro exit causing some disruption to trade flows across the Eurozone around mid-2014. Consequently, we expect exports of goods and services to expand 1.5% in 2013 and 0.5% in 2014 from 2.2% gain in 2012, according to the April 2013 forecast.
Trade and External Accounts Indicators 2010 Exports of Goods (US$ bil.) Imports of Goods (US$ bil.) Trade Balance (US$ bil.) Trade Balance (% of GDP) Current Account Balance (US$ bil.) Current Account Balance (% of GDP) 447.5 475.2 -27.7 -1.3 -72.7 -3.5 2011 523.5 546.6 -23.1 -1.1 -67.5 -3.1 2012 501.0 476.1 24.9 1.2 -23.0 -1.1 2013 516.5 475.6 40.9 2.1 -12.0 -0.6 2014 505.1 460.8 44.3 2.3 0.3 0.0 2015 559.2 512.9 46.3 2.2 1.1 0.1 2016 620.8 570.5 50.3 2.2 0.2 0.0 2017 674.8 618.9 55.9 2.3 3.3 0.1
Page 22 of 33
External Sector: Recent Developments

According to the latest custom-basis data, Italy enjoyed a larger trade surplus with the rest of the world in February 2013 as the result of a further sharp fall in the value of merchandise imports. Italy's merchandise trade balance measured in nominal terms with the rest of the world, excluding the European Union, improved to post a surplus of EUR1.086 billion (USD1.45 billion) in February, from a deficit of EUR1.195 billion in the same month of 2012, according to the latest customs-based data from the country's statistics office, ISTAT. The improved trade balance was due to a sharp fall in Italian imports from outside the EU, which fell by 9.6% year-on-year (y/y) to EUR29.805 billion. Clearly, Italian consumers remain reluctant to undertake major purchases, while firms are shying away from machinery and equipment investments. Meanwhile, exports to outside the EU dropped by 2.8% y/y to EUR30.891 billion. With regards to trade with the Eurozone, Italian exports shrank by 6.6% y/y to EUR16.773 billion, in line with recessionary conditions gripping the single-currency region. Again, depressed domestic spending trimmed the flow of imports from the European Union to Italy by 7.2% y/y to EUR16.393 billion. This resulted in Italy's trade surplus with the EU remaining relatively unchanged at EUR0.380 billion in February. Modest export gains occurred in fourth-quarter 2012, according to the national accounts. Exports of goods and services expanded by 0.3% quarter on quarter (q/q) in the fourth quarter, preceded by a 1.2% q/q gain in the third quarter. In addition, the annual rate of growth slowed to 1.9%, from 2.5% in the third quarter, and was up by 2.2% in 2012 as a whole. This was a better-than-expected outcome in the fourth quarter but Italian exports of goods were still under pressure by disrupted regional trade flows with real GDP falling back in Germany, France, the Netherlands, Spain, and the United Kingdom. Meanwhile, a breakdown of exports by destination reveals weaker demand from key export markets across the Eurozone in the first three quarters of 2012. The average level of merchandise export sales in nominal terms to the Eurozone contracted 1.0% y/y in the fourth quarter, compared with drops of 3.7% y/y in the third quarter and 4.3% y/y in the second. This spells the end of a steady export recovery after they plunged 19.1% in volume terms in 2009, when all sectors of manufacturing took large hits, particularly mechanical machinery and equipment, the traditional Italian export goods industries, and the transport equipment sector. Import demand shrunk again due to poor domestic demand conditions. Import demand also registered a pronounced drop in the fourth quarter, down 0.9% q/q and 6.6% on a y/y percentage basis, probably hit by weak capital spending. Overall, imports of goods and services contracted by 7.8% in 2012, a sharp reversal from gains of 1.1% in 2011 and 12.3% in 2010. Net exports lifted activity in the fourth quarter, boosting real GDP quarterly growth by 0.4 percentage point. This was up from a positive contribution of 0.6 percentage point in the third quarter. The current account improved for the 22nd successive month in February 2013 when compared with a year earlier. The current account recorded a deficit of EUR1.592 billion (USD2.126 billion) in February 2013, an improvement from a EUR2.902-billion deficit in the same month a year earlier. This was due to an improved trade balance when compared with a year earlier, which increased by EUR2.265 billion to record a surplus of EUR1.681 billion in February. The nominal value of merchandise exports decreased 2.6% y/y to EUR31.022 billion, while merchandise imports slumped by 9.5% y/y to EUR29.43 billion. Meanwhile, the services balance posted a narrower deficit of EUR0.483 billion, compared
Page 23 of 33
with a deficit of EUR0.842 billion in February 2012. Finally, the net factor income account improved by EUR0.30 billion to post a modest deficit of EUR0.802 billion in February. In 2012 as a whole, the current-account deficit stood at EUR9.5 billion, or 0.5% of GDP, compared with EUR48.446 billion, or 2.7% in 2011. Higher global crude oil prices led to another substantial current-account deficit in 2011. The current-account deficit stood at EUR50.554 billion in 2011, or 3.5% of GDP, compared with EUR54.7 billion in 2010.
Economic Structure and Context: Development and Strategy

