Anna Maria GrimaldiEuro area Economist, Banca Intesa

Italy: Where is the Exit?

Milan, March 2006

2

Manufacturing: it ‘s (soft ) party time

PMI & Industrial Output

42

46

50

54

58

62

1998 1999 2000 2001 2002 2003 2004 2005 2006-6%

-4%

-2%

0%

2%

4%

6%

PMI manufacturing (t-1), (LHS)industrial production % y/y, (RHS)

40

45

50

55

60

2001 2002 2003 2004 2005 2006-30

-25

-20

-15

-10

-5ISAE - order level (dx)

PMI manufact., new orders (sx)

Manufacturing output moving more in sync with managers judgment

Demand offering support ahead

Italy manufacturing has certainly improved. Since the Spring, confidence gained ground, mostly on solid gains in orders. Yet, industrial production only recently moved more in sync. With managers judgment.

Source: NTC, ISAE and ISTAT

3

Services: mangers say the future is bright

42

46

50

54

58

62

66

70

1999 2000 2001 2002 2003 2004 200542

46

50

54

58

62

66

70

Euro area Ger Ita Fra

We’ re even doing better than the EU average

The services confidence indicators have moved on a steep upward trend since teh start of the summer. The Italian PMI is now even above the EU average. Yet, so far actual output has disappointed, stagnating in the summer. We are confident value added will have contributed positively to GDP growth already in 2005.T4.

Source: NTC, ISAE

Services: value added and PMI

0%

1%

2%

3%

4%

5%

1998 1999 2000 2001 2002 2003 2004 2005 200648

50

52

54

56

58

60

62

64

PMI services (rhs)Value added y/y (lhs)

Yet, we are still waiting for the VA to step up

4

Disposable income holding up

40

45

50

55

60

65

1998 1999 2000 2001 2002 2003 2004 2005 2006-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0PMI jobs lag 2, (rhs)Employment total yy%, (lhs)

Employment to gain traction in 2006

-2.0

-1.0

0.0

1.0

2.0

3.0

1998 1999 2000 2001 2002 2003 2004 20050.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Real w ages (lhs)Contractual w ages (var % y/y) Inflation

Wages still growing more than inflation

The PMI composite job index suggests employment growth should gain traction over the coming months. Contractual wages are slowing down, but still growing well in excess of inflation. Thus, we see a modest pick-up in disposable income in the near future, which in turn should support consumer spending.

Source: NTC, ISTAT

5

Short - term prospects still betting on trend growth

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

2002 2003 2004 2005 2006-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0Line: year-on-year growth, %Bars: quarterly annualized growth, %

Forecast

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

2002 2003 2004 2005 2006

Final Domestic DemandNet ExportsInventories Building

Contribution to YoY GDP Growth

Forecast

GDP growth to return to trend driven... ...by domestic demand

Taking stock of the latest developments , we envisage gradual return to trend growth in 2006, as domestic demand should pick up and net trade should become less of a drag at least in 2006H1.

6

The “sick man” needs more than a few quarters of stronger growth

Italy has cumulated a 10pp growth gap with the rest of the EU since 1995.

The gap has widened since early 2001.

The differential with the EU could widen further unless serious reforms are implemented.

Source: Eurostat

Trend in GDP constant prices

95

100

105

110

115

120

125

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Ita AE excl. Ita

GDP = 100 in 1995 Q1

7

Exports is the culprit, so far!

Italy underperformance is largely accounted for by the weakness of export growth vis-a-vis its EMU partners.

Trend in domestic demand at constant prices Trend in exports at constant prices

Source: Eurostat

95

105

115

125

135

145

155

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

FranceGermanyItalySpainEuro Area ex-Germany

Domestic demand at constant prices (1994 Q1=100) 95

120

145

170

195

220

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

FranceGermanyItalySpainEuro Area ex -Italy

Export at constant prices (1994 Q1=100)

8

The good, the bad and the ugly!

Export market performance has diverged markedly within the EU starting from 1995. In particular, competitiveness deteriorated dramatically in Italy and to a lesser extent in France, while Germany and Spain have been able to maintain a much better position in global markets.

