Country Intelligence Report 2

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Created on 01 May 2013 Page 1 of 33

Country Intelligence: Report

Italy REPORT PRINTED ON 01 MAY 2013


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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 torising 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 beneeded 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


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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.


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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 of2014, 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.


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Economic Growth Indicators

2010 2011 2012 2013 2014 2015 2016 2017

Real GDP (% change) 1.7 0.5 -2.4 -1.9 -0.5 0.5 1.4 1.2

Real Consumer Spending (% change) 1.5 0.1 -4.3 -2.7 -0.9 0.2 1.3 1.2

Real Government Consumption (%

change)-0.4 -1.2 -2.9 -1.5 -0.7 0.4 1.0 1.0

Real Fixed Capital Formation (% change) 0.5 -1.4 -8.0 -3.8 -1.2 0.2 1.8 1.3

Real Exports of Goods and Services (%

change)11.2 6.6 2.2 1.5 0.6 1.9 3.5 3.2

Real Imports of Goods and Services (%

change)12.3 1.1 -7.8 -2.4 -0.5 2.3 3.6 3.1

Nominal GDP (US$ bil.) 2,053.7 2,195.8 2,012.4 1,987.5 1,943.4 2,108.4 2,305.0 2,467.9

Nominal GDP Per Capita (US$) 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


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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 fourthquarter. 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.


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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.


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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, weestimate 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


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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 " scheme" in the next few quarters. The scheme allows firms to send workers homecassa integrazione

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


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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 " scheme, withcassa integrazione

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.


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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 2011 2012 2013 2014 2015 2016 2017

Consumer Price Index (% change) 1.5 2.8 3.0 1.7 1.7 2.0 2.2 2.1

Wholesale-Producer Price Index (% change) 3.1 5.1 4.1 -0.1 1.2 1.8 2.1 1.8



of the GIIF bank.


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.


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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, privateservices 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 thesituation 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.


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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 2011 2012 2013 2014 2015 2016 2017

Exchange Rate (LCU/US$, end of period) 0.75 0.77 0.76 0.78 0.79 0.73 0.70 0.68

Exchange Rate (LCU/US$, period avg) 0.76 0.72 0.78 0.78 0.80 0.75 0.71 0.69

Exchange Rate (LCU/Euro, end of period) 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00

Exchange Rate (LCU/Euro, period avg) 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00



of the GIIF bank.


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 Septemberas 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.


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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.


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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 arisk 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 befully 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.


17/34


Monetary Policy Indicators

2010 2011 2012 2013 2014 2015 2016 2017

Policy Interest Rate (%, end of period) 1.00 1.00 0.75 0.50 0.50 1.50 3.00 3.75

Short-term Interest Rate (%, end of period) 0.81 1.39 0.62 0.20 0.22 1.21 2.60 3.72

Long-term Interest Rate (%, end of period) 3.99 5.29 5.37 4.70 4.62 4.06 5.03 5.25



of the GIIF bank.


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


18/34


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 coreEurozone. 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 haveperiodically 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.


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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.


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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 stilldeteriorating 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 governmenttargets 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


21/34


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 bereduced 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 contributemore 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.


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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 2013forecast.

Trade and External Accounts Indicators

2010 2011 2012 2013 2014 2015 2016 2017

Exports of Goods (US$ bil.) 447.5 523.5 501.0 516.5 505.1 559.2 620.8 674.8

Imports of Goods (US$ bil.) 475.2 546.6 476.1 475.6 460.8 512.9 570.5 618.9

Trade Balance (US$ bil.) -27.7 -23.1 24.9 40.9 44.3 46.3 50.3 55.9

Trade Balance (% of GDP) -1.3 -1.1 1.2 2.1 2.3 2.2 2.2 2.3

Current Account Balance (US$ bil.) -72.7 -67.5 -23.0 -12.0 0.3 1.1 0.2 3.3

Current Account Balance (% of GDP) -3.5 -3.1 -1.1 -0.6 0.0 0.1 0.0 0.1


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of the GIIF bank.


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 thesingle-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


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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


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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

acc

Country Intelligence Report 2

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Transcript of Country Intelligence Report 2