The performance of the economy since the early 1990s suggests that, in an absence of significant structural reforms, it will be trapped in a cycle of progressive decline. A key problem remains the high fragmentation of the Italian enterprise system, with a high incidence of very small enterprises struggling to compete in the face of a strong euro and increased competition from abroad. Second, there are excessive regulations in several markets and a lack of competition in many key services sectors. This includes the banking sector as well as others, which are able to pass on their low productivity onto their selling prices. Consequently, the competitiveness of the traded goods sector suffers as it is obliged to use inputs from the service sector, where unit labor costs have tended to increase faster than in the traded goods sector. Relatively high service prices, including among the highest for energy in the European Union (EU), have reduced profit margins in the traded goods sector. In more general terms, Italy needs to adjust more fully from the competitive devaluation model which existed prior to joining the euro to a model based on productivity gains and on higher value-added production and services. The export sector has struggled to regain much of its dynamism. Italy's past strengths are now responsible for heralding a period of very weak growth. The economy has developed strong specialization in the production of textiles, clothing and footwear, leather goods, furniture, and machine tools. This specialization, however, coupled with the high concentration of small enterprises in the traditional textiles and footwear sectors has made Italy vulnerable to strong price competition from low-cost producers in China, India, and Eastern Europe. In addition, Italy has endured a marked fall in price competitiveness within the euro, and even more acutely against non-euro countries after the euro recovered. Its real exchange rate has increased because of higher inflation than in the rest of the euro area, rising relative unit labor costs and the recovery of the euro from 2003. This has created serious problems for Italian exporters, given that the type of
Page 24 of 33
products in which they specialize tend to be highly price elastic. Consequently, Italy's export market performance has deteriorated rapidly, with its share of the nominal value of world exports falling to 3.0% in 2010 from 3.6% in 2007. In a pre-euro world, the short-term solution would have been a competitive devaluation. Italys largest problem remains its dismal public finances, with its public debt now estimated at 123.6% of GDP in 2012. Several items contribute to high levels of government spending, particularly the excessive cost related to the pension system. Future budgets will need to curtail more aggressively the large transfers to both local government and the health system, while reducing the high cost of the public sector employment. The government also needs to introduce more structural measures to bolster its receipts. Tax evasion is falling, but is still widespread, and entrepreneurial activity in some regions, particularly the south, is still conditioned by organized crime and corruption.
Economic Structure and Context: Demographics and Labor Markets

