ep BANCA D'ITALIA

EUROSISTEMA
WY)

Disinflation in the euro area
and the opportunities for the Italian economy

Address by Fabio Panetta
Governor of the Bank of Italy

The Cooperative Banking Group: opportunities and challenges
of a new banking model

Fiera di Roma, 30 November 2023

The financial system is a key infrastructure of any modern advanced economy.
It makes it possible to finance investment and growth, putting today's wealth to work for
tomorrow's prosperity.

Not all projects can be successful, and it is up to financial intermediaries and markets to
select, diversify and manage risks in order to direct resources towards the best of them.

Banks are playing a pivotal role at a time of heightened uncertainty with technological,
climatic and geopolitical changes affecting global economic activity and trade. During
this difficult transition, the efficient allocation of credit by banks is essential in order to
support the much needed transformations, digitalisation and decarbonisation of Italian
firms. This is particularly true for small and medium-sized enterprises, which receive most
of their external financing in the form of bank loans.

Their close relationships with customers and their understanding of local economies give
cooperative credit banks (banche di credito cooperativo, BCCs) a competitive advantage
in financing smaller companies.' The reform that led to the creation of the cooperative
banking groups few years ago has not eroded this advantage: currently BCCs provide
one-fifth of total loans to small businesses, compared with much smaller shares of other
categories of loans.?

Overall, the Italian banking system is in a good profitability and capital position. Thanks
also to the public policies implemented in recent years at both European and national
levels, it has been able to recover from the economic fallout of the pandemic and the

See, for example, E. Sette and G. Gobbi, (2015), 'Relationship lending during a financial crisis', Journal
of the European Association, Vol. 13, pp. 453-481, which shows that, in the years following the global
financial crisis, credit growth was higher and its cost lower the shorter the distance between a bank and
its customers, the longer the relationship between them, and the higher the share of the firm's debt held
by the bank. The effects were stronger for small firms.

The BCCs currently have a 10 per cent market share of total loans to households and firms.

invasion of Ukraine without great difficulty. The ratio of non-performing loans to total
loans has been declining continuously since its peak in 2015 (Figure 1).? Profitability has
risen to levels not seen since before the global financial crisis, driven by the increase
in interest income and the decline in loan loss provisions. The CET1 ratio reached a
historical high of 15.6 per cent.

The sound condition of banks provides stability to the Italian financial system as a whole.
It is a source of strength for the overall economy, as has been explicitly noted by leading
international credit rating agencies in their recent rating reviews for Italy.

As the economic situation in Europe and Italy weakens, some of the factors that have
contributed to strengthen banks so far may recede in the coming months.

According to our projections, the combined effect of the cyclical slowdown and high
interest rates could spur a reversal of the NPL trend. The relatively high interest rates
could lead to higher bank funding costs and squeeze interest income. Liquidity conditions
will become less favourable due to the shrinking of the Eurosystem's balance sheet.

Steps must be taken now to mitigate these risks, swiftly adjusting loan loss provisions to
reflect changes in credit quality. Funding plans should be adapted to take account of the
decreased availability of liquidity and should be implemented promptly. In recent weeks,
we have asked the banks under our direct supervision to do so.

The Italian banking system is able to withstand unfavourable developments. We can
expect its profitability to decline in the next two years, but it should remain largely
positive.

1. Monetary policy and disinflation

In the euro area, financing conditions have tightened, with effects spreading from the
manufacturing to the services sector. The strong employment growth, that has been
driving demand, is slowing (Figure 2). Output declined somewhat in the third quarter
of this year and will remain weak in the fourth quarter. Risks to economic growth are
tilted to the downside, partly due to the uncertainty stemming from acute geopolitical
tensions.

Inflation has fallen sharply since last year's peak. In the euro area, the twelve-month
headline inflation rate fell to 2.9 per cent in October. Core inflation - which excludes food
and energy - also declined, to 4.2 per cent.