Source: OECD

99.6

99.8

100.0

100.2

100.4

100.6

100.8

101.0

101.2

101.4

1995 1997 1999 2001 2003 2005

GermanyJapanUSUKChina

99.5

99.6

99.7

99.8

99.9

100.0

100.1

100.2

1995 1997 1999 2001 2003 2005

GermanyFranceUSUKSpainItaly

Source: OECD

Export market performance cumulated changes (1995 = 100)

9

Price competitiveness is part of the story ...

The divergence in export performance can be partly explained looking at price competitiveness.

Italy fared a much worse export market performance as it failed to cut export prices by as much as its competitors did.

Source: EU Commission

Relative export prices Real effective exchange rate deflated with export deflator

75

80

85

90

95

100

105

110

1992 1994 1996 1998 2000 2002 2004

GermanyFranceSpainItaly

80

85

90

95

100

105

110

115

1992 1994 1996 1998 2000 2002 2004

EU - 12 ItalyGermany FranceSpain

1992 Q1 = 1001992 Q1 = 100

10

... but cost competitiveness matters too... to cover spiralling unit labour costs

The trend in margins suggests that higher export prices were not sufficient to cover the massive increase in Italy unit labor costs (ULC).

Thus the ability to tame ULC seems the key in order to stay competitive in export markets.

Note: Data are indexed 100 in 1992Q1. Source: EU Commission

Higher prices only barely enough ...

Source: EUROSTAT National Accounts

Real effective exchange rate deflated with ULC

75

80

85

90

95

100

105

110

115

120

125

1995 1997 1999 2001 2003 2005

EU - 12

Italy

GermanyFrance

Spain

96

97

98

99

100

101

102

103

104

1998 1999 2000 2001 2002 2003 2004

EU-12FranceGermanySpainItaly

Margins; 1998=100

11

There is more ...

The residuals of a regression of export market performance on relative export prices suggest that price competitiveness alone is not enough to explain Italy export market underperformance vis-a-vis its EU partners.

Residuals of a regression of export market performance on relative export prices

Source: OECD and Banca Intesa estimates

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

1989 1991 1993 1995 1997 1999 2001 2003

-6.0

-4.0

-2.0

0.0

2.0

4.0

6.0

Italy France Germany

12

“What” you sell ...

The euro area is specialized in medium tech exports (49% of total exports) vis-a-vis 37% in world exports, while it is less specialised in high tech exports, which have become more relevant in recent years.

Euro area and world exports by sector

Source: ECB calculations in “Competitiveness and the export performance of the Euro area”, Working paper n. 20, June 2005

2000-01 1985-89 2000-01 1985-89 2000-01 1985-89 2000-01 1985-89 2000-01 1985-89Low Tech

29.7 38.4 32.8 41.1 21.0 26.0 28.0 38.0 44.0 47.0

Medium Tech

48.9 47.6 36.6 40.4 58.0 58.0 51.0 48.0 44.0 42.0

High Tech

21.4 14.0 30.6 18.5 21.0 15.0 21.0 14.0 13.0 12.0

Germany France Italy

.

(Food, textiles, paper, wood, basic metals)

(Chemicals, manufacture of agricultural & industrial machinery, manufacture of transport equipment)

(professional & scientific equipment, manufacture of electrical machinery)

EU World

13

... and “where” are also key factors!

Exports to China as a %of total Extra EU exports

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

1995 2000 2004

Germany ItalyFrance

Exports to Eastern Europe as a %

of total Extra EU exports

Exports to OPEC as a %of total Extra EU exports

0%1%

2%3%

4%5%

6%7%

8%9%

10%

1995 2000 2004

Germany ItalyFrance

0%

1%

2%

3%

4%

5%

6%

7%

8%

1995 2000 2004

Germany ItalyFrance

The geographical specialization penalizes Italian exports in particular vis-a-vis to Germany. Indeed, Italian exports towards China count less on total exports than they did in 1995.

Italy exhibits a share of exports towards Eastern European countries similar to the one of Germany. Yet, Italian exports are mainly intra-industry and thus not too sensitive to these countries’ cyclical trends.

14

Italy structural problems do not end here

Italy underperformance in international markets is largely explained by the massive increase in ULCs.

The divergence in ULC trends can be ascribed only in part to the dynamics of compensation paid by companies and it is largely due to those of productivity.