Job growth began to pickup after the start of the labor-market reforms in 1998, and had been strong from 2001 until stalling with the onset of the Great Recession during 2009. The recent labor-market reforms have improved flexibility of work contracts, and have reduced hiring and firing costs for marginal and new workers. The Treu and Salvi Laws, passed in 1997 and 2000 respectively, relaxed the regulations on part-time employment. In 2001, Italy implemented the 1999 European Union (EU) Directive on temporary work. For the first time, the law made it possible to hire workers on a temporary basis (provided the reasons for term employment are clearly stated in the contract). Italy features another form of employment contract, which is legally framed as a self employment, but very often has the attribute of dependent employment. Indeed, "CO.CO.CO." (Collaborazione Coordinata e Continuativa) workers include a variety of professional figures, from qualified professionals to de-facto dependent workers. The Biagi law transformed the CO.CO.CO contracts in project contracts, primarily contracts related to the existence and duration of a pre-specified project. CO.CO.CO workers were not required to pay social security contributions, and are still not eligible for maternity leave, unemployment insurance and paid vacation. The Biagi law now requires that social security is paid and grants eligibility for maternity leave, unemployment insurance, and paid vacation. There are no official statistics on the number of these contracts, but administrative sources estimated more than 2 million contracts in 2000. Despite a spate of labor-market reforms in the late 1990s and early 2000s, specific inefficiencies continue to prevail in the Italy. They include: Italy has a substantially lower employment ratio when compared with most of the countries in the European Union (EU), particularly among women, older workers, and the young. Despite employment rates of prime-aged males being above 70%, the overall employment rate in Italy stood at a lowly 57.0% in the third quarter of 2011. This is accompanied by painfully high youth unemployment, with 30% of 18- to 24-year-olds currently unemployed. A dual labor market has been encouraged by past reforms. Italy has adopted asymmetric reforms to increase labor-market flexibility, which entailed adopting less restrictive regulations on temporary contracts alongside strong employment protection for permanent workers. Consequently, firms have shown a very strong bias towards recruiting workers on temporary contracts, especially with first-time contracts, which tend to be less productive. With recent labor-market reforms failing to address the high cost and the legal obstacles of dismissing workers on permanent contracts, firms remain reluctant to hire workers permanently because they struggle to dismiss non-productive workers. This is encapsulated by the symbolic Article 18 of the labor statute implemented in 1970, which requires firms with more than 15 employees to reinstate workers who have been wrongly dismissed, with full payment of lost salary, and this covers around two-thirds of all workers. Furthermore, firms are reluctant to invest and train workers on temporary contracts, adding to the productivity malaise. Italian labor-market laws are too wide-ranging and inflexible, with the process of dismissing workers a laborious and costly one for employers. Therefore, the response to tougher economic conditions at both the firm and national level, as well as technology shocks, has been too slow. Indeed, firms can only dismiss workers for business reasons as part of a company restructuring, while it is difficult to remove unproductive individual workers.
Page 25 of 33
The wage-bargaining framework in Italy is too centralized, which prevents wages adapting to specific productivity and demand conditions at the firm level. About 60% of Italian workers are covered by collective wage bargaining agreements (IMF, 2009), which is high when compared with the rest of the EU. The lack of flexibility in Italy's centralized wage-bargaining system was illustrated by the Italian carmaker Fiat having to create new companies to manage its factories in Italy to circumvent national labor contracts in 2010.Furthermore, the current wage formation system is even more punishing for small enterprises, with the nationally negotiated wages having greater weight than those negotiated at the firm level. Italy's unemployment insurance system is too wide-ranging and also has "dual characteristics. Unemployment benefits are initially high, with a net replacement ratio of 60% before dropping to zero after eight months (12 months for workers aged over 50). In addition, tough eligibility rules restrict the number of individuals who qualify for unemployment benefits. On the other hand, the wage supplementation fund scheme (cassa inegrazione) is substantially more generous, both in terms of level and duration. The scheme makes up the pay of permanent employees affected by temporary layoffs (who are not considered unemployed) or under shorter working hours for a maximum of two years. It is limited to workers on certain contracts, with the participating firms mostly large and located in the north. Italy has a relatively high tax and social security wedge on labor income. According to IMF calculations, a single taxpayer at average earnings takes home less than 55% of what he or she costs the employer. This drops to 50% for workers on higher earnings. Overall, the average tax wedge in Italy is at least 10 percentage points higher than the OECD average, which remains a major reason for low labor utilization, and weighs down on both employment and growth potential. The technocratic government led by Mario Monti passed a new labor reform bill in 2012. The main goal of the new reform bill is to remove some of the dismissal restrictions currently specified in Article 18, which require firms with more than 15 employees to reinstate workers who have been wrongly dismissed, with full payment of lost salary. The reform bill does not scrap Article 18, but amend its scope by allowing firms to dismiss workers for business reasons on payment of compensation. In cases of wrongful dismissal for misconduct, it will be left up to a judge to decide if the worker should be reinstated or just receive compensation. The compensation for wrongful dismissal could range from 15 to 27 months' salary, based on the number of years worked. Automatic reinstatement would only remain for cases of proven discrimination. Finally, the planned changes to Article 18 would only apply to new hires. The reform also wants to introduce a special legal procedure for dismissal disputes in order to speed up decisions and overcome the current system, which allows workers to be reinstated after years of dispute. The reform also makes short-term contracts more costly for employers by raising the tax and welfare contributions they have to pay by 1.4 percentage points. Firms will be reimbursed the extra tax if the temporary contract is made permanent.
Economic Structure and Context: Monetary System