As at last June, non-performing loans net of provisions amounted to 1.4 per cent of total loans.
In the first six months of 2023, the return on equity was 13.2 per cent on an annual basis.
The CET1 ratio is the ratio of common equity tier 1 capital to risk-weighted assets.

In the six months up to September 2023, the number of persons in employment increased by 0.5 per
cent compared with the previous six-month period, about one-quarter of the peak reached at the end
of 2021.

Indicators of inflation momentum, which can be more informative than the usual year-
on-year inflation rate when inflation is changing rapidly,' confirm that disinflation is well
under way; based on these indicators, core inflation stood at 2.6 per cent in October
(Figure 3).

In the coming months we might witness a temporary increase in inflation owing to base
effects, especially for energy prices.® However, this development is not due to a pick-up
in inflationary pressures: beyond these purely statistical effects, inflation - especially core
inflation - is expected to decline in 2024.

The restrictive monetary policy of the European Central Bank (ECB) was necessary.

High inflation distorts consumption, saving and investment decisions and has hidden
and inequitable redistributive effects. Both these factors hamper growth and reduce the
well-being of citizens, especially those on low incomes.

Price stability also contributes to the sustainability of public finances, especially in highly
indebted economies. In the decade before the pandemic, low inflation compressed risk
premia on government bond yields, allowing European sovereign issuers to finance
themselves at low costs despite a sharp, gradual increase in the debt-to-GDP ratio
(Figure 4). This trend has been interrupted in recent years, as inflation has led to an
increase in risk premia.

According to the projections published by the ECB in September and the data that have
become available since then, the current level of policy rates is sufficient to bring inflation
back to our 2 per cent target over the medium term. Monetary conditions need to remain
tight for as long as necessary to consolidate disinflation. The duration of this phase will
depend on development in macroeconomic variables; it could be short if continued
weakness in economic activity accelerates the decline in inflation.

We need to avoid unnecessary damage to economic activity and risks to financial stability,
which would ultimately jeopardise price stability.

In this respect, the pass-through of monetary policy impulses into financing conditions is
proving to be stronger than expected. The cost of bank credit has increased considerably
(Figure 5). The growth rates of monetary and credit aggregates have fallen sharply to
levels similar to or below those recorded in the aftermath of the global financial crisis and
the sovereign debt crisis in the euro area (Figure 6).

When inflation changes rapidly, the year-on-year inflation rates that are typically used in the public
debate (i.e. the change in prices compared with one year ago) may not be very informative about the
current change in the prices of goods and services. This reflects the fact that year-on-year inflation
rates may give too much weight to data that are too far in the past. In such a situation, it is useful to
get an indication about turning points by also looking at more recent inflation developments, including
changes in prices over a period of three months based on seasonally adjusted data.

The base effect is the temporary effect on the measurement of inflation resulting from unusual price
developments in the initial (base) period for which inflation is calculated.

Moreover, the ECB's monetary tightening has so far only produced some of its effects
and - based on past experience -- is likely to continue to dampen demand in the future.
For example, a large amount of medium- and long-term fixed-rate debt incurred by
households and firms during the low-inflation period will mature in the coming months
(Figure 7).° Roll-overs will be at higher interest rates, which will have a negative impact
on consumption and investment.

In addition, the current monetary tightening is different from previous ones. Its effect
is not only due to traditional increases in policy rates, but also to a contraction of the
Eurosystem's balance sheet, which reduces the supply of liquidity.

On the one hand, the reduction in the stock of securities held by central banks will push
up medium- and long-term yields, with further tightening effects.

On the other hand, the reduced supply of liquidity will affect credit market conditions.
The decline in bank reserves will increase competition in the deposit market, leading to
a further increase in banks' funding costs and hence higher lending rates to firms and
households. Empirical evidence also suggests that a decline in banks' excess reserves
reduces the supply of credit."° In turn, firms' reduced cash holdings will make their
investment decisions more sensitive to higher interest rates.

