The The Governor's Governor's
Concluding Concluding Remarks Remarks
Annual Report
Rome, 29 May 2018
year
financial
124th
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The Governor's
Concluding Remarks
Annual Report
2017 - 124th Financial Year
Rome, 29 May 2018

Ladies and Gentlemen,
The Italian economy is gaining strength, employment continues to
recover, and some of the sources of systemic risk in the banking system have
been eliminated. To consolidate the results achieved, accomplish further
progress, and remove structural fragilities, we must press on with the reform
agenda.
It is necessary to respond with determination to the changes brought
about by globalization, technological innovation, and demographic trends.
The protection of savings, necessary to support economic growth, hinges
upon orderly conditions in the financial markets. These, in turn, rely on the
credibility of the policies to revamp the structure of the economy, enhance
productivity and keep public debt in check.
The risks connected with the weakening of international cooperation,
which are both geopolitical and related to the economy and trade, have
been compounded by the current hesitations in furthering the European
project and by the tensions in our country. Italy's must be a respected voice,
including in the debate on redesigning the European Union's regulatory and
institutional set-up, a voice that is all the more important in this period of
profound social, economic and financial transformation.
These are the topics to which I will devote my attention today, which
as always draw on the analyses included in the Annual Report and in our
other publications on economic, financial, supervisory and regulatory issues,
produced thanks to the professionalism and dedication of the Bank of Italy's
staff. To them I would like to express my gratitude, both personally and on
behalf of the Governing Board and the Board of Directors.
For an overview of our annual accounts and an analysis of the Bank of Italy's
operations and activities, I refer you to our two dedicated publications. The
first was released on 29 March on the occasion of the Meeting of Shareholders,
while the second will be published today. A new volume describing the Bank's
functions has also been added to the range of publications we use to account
for the work we do.
The international economic situation and monetary policy
in the euro area
In 2017 the world economy grew at a vigorous pace, at close to 4 per cent
(Figure 1). This reflected a generalized acceleration in investment and world
trade, whose growth outpaced that of GDP. The expansion in economic
activity is widespread across all the major countries, and is expected to remain
robust in the near future.
However, risks are in no short supply. The introduction of trade protection
measures and possible retaliations would have serious repercussions for global
production. The uncertainty generated by statements and announcements
foreshadowing protectionist drifts is, in itself, negatively affecting the
investment plans of firms active in the international markets. This is in part
due to the ongoing debate between those who want to see a trade system
based on bilateral agreements and those who underscore the importance of
preserving the international rules on trade that have underpinned economic
integration and development for decades.
Additional risks are associated with the high level of global debt, in
both private and public hands, which in the third quarter of 2017 reached
245 per cent of GDP, 35 percentage points more than at the end of 2007.
The increase was especially marked in the emerging economies (up from
121 to 192 per cent of GDP), where a large portion of corporate debt is
denominated in foreign currency. Unexpected hikes in bond yields in the
United States, also in connection with the possible effects of an excessively
expansionary fiscal policy, and sharp fluctuations in exchange rates, could
generate turbulence in capital markets.
GDP growth in the euro area is proceeding at a good pace. In 2017 it was
equal to 2.4 per cent, owing to the resilience of consumption and investment
which, as exports strengthened, continued to benefit from the increase in
employment and favourable borrowing conditions. Despite the indications
of a slowdown that emerged in the early months of this year, the outlook
remains favourable.
Inflation is returning to levels consistent with the price stability objective,
namely a rate of inflation below, but close to, 2 per cent over the medium
term (Figure 2). Core inflation, which excludes food and energy products,
remains weak; in order for it to strengthen, inflation expectations must
recover fully and unemployment, which is still holding back wage growth in
some countries, must be reabsorbed.
The improved economic situation has strengthened the ECB Governing
Council's confidence in the convergence of inflation towards the objective
and has created the conditions for a gradual recalibration of monetary policy
measures. Uncertainty about the future performance of inflation means we
must proceed with caution. So far, the recalibration of measures has occurred
without creating the tensions on financial markets or surges in long-term
yields feared by several observers.
At its last monetary policy meeting the Governing Council reiterated the
need to maintain a high degree of accommodation. For this purpose it can
rely on several instruments: the Eurosystem's sizeable stock of assets; the net
purchases of securities that will continue at least until the end of September;
the reinvestment of the principal payments from maturing securities; and the
very low level of key interest rates and guidance on their future performance.
The normalization of monetary policy conditions in the euro area will
reflect the gradual consolidation of economic activity and of the inflation
outlook. This will make it easier to absorb future interest rate increases. The
need for caution is also corroborated by the positive results on growth and
inflation achieved by the Federal Reserve in the United States, where an
expansionary monetary policy is being followed by very gradual normalization
(Figure 3).
The Italian economy today
The Italian economy is recovering. GDP growth gained strength last year,
reaching 1.5 per cent and exceeding the expectations of the main forecasters.
Macroeconomic policies were still the main driver but growth is increasingly
self-sustained.