Since the euro was launched in 1999, monetary targets in the Eurozone have been set by the European Central Bank (ECB). There are currently 17 member states that compose the Eurozone, each of whom surrendered monetary sovereignty upon joining the union. Oversight of the Economic and Monetary Union (EMU) is vested with the European Commission, although control of monetary policy and the European Monetary System is administered by the independent ECB. The euro is the sole legal tender of Austria, Belgium, Cyprus (excepting Northern Cyprus), Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. As one of the world's major convertible currencies, the euro operates on a free float, although the ECB reserves the right to intervene in the foreign-exchange market to smooth over fluctuations in the euro exchange rate. It has done this in practice, but eschews active exchange-rate management. Rather, its main objective is to preserve price stabilitythat is, to preserve the value of the euro. Although it sits atop the European System of Central Banks (ESCB), the ECB also delegates this objective of maintaining price stability to all member states' national banks, with the proviso that the ESCB will generally support the economic policies and objectives of the European Union (EU).
Page 26 of 33
Price stability is defined as a year-on-year (y/y) increase in the EU's preferred measure of inflation, defined by the Harmonized Index of Consumer Prices (HICP) for the euro area of below but close to 2%. Thus, the governing council of the bank has determined that medium-term price stability involves keeping inflation at approximately 2%. The HICP is used for measuring inflation in the context of international, mostly inner-European comparisons. Its calculation relies on harmonized concepts, methods, and procedures and is designed to reflect the development of prices in the individual states based on national consumption patterns. The HICP serves, among other things, to measure the convergence criterion of "price stability" as a basis for judging whether a member state can participate in the European EMU. The HICP is calculated for each EU member state, as well as Norway and Iceland. It is used to form aggregates for the Eurozone (Monetary Union Index of Consumer PricesMUICP), for the EU (European Index of Consumer PricesEICP), and for the European Economic Area (European Economic Area Index of Consumer PricesEEAICP). The ECB makes use of the MUICP in the context of its monetary policy to judge price stability within the Eurozone. The governing council effectively consists of the 6 members of the executive board and the 17 governors of the national central banks of the euro area. The key task of the governing council involves formulating the monetary policy for the euro area. The ECB has frequently come under political pressure over interest rates and, increasingly during the Eurozone sovereign debt crisis, other elements of monetary policy (such as liquidity provision and bond buying). Nevertheless, it has jealously guarded its independence and has refused to bow to outside pressures, despite the best efforts of member states. Indeed, it is to its credit that it has been able to steer a relatively influence-free trajectory for monetary policy given the Eurozone's peculiar makeup (i.e., an amalgam of several countries whose economies are, despite significant convergence, still relatively disparate). Until the Eurozone sovereign debt crisis, the bank tended to err on the side of inaction, earning itself a reputation for being unresponsive to conditions in the Eurozone. Nevertheless, the bank insists that its mandate is to keep the price level stable, and as such has remained immune to political demands. The ECB has certainly been highly active during the Eurozone sovereign debt crisis. While it has remained unwilling to take its key Eurozone interest rate below 1.00%in marked contrast, for example, to both the US Federal Reserve and the Bank of Englandthe ECB has undertaken a number of non-standard measures to counter the problems. Most notably, this has included making massive liquidity available to banks and, to a lesser extent, buying sovereign bonds of the pressurized countries on secondary markets.
Economic Structure and Context: Financial System

The Italian banking sector has become more consolidated, and has gone from being one of the most fragmented and inefficient in Europe to having a concentration ratio similar to that of France, and above that of Germany. By 2000, around 50% of the banking sector was located among the five largest banks in the country, following hundreds of mergers during the 1990s. Key to the consolidation was the sale by government and charitable foundations of large quotas of their holdings in the banking sector. The spate of mergers has allowed banks to specialize in more profitable business areas than traditional deposit-and-loan products. It has also allowed them to protect themselves more effectively against foreign intrusion and to expand overseas. The ambitious UniCredito, one of Italy's biggest banks, has interests in Central Europe, for instance. Despite a potentially risky large exposure to Italian government bonds, the banking sector remains relatively secure. Indeed, the Italian banking system appears to be sounder than most of the Eurozone, partly due to the traditional character of many domestic banks, which are based on a higher dependence on retail deposits for funding than many other European banks. Importantly, the Italian banking system did not oversee a property bubble or even a credit explosion during the past decade. Rather like the banking sector, the country's financial capital, Milan, has historically lagged some way behind its European counterparts, particularly those of Frankfurt and London. Despite some growth in the 1980s, the capitalization of La Borsa by 1992 had shrunk to just 12.2% of GDP, at a time when there were 229 companies registered on the exchange. The Borsa nevertheless came to life dramatically in the late 1990s amid the banks' merger mania. Between 1995 and 2000 the
Page 27 of 33
Borsa's capitalization expanded by 378%growing to 70.2% of GDP. The creation of the Nuovo Mercato (equivalent to the German Neue Markt) helped fuel the financial sector, listing 42 new technology and hi-tech stocks by 2001. Subsequently, the Borsa has suffered from the international market downturn, dropping sharply. Combined with a banking sector seeking to make profits outside of its traditional savings and loans business, the capital markets look set to become increasingly important to the economy. If combined with structural reforms, particularly regarding labor taxation, the increasing medium-term importance of La Borsa could encourage greater corporate consolidation within the country.
Economic Structure and Context: Key Sectors