For these reasons, we need to proceed cautiously with the normalisation of the
Eurosystem's balance sheet. Having raised our policy interest rates to a level that would
restore price stability, a sharp reduction in the Eurosystem's balance sheet, after the
rapid reduction of recent months (Figure 8),'' could have a contractionary effect on the
economy that would not be justified by the inflation outlook.

2. Investments, innovation and growth in Italy

After the recovery registered in the aftermath of the pandemic, the Italian economy is
stagnating, as is the rest of the European economy. According to the projections available,
production is likely to pick up pace in the coming months; growth is expected to stay
below 1 per cent in 2024."

The priority now is to avoid the risk of regressing to the unsatisfactory growth rates of
the last two decades, building on the signs of a vibrant economy that have emerged so

For firms, it is estimated that the cost of outstanding loans has so far factored in only two thirds of the
increase in key interest rates.

See, for example, C. Altavilla, M. Rostagno and J. Schumacher (2023), 'Anchoring QT: Liquidity, credit and
monetary policy implementation', CEPR Discussion Paper No. 18581. The findings of the Eurosystem's
bank lending survey confirm that the gradual reduction in liquidity is having a negative impact on credit
supply.

See, also P. Lane, 'Inflation and monetary policy in the euro area', remarks at the Michael Chae Seminar
on Macroeconomic Policy, Harvard University, Cambridge, 2023.

According to the projections made last October, in Italy GDP is set to grow by 0.7 per cent in 2023,
0.8 per cent in 2024 and 1.0 per cent in 2025 (see 'Projections', Banca d'Italia, Economic Bulletin, 4, 2023).

far. In recent years, the recovery has been driven by the expansion in investment, which
has grown by more than 20 per cent since the end of 2019, against a fall of 4 per cent for
the euro area as a whole. This is a major change, especially in comparison with the years
following the global financial crisis and the sovereign debt crisis (Figure 9)."?

The increase in investment was not limited to construction, which has been fuelled by
very substantial tax incentives since 2021. The contribution of expenditure on machinery
and intangibles, which last year returned to euro-area average levels as a percentage of
GDP, is significant, thus closing a long-standing gap (Figure 10).

The recovery in investment is a sign of confidence in the outlook for the Italian
economy, which needs to be sustained and reinforced by directing resources towards
growth-boosting projects.

Italy's structural growth problem is well known, as are its causes.

However, I would like to draw your attention to a fundamental fact: Italy's economy has
been suffering from stagnating labour productivity for more than two decades, compared
with an annual increase of 1 per cent in the rest of the euro area (Figure 11). This is
mainly explained by the disappointing growth in total factor productivity - i.e. efficiency
gains from new technologies, organisational improvements, product innovation and the
expansion of the most efficient firms.'°

Barring any corrections, these trends will continue to have a bearing on development
also in the years to come.

The road to the recovery of the Italian economy passes through investments and
productivity and, finally, growth. Given the demographic outlook, employments
contribution to economic activity will be nil at best, even in the most favourable scenarios."
Growth will therefore depend on the ability to increase output per unit of labour.

Investment shrank from 21.7 per cent of GDP in 2007 to 16.7 per cent in 2014. In 2019, it stood at 18 per
cent, around 4 points lower than before the global financial crisis and the euro area average. In absolute
terms, between 2007 and 2019, investment fell by 19 per cent overall in Italy, compared with a 6.8 per
cent growth in the euro area. In 2022, investment returned to levels just below those of 2007.

Investment in machinery and intangibles had fallen from around 10 per cent of GDP in 2007 to around
8 per cent in 2013, more than 1 percentage point below the euro-area average. The gap, which in 2019
rose further to 1.5 percentage points, was closed in 2022.