Demand reflected the positive performance of consumption and,
especially, investment, which rose by 3.8 per cent, though it is still far from
pre-crisis levels. Increased capital formation, which was lacking in the early
years of the expansionary phase, is laying the groundwork for a continuation
of growth. Investment in capital goods benefited from tax breaks, incentives
for technological innovation, favourable borrowing conditions, and the
gradual increase in firms' confidence in the outlook for demand. Growth in
consumption was partly attributable to that in employment, which in turn
was driven by the measures supporting labour demand. Despite the increase
in labour market participation owing to brighter employment prospects,
unemployment actually decreased from the peak of just under 13 per cent
recorded in 2014 to about 11 per cent (Figure 4).
Exports continue to be a major driver of growth. In 2017 they expanded
by 5.4 per cent, more than in the other major euro-area countries. The
increase was consolidated in the second half of the year despite the strong
appreciation in the exchange rate since the spring. This is a sign of our
firms' renewed ability to compete in the international markets. Mostly
thanks to the current account surplus, Italy's net foreign liabilities have
continued to diminish, falling from 23 per cent of GDP in 2013 to less
than 7 per cent. This compares with net foreign assets equal to 60 per cent
of GDP for Germany and net foreign liabilities equal to 20 and 80 per
cent of GDP for France and Spain respectively (Figure 5).
The expansion in production was widespread across almost all sectors:
value added accelerated in manufacturing and services and posted its first
significant increase in construction since 2006. This was accompanied by
a recovery in the demand for loans, supported by low interest rates. Credit
access conditions improved, though difficulties persist for small businesses
and construction firms, which still present higher risk.
Overall, consumer price inflation returned to positive territory in 2017,
reaching 1.3 per cent, but it weakened in the early months of 2018. The core
component has remained below 1 per cent since last autumn. Wages and
productivity both recorded modest growth. Italian firms have retained the
competitiveness gains achieved in recent years.
In the early months of 2018, in Italy too there were signs of a slowdown
in manufacturing and of a slight decrease in business confidence indices. The
prevailing view is that this is a temporary setback; industrial production appears
to have recovered somewhat since March. A scenario of moderate growth and
gradually rising inflation remains the most probable one. However, downward
risks have increased, also in connection with international developments.
Preserving the confidence of households, firms and investors is a
necessary condition for the continuation of economic growth. The effects
of a less expansionary monetary policy would be moderate also thanks to
the low indebtedness of households and to the reduction in that of firms,
the limited exposure of financial intermediaries to the consequences of a rise
in interest rates, and the high average residual maturity of the public debt,
which currently stands at more than seven years. It is crucial that conditions
in the financial markets remain favourable.
Our economy is in a different cyclical phase compared with the past. The
crisis was much deeper and longer than any previous one, and the recovery
slower than on other occasions. In five years output has recouped only half
of the nine percentage points lost during the double-dip recession. There
continue to be ample margins of idle production capacity and, in particular,
of labour market slack.
Italy's economy is still expanding at below the average rates recorded in
the other euro-area countries; last year the gap was one percentage point.
Labour productivity growth is insufficient; in 2017 it was less than half that
of the rest of the area. Demographic trends indicate that in the years to come
there will be a reduction in the active population and higher numbers of
older people. The cyclical recovery aside, Italy's growth potential must be
consolidated.
Structural issues
Much has already been said about the structural problems of Italy's
economy. Essentially, growth potential is being impaired by the tough
conditions in which firms operate; many struggle to remain on the
market, few expand. Noted problems include the inefficiencies and delays
characterizing general government and civil justice, the shortcomings in
regulating the entry and exit of firms from the market, the constraints on
competition and phenomena of illegality, the high taxation of the factors of
production and underinvestment in innovation, research and human capital.
Important initiatives have been taken in recent years but improving the body
of institutions, rules and practices on which economic activity is based and
which influences the behaviour of workers and firms is a long-term endeavour.
The reforms that pursue these goals have a significant impact on growth and
employment though their effects are distributed over a longer time horizon.
Lazy short-termism cannot be allowed to dictate the agenda.
Italy's anaemic growth in the last twenty years is primarily the result
of stagnant productivity, in itself a reflection of the country's fragmented
economic structure in which small firms, on average poorly capitalized and
often little inclined to expand, tend to dominate. Small businesses, which far
outnumber those in the other advanced countries, are less productive in Italy,
not only than their larger counterparts but also with respect to foreign firms
of comparable size.
There are, however, signs of improvement. The reorganization of
production, which had got under way even before the double-dip recession,
has intensified in the wake of the crisis. The capacity of our economy
to put resources and energy into more productive initiatives, while still
low by international standards, is increasing. The exit of many firms from
the market has been offset by the entry of new innovative businesses and
the strengthening of those that succeeded in repositioning themselves on
a path of growth. These developments have partly softened the negative
impact on productivity of the fall in investment during the crisis.
The beneficial effects of a reallocation of activity towards the most
efficient firms have been apparent among exporters; along with the recovery
of price competitiveness, the reforms have enabled firms to staunch the losses
in Italy's export market shares. Though still limited by international standards,
innovative activities and the use of new technologies are on the rise. Spending
on research and development, though still below that recorded in the other
main economies, has risen by almost 20 per cent since 2015, reflecting strong
growth in private investment.