Shoes, Textiles, Luxuries: A large number of Italy's small producers specialize in the production of shoes, leather goods, and textiles, as well as domestic furniture. The area of manufacturing is concentrated in the Central Italian regions of Tuscany and Marche. After manufactured engineering, this is the biggest foreign currency earner in the country. The industry, however, is constantly under pressure from cheaper cost producers and represents income-elastic goods, which suffer sharply in the wake of any drop in external demand. Automotive: The Fiat group's domination of the Italian automotive industry is almost total, but the company is in serious financial trouble and is currently undergoing painful restructuring. More than 90% of all vehicles produced in the country are made by one of the group's core brands, such as Fiat, Alfa Romeo, Lancia, or truck-making division Iveco, and much of the remainder is made either by Fiat-owned companies or manufacturers in alliance with the Italian giant. The reorganization of suppliers during the 1990s has hit component manufacturers however, and the slump in domestic demand has struck the car-making division of Fiat, Fiat Auto, very badly in recent years. The government collects around USD70 billion in automotive taxation every yeararound 20% of Italy's total taxation income. Industrial Machinery: The largest sector of industrial output is within machinery and metals production. Heavy industry is mainly concentrated in Emilia-Romagna, Lombardy, Piedmont, and Liguria. But there are serious concerns about the country losing out in the hi-tech sector as lower-priced foreign competitors in the industrial machinery sector undercut Italian producers. Tourism: A key earner of foreign currency, tourism is not as large or as developed as in France or Spain. The number of foreign visitors to Italy stood at 46.1 million in 2011, up from 43.6 million in 2010. This compares with 79.5 million and 56.7 million visitors to France and Spain in 2011, respectively. Telecoms: Liberalization of the industry occurred in the 1990s, but Italy has been slow to inject greater competition, with the former state monopoly Telecom Italia particularly reluctant to embrace change, as evidenced by continuing investigations into its potential abuse of a dominant position by the country's Competition Authority. This has led to slower industry revenue growth than was expected. There has been a cellular boom in Italy second only to those in Nordic countries. The penetration rate for mobile phones is above 90%, although the country lags in terms of broadband penetration, fixed-line revenues, data networks transmission, cable TV penetration, and other telecoms sectors. Italy: Top-10 Sectors Ranked by Value Added 2012 Level (Bil. US$) 1. Real Estate 2. Public Admin. and Defense 3. Health and Social Services 4. Business Services 5. Retail Trade - Total 6. Construction 236.8 123.1 115.3 115.1 108.8 101.9 2013 Percent Change (Real terms) -1.1 -1.9 -2.2 -0.9 -2.5 0.4 Percent Share of GDP (Nominal terms) 13.3 6.9 6.5 6.5 6.1 5.7
Page 28 of 33
7. Wholesale Trade 8. Education 9. Banking and Related Financial 10. Hotels and Restaurants Top-10 Total
94.7 85.5 74.1 72.1 1,127.5
-0.9 -0.6 -1.1 -2.1
5.3 4.8 4.2 4.0 63.3
Source: World Industry Service, IHS Global Insight, Inc. Updated: 16 Apr 2013
Economic Structure and Context: Natural Resources