The measurement of total factor productivity is inherently imprecise, but it provides clear indications
about the lags of our production system. Since 2000, total factor productivity has increased by 11 per
cent in the euro area (0.5 per cent annually), while it decreased by almost 3 points in Italy (-0.1 per cent
annually).

According to Istat's projections, the working age population (those aged between 15 and 64) will fall by 16 per
cent over the next 20 years. This decline could be offset by higher labour market participation of women and
young people and lower levels of unemployment. But even if we were able to bring the participation rates up
to EU average levels, employment's contribution to growth would still be basically nil. This contribution could
be greater if we increased the flow of regulated labour migration compared with Istat's baseline projections,
which already take into account net inflows of 130 thousand people per year until 2040.

The unsatisfactory performance of total factor productivity should, in turn, be seen in light
of the changes that have taken place since the 1990s. It was at that stage that the Italian
economy started to lag behind: first in information and communication technologies
and later in digital technologies and in intangible capital endowment," thus laying the
foundations for low growth.'®

It is therefore essential to ensure the continuity of the ongoing recovery in capital
accumulation. However, even this will not suffice without a sharp increase in the innovation
capability of Italy's economic system. We must not repeat the experience of the 2000s,
when strong investment growth was associated with meagre productivity gains."

Investment in intangibles remains more than 1 point of GDP lower than in the euro
area.*° While there is no shortage of highly innovative and internationalised firms, the
share of firms that are lagging behind, both in terms of their ability to develop advanced
products and services and of their adoption of new technologies, starting with digital
technologies, is still large.

The gap between firms at the technological and production frontier and other firms is a
common problem in several countries,*! though it is more pronounced in Italy. Here, the
rate of adoption of new technology and the productivity rate are significantly higher for
large and older firms than it is for small and young enterprises; likewise they are higher
for firms in the Centre and North than for those in the South and Islands."

Intangible capital is accumulated through investment in intangible goods such as patents, trademarks,
software, research and development.

It is estimated that at the end of the 1990s Italy lagged behind the United States in information and
communication technology by about seven years. See M. Bugamelli and P. Pagano, 'Barriers to investment
in ICT', Applied economics, 2004. Subsequent papers suggest that this divide eventually shrank, though
Italy started to lag behind in the adoption of new digital technologies and the investment in intangible
goods. See A. Brandolini and M. Bugamelli, 'Report on trends in the Italian productive system', Banca
d'Italia, Questioni di economia e finanza (Occasional Papers), 45, 2009; M. Bugamelli and F. Lotti,
'Productivity growth in Italy: a tale of a slow-motion change', Banca d'Italia, Questioni di economia e
finanza (Occasional Papers), 422, 2018.

19 Between 2000 and 2007, the invested capital stock grew at rates not dissimilar to the euro-area average;
however, total factor productivity stagnated in Italy, while it improved by around 0.8 per cent annually
in the euro area. Unlike in the rest of the euro area, in Italy investment was concentrated in construction
rather than in expenditure for machinery and intangibles.

20 In 2022, total investment in intangibles stood at 3.2 per cent of GDP, against 4.5 per cent for the euro

area on average. In 2021, expenditure for research and development as a share of GDP alone stood at
1.5 per cent, lower than in Germany, France and the euro area as a whole by 1.7, 0.7 and 0.8 per cent
respectively. In the private sector, expenditure was equal to 0.9 per cent of GDP, compared with an
average of 1.5 per cent in the euro area and of 1.8 per cent in OECD countries as a whole.

21 The limited innovation capacity of a large portion of the production system helps explain why, overall,

advanced economies have so far derived limited productivity gains from new digital technologies. See
F. Andrews, C. Criscuolo and P. N. Gal, 'The best versus the rest: the global productivity slowdown,
divergence across firms, and the role of public policy', OECD Productivity working papers, 26, 2016;
F. Calvino and C. Criscuolo, 'Business dynamics and digitalization', OECD Science, Technology and Industry
Policy Papers, 62, 2019, OECD Publishing, Paris.

a2 Calvino, S. De Santis, I. Desnoyers-Jameet, S. Formai, I. Goretti, S. Lombardi, F. Manaresi, G. Perani,

'Closing the Italian digital gap: The role of skills, intangibles and policies'; OECD Science, Technology and
Industry Policy Papers, 126, 2022, OECD Publishing, Paris.