Source: EUROSTAT, National accounts

90

100

110

120

130

140

150

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

EU-12

France

Germany

Spain

Italy

Unit Labor Costs (ULC)

95

100

105

110

115

120

125

130

135

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

EU-12

France

Germany

Spain

Italy

Compensation per employee

15

Italy is clearly loosing the productivity race

Source: OECD Economic Outlook

Note: data are rolling five years averages

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Eu-12 correctedFrance correctedItaly correctedSpainGermany

Labor productivity % change

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Eu-12 correctedFrance correctedItaly correctedSpainGermany

Hourly productivity % change

16

Italy industry structure is penalizing...

0%

20%

40%

60%

80%

100%

Italy Germany France UK Spain

1_9 10_19 20_49 50_249 ge_250

Italy counts the largest number of small & medium size enterprises

0%

20%

40%

60%

80%

100%

Italy Germany France UK Spain

High-technology Medium-high-technology Medium-low-technology Low-technology

Italy industry value added is low-tech intensive

Source: Eurostat Note: data refer to 2002

17

...as it acts as a cap on productivity growth

60

70

80

90

100

110

120

130

140

Low tech High tech Medium- lowtech

Medium-hightech

Productivity varies with tech intensity

40

60

80

100

120

140

160

1_9 10_19 20_49 50_249 ge_250

Size also matters

Source: Eurostat , GGDC productivity database Note: data refer to 2002

18

Productivity losses now spreading to services

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

1995 1996 1997 1998 1999 2000 2001 2002 2003

Germany France Italy

Productivity in the services sector

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1995 1996 1997 1998 1999 2000 2001 2002 2003

France France Italy

Productivity in wholesale and retail trade

Source: Eurostat and ISTAT

19

Looking for a turnItaly ICT intensity is one of the lowest in

the EU-12Total factor productivity is on a declining

trend in EU-12 even more so in Italy

The decline in labor productivity is explained by the slowdown in total factor productivity namely a deterioration in the overall efficiency of the production process.

Lower investment in ICT capital also plays a role. The EU-12 has a large gap to fill, for Italy the distance is massive.

Source: EU Commission AMECO database Source: Eurostat structural indicators database Note: Data are in % of GDP

0.00

0.20

0.40

0.60

0.80

1.00

1.20

1.40

1.60

1977 1980 1983 1986 1989 1992 1995 1998 2001

EU-12 France Germany

Italy US Spain

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

2000 2001 2002 2003 2004

Euro-zone GermanySpain FranceItaly US

20

A supply shock behind the trend reversal in productivity?

One of the explanations provided for the trend reversal in productivity growth is a supply side shock namely the labor market reforms of the 90s. If that was the case the reversal in productivity should be temporary and not structural. Yet, a recent EU Commission study shows that the supply shock can only account for a small part of the productivity decline.

But let us also make a positive remark. The EU has large room for improvement, if the appropriate reforms are implemented. Certainly, at this stage they are mandatory.

Share of low skilled in total employment Share of high skilled in total employment

Source: Eurostat Structural Indicators Database

10%

20%

30%

40%

50%

60%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

EU -12 DenmarkGermany

FranceItaly

The increase in the low skilled workers in Italy coincides with the tax credit

10%

20%

30%

40%

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

EU -12 Denmark

Germany

France

Italy

21

Labor force participation and human capital must rise2003 total graduate per 1000 of

population aged 20-29Female participation rate

( in % of working age population)

Labor market reforms still have a long way to go to increase the utilization of labor input. Labor participation in the EU remains almost 10 percentage points below the US level despite the increase seen in the 90s. The gap remains particularly dramatic for women.

Not only should reforms in Europe aim at increasing the use of labor input but also the skill content of its labor force.

Source: OECD Employment Outlook Source: Eurostat

40

45

50

55

60

65

70

75

1990 2000 2001 2002 2003 200440

45

50

55

60

65

70

75

EU -12 Italy FranceGermany Spain US

0

10

20

30

40

50

60

70

80

Germany Italy Eu -12 Neth Spain US France

22

And don’t forget about product marketsState ownership remains very high in the EU and... ... so is involvement in business operations

Source: OECD Product Market Regulation Indicators. OECD working paper 419, April 2005.