The forestry industry has traditionally been limited and significant amount of wood is still imported. Most of the old growth forests have already been harvested, and the resulting soil erosion has hampered the industry. There have been some advances in recent years, however, and the timber harvest in 2002 was 7.8 million cubic meters. Italy has very low indigenous oil reserves. It is estimated at only 622 million barrels, and therefore has to import more than 90% of its demand from the Middle East, particularly Algeria and Libya. Domestic gas production has also been falling for over a decade but reserves are still estimated at 230 billion cubic meters. Natural-gas imports account for around 75% of total consumption. Gas is primarily imported from the Netherlands and Russia. Even though mining as a whole contributes only a small portion to the country's economy, production in some minerals is considerable. Mineral resources include barites, lignite, pyrites, fluorspar, sulfur, and mercury. Italy is the world's largest producer of pumice and related materials, based on the isolated island of Lipari, and is also the largest producer of feldspar, which is used in the production of ceramics. Italy's coastal waters are rich in fish, despite the continuing depletion of Mediterranean stocks. The total catch in 2003 was 314,807 tons, with a value of about EUR1.4 billion. Anchovies, sardines, hake, mullets, and swordfish together accounted for 44% of the volume in 2003.
Economic Structure and Context: Trade Profile

Italy specializes in highly price elastic goods, notably clothing and footwear, as well as capital equipment. Mechanical machinery and equipment accounts for the largest share of Italian commodity exports, recorded at a 17.8% of total commodity exports in 2010. Basic metal products and fabricated metal products and transport equipment account for the next largest export shares, at 11.7% and 10.2%, respectively. The share of clothing (including in leather and fur) and footwear exports stood at 6.6% in 2010, which has fallen from over 10% in the early 1990s in line with increasing competition from low-cost producers in Far East, particularly those from China. During the 1970s and 1980s, Italy's trade with other European Union (EU) countries expanded dramatically. This has fallen back since the early 1990s, with Italy's still largest export markets Germany and France accounting for a smaller share of Italian commodity exports in 2010, at 13.2% (down from 19.2% in 1990) and 11.8% (down from 16.3%), respectively. The country's dependence on imported coal, oil, electricity, and other essential goods continues to weigh on the balance of trade. The imbalance is also partly offset by the tourism industry, remittances from Italian nationals abroad, and shipping revenues. Italy: Major trading partners, 2011 EXPORTS IMPORTS
Page 29 of 33
Country Germany France United States Spain Switzerland United Kingdom China Belgium Poland Turkey
Billions of USD 68.7 60.8 30.4 27.7 27.7 24.4 13.8 13.6 13.1 12.9
Percent share 13.3 11.8 5.9 5.4 5.4 4.7 2.7 2.6 2.5 2.5
Country Germany France China Netherlands Spain Belgium United States United Kingdom Switzerland Russia
Billions of USD 86.9 46.5 40.6 29.0 24.9 20.3 16.1 15.0 13.9 13.4
Percent share 16.5 8.9 7.7 5.5 4.7 3.9 3.1 2.9 2.7 2.6
Source: IMF, Direction of Trade
Italy: Major trading partners, 2000 EXPORTS Country Germany France United States United Kingdom Spain Switzerland Belgium Netherlands Austria Greece
Source: IMF, Direction of Trade
IMPORTS Billions of USD 35.7 29.7 24.5 16.3 14.8 8.0 6.5 6.3 5.2 4.8 Percent share 15.1 12.6 10.4 6.9 6.3 3.4 2.7 2.7 2.2 2.0 Country Germany France Netherlands United Kingdom United States Spain Belgium Switzerland Russia China Billions of USD 41.2 26.8 14.0 12.8 12.5 9.7 9.5 7.8 7.6 6.5 Percent share 17.5 11.4 5.9 5.4 5.3 4.1 4.0 3.3 3.2 2.7
Medium- and Long-Term: Outlook