Thus, we need to broaden the pool of innovative and dynamic firms, while fostering the
adoption of technology among the rest. It is an ambitious goal, one which requires not
only investment but also the enhancement of human resources. Technology, management
skills and labour quality are key and complementary ingredients for innovation and
development.

Public policies and the commitment of the entire production and financial system, which
in these difficult years has shown resilience and a recovery capacity on which to build in
order to boost Italy's economic growth, should focus on and persevere with these goals.

3. Conclusions

In the euro area, risks to price stability have not disappeared and must be monitored in
order to promptly identify and counteract potential inflationary pressures.

However, disinflation is well under way and the current level of the ECB key interest rates
is sufficient to bring inflation back to the 2 per cent target. But the ECB's tightening will
continue to unwind over the coming months; its impact on demand may be much stronger
than had been expected, also in relation to the reduction in the supply of liquidity.

The normalisation of the Eurosystem's balance sheet must avoid abrupt adjustments,
which would not be justified by the inflation outlook and could even be counterproductive
for growth and price stability.

In Italy, the goal of raising productivity requires that changes be made in a number of
areas. Investing in innovation marks the starting point for the action required, but this
does not mean that other measures are any less urgent. The productivity of a system
depends on a variety of factors, such as the skills of the workforce, the functioning of the
financial system, the degree of competition, labour market rules, and the functioning of
the public administration, particularly the justice system.

Above all else, the debt-to-GDP ratio must be reduced. High public debt diverts resources
that could go to counter-cyclical policies, social programmes and development measures;
it increases the cost of financing for private firms, hampering their competitiveness and
dampening the incentive to invest; it makes our economy, and ultimately the whole
country, vulnerable to the erratic movements of financial markets.

Debt has been a weight on the Italian economy's shoulders for too many years. We must
free ourselves from it by avoiding the mistakes of the past, acting on both the public
finances and on growth. This task is not an easy one and we will have to tackle it bearing
in mind that we need to continue efforts to relaunch the economy in the South and
Islands.

These issues are being widely analysed and discussed. The Bank of Italy will continue to
do so, as it always has done. I will personally examine them more in depth in the future.


FIGURES


Figure 1

Capitalisation and credit quality of Italian banks

(per cent)
16+ +12
NPL ratio
145 (right-hand scale) 10
12+ Lg
10+ +6
CET' ratio
85 14
64 +2
44 +O

2007 2009 2011 2013 2015 2017 2019 2021 2023

Source: Supervisory reports.
Note: Ratio of non-performing loans to total loans net of loan loss provisions; year-end data, end-June for 2023.

Figure 2
Forward-looking euro-area employment indicators
(per cent; index number, long-term average = 100)
3.54 Employment expectations L415
(right-hand scale)

3 + 100

2.57 85
Vacancies

24 + 70

1.55 fb 55

2019 +2020 2021 2022 2023

Sources: European Commission and Eurostat.
Note: Vacancies as a share of total jobs (sum of employment and vacancies) for the non-farm private sector and
Employment Expectation Index.

Figure 3

Inflation
(annualised three-month percentage changes)

18 Euro area 18 25 Italy 25
14 14 20 Headline 20
10 Headline 10

6 6

2h Rg of Wf --------- YAY 2

-2 -2 -

2019 2020 2021 2022 2023 2019 2020 2021 2022 2023

Sources: Eurostat and Istat.