The product market reforms of the 90s have yielded some results. Yet, there is still a long way to go and further benefits could result if the deregulation process continues in particular both in the services sector and network industries.

0.0

1.0

2.0

3.0

4.0

5.0

6.0

US

UK

Sw

eden

Gre

ece

Spa

in

Ger

man

y

Cze

ch re

p

Fran

ce

Italy

Turk

ey

1998 2003

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

US

Net

herla

nds

Ger

man

y

UK

Sw

eden

Fran

ce

Cze

ch re

p.

Italy

Japa

n

Turk

ey

Spa

in

Gre

ece

1998 2003

23

Public finances: Italy’s Damocles' sword!

Tentative paths of Italy’s public finances under different election outcomes

The electoral programs of the competing parties are both vague. Public spending increases are on both agenda.

Yet, Mr Prodi has clearly stated he plans to:> unify capital gains taxation to 20% = this should earn the government around 4/5 bln €.

>reintroduce tax on bequests for assetts worth more than 500k € . We think it is highly unlikely the tax will bring the government’s coffer sizeable additional revenues.

>In previous legislation, Mr Prodi managed to bring public finances on a sustainable path and keep expenditure under control. Yet, back the EMU entrance race was on.

Italy public finances as a% of GDP

0.0

2.0

4.0

6.0

8.0

92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07105

107

109

111

113

115

117

119

121

123

125Debt CDL (dx)

Debt Unione (dx)

Primary balance Unione

Primary balance CDL

24

What’s needed to mend the hole?The debt will explode unless a larger

primary surplus is restoredDelaying the correction will only increase the pain

for future generations

20.0%

40.0%

60.0%

80.0%

100.0%

120.0%

140.0%

160.0%

180.0%

200.0%

220.0%

2006

2009

2012

2015

2018

2021

2024

2027

2030

2033

2036

2039

2042

2045

2048

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%Debito Avanzo primario, (dx)

L'avanzo primario è tenuto costante allo 0,5% del Pil su tutto l'orizzonte temporale

60% = limite di Maastricht per il debito

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

90.0%

100.0%

110.0%

120.0%

2006

2009

2012

2015

2018

2021

2024

2027

2030

2033

2036

2039

2042

2045

2048

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

Debito Avanzo primario, (dx)

60% = limite di Maastricht per il debito

25

Italy: main macro projections

T1 T2 T3 T4 T1 T2 T3 T4

GDP (constant prices) 1.1 0.0 1.2 1.0 -0.3 0.2 0.1 0.3 1.3 1.0 1.1 1.5

- q/q change -0.5 0.7 0.3 -0.2 0.4 0.4 0.3 0.3

Private consumption 0.5 0.1 1.0 0.8 0.0 0.6 0.4 0.0 0.3 0.2 0.3 0.3

Fixed investment 0.5 1.2 1.5 0.3 0.2 0.4 0.0 0.5 0.4 0.4 0.4 0.3

Government consumption 2.2 -0.6 1.5 3.8 -1.0 1.6 1.3 -0.4 -0.1 0.6 0.5 0.4

Export -4.0 -4.0 3.7 8.9 -2.8 4.2 1.1 2.8 -2.0 1.4 1.6 1.0

Import -0.5 -0.5 2.9 3.4 -4.6 5.2 2.9 2.0 -2.0 0.7 0.0 1.0

Stockbuilding (% of GDP) 0.0 0.0 0.3 0.3 0.1 -0.3 -0.7 0.1 0.2 0.3 0.5 0.0

Current account (% of GDP) -0.1 -0.8 -1.3 0.7

Deficit (% of GDP) -3.2 -4.1 -4.3 -4.1

Debt (% of GDP) 106.6 108.5 108.9 109.1

CPI (y/y) 2.2 2.0 1.9 1.7 1.9 1.8 2.0 2.0 2.0 2.0 1.8 1.8

Industrial production -0.6 -1.0 1.1 1.9 -2.6 -1.3 -0.2 0.1 1.8 1.1 0.6 0.9Unemployment (%) 8.1 7.8 7.7 7.7 7.9 7.8 7.8 7.7 7.7 7.7 7.6 7.6

2005 20062006p 2007p2004 2005