Italy has passed some legislation to inject greater competition into several key professional and service sectors. The reform bill abolishes the use of minimum professional tariffs for all sectors, with the notable exception of the legal profession. The bill also increases the number of pharmacy licenses nationwide. Nevertheless, having accepted a number of amendments applied by the Senate (upper house of parliament), ministers have been accused of watering down proposals. Pressure from transport workers led to a rapid climb-down on the proposed liberalization of taxi licenses. Nevertheless, this is an important first step to dismantling the excessive regulation in key sheltered service sectors. This first layer of economic liberalization reforms will bring about some incremental benefits, but more profound measures will be required to realign Italy's growth potential with the leading performers in the Eurozone. The main battleground remains the labor market, with the economy needing far-reaching labor reforms to reverse Italy's poor productivity performance. First, the wage-bargaining framework in Italy remains too centralized, which
Page 30 of 33
prevents wages adapting to specific productivity and demand conditions at the firm level. A truly decentralized wage formation system in Italy would provide wider scope to alter working conditions, break the link with projected inflation, and allow the greater use of performance-related pay. Second, Italy's labor laws are too wide-ranging and inflexible, with the process of dismissing workers a laborious and costly one for employers. Despite recent reforms, the high cost of dismissing workers and the legal obstacles prevail, and continue to discourage the recruitment of permanent employees. More importantly, it makes it difficult to lay off non-productive workers on permanent contracts, resulting in a bias towards less-productive employment. The technocratic government has responded by presenting a new labor market reform bill, which is currently passing through parliament. The main goal of the reform bill is to remove some of the dismissal restrictions currently specified in Article 18, which require firms with more than 15 employees to reinstate workers who have been wrongly dismissed, with full payment of lost salary. The reform proposals do not plan to scrap Article 18 but amend its scope by allowing firms to dismiss workers for business reasons on payment of compensation. In cases of wrongful dismissal for misconduct, it will be left up to a judge to decide if the worker should be reinstated or just receive compensation. The compensation for wrongful dismissal could range from 15 to 27 months' salary, based on the number of years worked. Automatic reinstatement would only remain for cases of proven discrimination. Finally, the planned changes to Article 18 would only apply to new hires. The reform also wants to introduce a special legal procedure for dismissal disputes in order to speed up decisions and overcome the current system, which allows workers to be reinstated after years of dispute. The draft reform also intends to make short-term contracts more costly for employers by raising the tax and welfare contributions they have to pay by 1.4 percentage points. Firms will be reimbursed the extra tax if the temporary contract is made permanent. Business lobby groups were opposed to more profound proposals to significantly reduce the use of temporary hires. Assuming the introduction of far-reaching structural reforms in Italy and short-term adjustment pains, real GDP growth could stabilize in the 1.21.5% range in the outer years of the forecast period. Currently, we estimate long-term growth at around 1.0%, which assumes a less aggressive reform agenda, while the economy is weighed down by poor demographics. Clearly, an underlying improvement in competiveness in the upbeat scenario would help Italy to better exploit any growth in the trade-weighted index of world demand for Italian products beyond the short term, and provide more ammunition to protect its under pressure export market shares in the face of the anticipated steady appreciation of the euro and intense competition from low-cost producers in the Far East and Eastern Europe. In addition, further labor market reforms would be required to encourage higher labor-force participation in order to offset the projected decline in working population, and help to lift the employment ratio, which remains the lowest in the euro area. Without a significant package of economic-liberalization reforms, Italy's long-term outlook remains challenging. The population is aging fast, which will lower Italy's potential output growth for many years to come. Without significant reform, IHS Global Insight expects potential growth to fall from around 1.7% in 2005 to 1.2% by 2030 as the population ages. The birth rate has fallen from 18.4 per 1,000 inhabitants in 1960 to an estimated 8.89 in 2005. With steadily longer life expectancy, the ratio of elderly persons to children under 6 years old has increased from 1 in 1961, to 1.8 in 1981 and 2.6 in 1991. Consequently, the median age in Italy has climbed from 33 years in 1975 to 41.77 years in 2005, and is projected to rise to 51 years by 2024. Further labor-market reforms are required to encourage higher labor-force participation in order to offset the decline in working population. Major labor-market reforms have produced encouraging results, but the employment ratio remains the lowest in the euro area. Increasing wage flexibility and reducing the tax wedge over time will be required to raise employment. Prime Minister Mario Monti also wants to address the inequality of pension entitlements across Italy, noting that the system "awards high pensions to some and low ones to others." High state pension expenditure remains a huge drain on government finances, accounting for most of the social protection budget, and is expected to remain at around 15% of GDP between now and 2040, according to the latest calculations from the Ministry of Economy and Finance. A heavy burden on the state's pension obligations is the high incidence of male workers who qualify for early retirement known as "seniority pensions" after satisfying the retirement eligibility of 35 years of social security contributions and a minimum age requirement of 61 years from 2010. An option for Monti could be to ratchet up the minimum age of
Page 31 of 33
requirement, or lengthen the "exit window," which is a postponed entitlement to early retirement. Another area of potential reform is to accelerate the transition from a defined-benefit system (based on final earnings to a less burdensome notional defined-contribution system, which will only be fully effective after 2030). According to government estimates, the stock of pensions calculated (fully or partially) according to the old defined-benefits rules will still be over 45% in 2050. Despite a flurry of reforms since the 1990s, Italy's pension-earnings ratio was the second largest in the Eurozone in 2007, behind only Greece, which in conjunction with a low effective retirement age does make considerable demands on Italy's welfare spending. Further reform will be needed, given that the pension system is facing a sizeable demographic shock. Given the low birth rate, Italy's population is set to age rapidly over the next 50 years. Assuming no sharp acceleration in net immigration, the working-age population is set to shrink markedly over the next 50 years. Currently, there are four working people available to support each pension, but this is expected to narrow to 1.63 workers by 2050, according to Eurostat estimates.
Analyst Contact Details:
Raj Badiani, Howard Archer
Italy: Country Reports - Recent Analysis