Figure 4

Public debt, government bond yields and inflation in the euro area
(as a percentage GDP; per cent; 12-month percentage changes)

100+ + 14
95-4 Debt-to-GDP ratio 49
90+ 10
855 8
80+ L6
755 4
707 r2
65+ Lo
0"

2000 2005 2010 2015 2020

Sources: Eurostat and Refinitiv.
Note: GDP-weighted average of euro-area countries' ten-year government bond yields.

12

Figure 5

Lending interest rates

(per cent)
6} .. 6 5 5
Firms Households
5 5 4 4
4 4
3 Euro area +3
3 3
2 2 2 2
Euro area
1 1 1 1
2021 2022 2023 2021 2022 2023
Sources: European Central Bank.
Note: Interest rates on new loans to firms and on new mortgage loans to households for house purchase.
Figure 6
Real money and credit growth in the euro area
(12-month percentage changes)
20} Financial I Sovereign 20 15) Financial Sovereign 15
crisis debt crisis

1
1
debt crisis crisis!
1
H

10 10

10 Lending to 10

firms

0 0 5
H
' 0 ' 0
-10 ! -10 H
! M1 5 ! H Lending cA 5
-20 ! -20 . ! i ousenor'sv
2005 2010 2015 2020 2005 2010 2015 2020

Sources: European Central Bank and Eurostat.

Note: The monetary aggregate M1 includes currency in circulation and overnight deposits. The monetary aggregate M3
includes, in addition to M1, deposits with an agreed maturity of up to two years, deposits redeemable at notice of up to
three months, money market fund shares or units, repos and bank bonds with a maturity of up to two years. Real money
and credit are calculated by deflating their nominal values using the consumer price index.

Figure 7

Long-term fixed-rate loans
(per cent of total loans)

12.5 42.5 28 71

Firms Households
10 40
Euro area 24 67
(right-hand scale)
75 37.5
20 Euro area 63
5 35 (right-hand scale)
2.5 32.5 16 59
0 30 12 55
2014 2016 2018 2020 2022 2014 2016 2018 2020 2022

Source: European Central Bank.
Note: Share of fixed-rate loans with a residual maturity of over one year in total loans in each sector of each economy.

13

Figure 8

Balance sheets of the main central banks: total assets
(index number)

105+ +105
100+ Bank of England + 100
955 +95
Federal Reserve
905 + 90
855 +85
80, + 80
Eurosystem
757 T T T T T T T T T T T r 75
0 10 20 30 40 50 60 70 80 90 100
Weeks

Sources: European Central Bank, Bank of England and US Federal Reserve.

Note: The index is set at 100 for the latest available data prior to the first increase in policy rates by the central banks shown
in the figure; the x-axis starts on 15 July 2022 for the Eurosystem, on 11 March 2022 for the Federal Reserve and on 10
December 2021 for the Bank of England.

Figure 9
Investment
26 Per cent of GDP 26 130) index number, 2000=100 130
24 24 120 120
Euro area
22 Euro area 22 110 110
20 20 100 100
18 18 90 90
16 Italy 16 80 80
14 14 70 70
2000 2005 2010 2015 2020 2000 2005 2010 2015 2020

Source: Eurostat.
Note: Public and private investment.

14

Figure 10

Breakdown of investment

(per cent of GDP)
134 Construction 13 12 Machinery and intangibles 12
12 12
Euro area "1 11
11 11 Euro area
10 10 10 10
9 9
9 9
8 Italy 8
7 7 8 8
2000 2005 2010 2015 2020 2000 2005 2010 2015 2020
Source: Eurostat.
Note: Public and private investment.
Figure 11
Hours worked and labour productivity
(index number, 2000=100)
1104 Hours worked 110 125 Productivity 125
120 120
105 Euro area 105
115 115
100 100 110 Euro area 110
105 105
95 95
100 100
Italy
90 90 95 95
2000 2005 2010 2015 2020 2000 2005 2010 2015 2020

Source: Eurostat.
Note: Productivity is measured as GDP per hour worked.

15

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