Economic
1. Italian unemployment rate stands at 11.5% in March

01 MAY 2013
Country - Economic - Sovereign Risk
2. With calls for both fiscal consolidation and growth, new Italian PM avoids divisive detail
01 MAY 2013
Economic
3. New Italian government reaches out to downtrodden consumer

30 APR 2013
Economic - Sovereign Risk
4. Italy upholds support to Mozambique

30 APR 2013
Page 32 of 33
5. Investors welcome new Italian government, but major economic, fiscal, and reform challenges lie ahead
29 APR 2013
6. Italian two-year bond auction enjoys lowest yields since 1999 as political gridlock nears end
25 APR 2013
Economic
7. Italian consumer confidence posts surprise improvement in April

24 APR 2013
Economic
8. Italian retail sales slip again in February

24 APR 2013
9. Re-election of Napolitano as Italian president triggers positive reaction in debt markets

23 APR 2013
10. Italian Treasury confirms higher debt issuance plan for 2013, continues to enjoy comfortable primary debt operations
17 APR 2013
Created on 01 May 2013 Reproduction in whole or in part prohibited except by permission. All Rights Reserved Information has been obtained by sources believed to be reliable. However, because of the possibility of human or mechanical errors by our sources, IHS Global Insight Inc. does not guarantee the accuracy, adequacy, or completeness of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. http://www.ihsglobalinsight.com/
Page 33 of 33
Copyright of Italy Country Monitor is the property of IHS Global Inc. and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holder's express written permission. However, users may print, download, or email articles for individual use.

Country Intelligence Report 2

Transféré par

Informations du document

Description originale:

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

Country Intelligence Report 2

Transféré par

Droits d'auteur :

Formats disponibles

Country Intelligence: Report

REPORT PRINTED ON 01 MAY 2013

Created on 01 May 2013

Created on 01 May 2013

Outlook and Assumptions: Outlook

Outlook and Assumptions: Domestic Assumptions

Created on 01 May 2013

Outlook and Assumptions: Alternative Scenarios

Economic Growth: Outlook

Created on 01 May 2013

Created on 01 May 2013

Economic Growth: Recent Developments

Created on 01 May 2013

Created on 01 May 2013

Economic Growth: Consumer Demand - Outlook

Economic Growth: Consumer Demand - Recent Developments

Created on 01 May 2013

Economic Growth: Capital Investment - Outlook

Created on 01 May 2013

Economic Growth: Capital Investment - Recent Developments

Labor Markets: Outlook

Created on 01 May 2013

Labor Markets: Recent Developments

Created on 01 May 2013

Inflation: Recent Developments

Created on 01 May 2013

Exchange Rates: Outlook

Created on 01 May 2013

Exchange Rates: Recent Developments

Created on 01 May 2013

Created on 01 May 2013

Economic Policy: Monetary Policy and Outlook

Created on 01 May 2013

Economic Policy: Monetary Policy - Recent Developments

Created on 01 May 2013

Created on 01 May 2013

Economic Policy: Fiscal Policy and Outlook

Created on 01 May 2013

Economic Policy: Fiscal Situation - Recent Developments

Created on 01 May 2013

Created on 01 May 2013

External Sector: Outlook

Created on 01 May 2013

External Sector: Recent Developments

Created on 01 May 2013

Economic Structure and Context: Development and Strategy

Created on 01 May 2013

Economic Structure and Context: Demographics and Labor Markets

Created on 01 May 2013

Economic Structure and Context: Monetary System

Created on 01 May 2013

Economic Structure and Context: Financial System

Created on 01 May 2013

Economic Structure and Context: Key Sectors

Created on 01 May 2013

94.7 85.5 74.1 72.1 1,127.5

-0.9 -0.6 -1.1 -2.1

5.3 4.8 4.2 4.0 63.3

Economic Structure and Context: Natural Resources

Economic Structure and Context: Trade Profile

Created on 01 May 2013

Source: IMF, Direction of Trade

Medium- and Long-Term: Outlook