Improvements in the field of innovation also reflect measures affecting
the entire production chain since 2012. Support for innovative start-ups and
tax credits for research and development have proven especially important,
as have the hyper-amortization of investment in new technologies and the
introduction of tax breaks on revenues generated from patents and other
innovations. The tax incentives designed to facilitate recourse to equity capital
have helped firms to strengthen their capital bases, enhancing their ability to
absorb losses, fund innovative projects, and develop their activities.
Yet Italy's firms continue to be penalized by burdensome administrative
procedures and lengthy civil trials. Productive activity also suffers from
distortions of competition caused by tax evasion, corruption and organized
crime. These phenomena feed into one another and, along with inadequate
procedures for the planning and award of public works contracts and their
execution, help explain the shortages in vital infrastructure that are hampering
the economy's growth potential.
Low productivity and an insufficient ability to innovate also reflect gaps,
by international standards, in the knowledge and skills of Italian students
and adults, which act as both cause and effect. It is another vicious circle that
contributes to keeping employment and labour force participation rates below
the levels prevailing in the other European countries. The issue of human
capital will become increasingly important as the use of new technologies
increases and demand falls for workers who perform standardized and repetitive
activities. Without sufficient public and private investment in training, there
will be serious adverse effects on employment and income inequality will be
aggravated. Addressing these risks requires decisive intervention: developing
a collective appreciation of the importance of lifelong training beyond the
years of formal education is a vital challenge for Italy.
The labour market has seen sweeping changes. The reforms have had a
positive overall effect on trends in employment. Firms' propensity to hire
workers on open-ended contracts has increased. And yet unemployment
remains high, especially in Italy's Mezzogiorno and among young people.
New social safety nets have increased unemployment benefits without
generating excessive disincentives for jobseekers. The effects of the new set
of active policies, however, are barely perceptible; the share of those drawing
unemployment benefits without actively seeking work has not fallen.
The long crisis has increased social malaise. According to Istat data, in
the last ten years the share of households in absolute poverty has practically
doubled, climbing to almost 7 per cent. This share is higher in the Mezzogiorno
and, above all, in households with foreign nationals; the position of young
people has worsened with respect to older generations.
The resources unlocked by the introduction of a minimum income
di
scheme (reddito inclusione) cover around 40 per cent of households in
absolute poverty. In any decision to broaden its scope, or to adopt other
measures, care must be taken not only to avoid discouraging beneficiaries
from seeking regular work but also in relation to the effects on the public
finances.
The territorial disparities of Italy's economy encapsulate and lay bare all
the structural fragilities listed above: in the country's capacity for economic
growth, in the productivity of its firms, in the availability of work and the
quality of public services. It is an age-old problem; after the progress recorded
in the 1960s, the gap began to increase again; it widened further during
the double-dip recession. Compared with 2007, GDP is lower by almost
ten percentage points in the Mezzogiorno and by around four points in the
Centre and North. The gap between the employment rates in the two areas,
respectively 44 and 65.5 per cent, has widened by around three percentage
points, reflecting the fall recorded in the Mezzogiorno. With the economic
recovery under way, the government can more easily remove the obstacles to
entrepreneurship and help close the gaps that have emerged in increasingly
large swathes of the country.
Public finances
Public policy operates on two complementary levels. The first concerns
legislative and regulatory aspects, and how general government is organized
and administered; the second has to do with the raising and deployment of
resources for infrastructure, public services and redistributive measures. If
these interventions are to contribute effectively to the country's development
and not end up endangering financial stability, they must be carried out in
the full awareness of budgetary constraints.
At the end of last year, Italy's public debt amounted to almost 132 per
cent of GDP. This is a very high figure by past standards. It is more than 50
percentage points above the average in the rest of the euro area and it is an
element of constraint and the main source of vulnerability for the economy.
It discourages investment by raising the cost of borrowing and fuelling
uncertainty; it leads to greater distortions in taxation, impairing Italy's
capacity to generate income, save, and invest. It reduces the scope for social
and macroeconomic stabilization policies. It exposes the country to crises
of confidence, especially dangerous when, in addition to covering annual
borrowing requirements, very large volumes of securities nearing maturity
must be refinanced (which together amount to €400 billion per year in Italy).
Debt-to-GDP dynamics largely depend on the primary fiscal balance
- in other words on the difference between public revenue and expenditure
net of interest expense - and on the gap between average borrowing costs and
the nominal growth rate of the economy. These variables influence each other;
in particular, a worsening of the primary balance, even if only anticipated,
can stoke fears about the solidity of the public accounts and raise government
borrowing costs (Figure 6).
Having widened considerably during the sovereign debt crisis, the spread
between the average cost of the debt and GDP growth narrowed to around
1 per cent. It could narrow further over the next few years so long as the
economic situation remains positive. If the tensions of the last few days
subside, the cost of debt will also fall, if only slightly, when the securities
that were placed at higher rates than newly issued ones come to maturity.
This could be achieved even with the gradual normalization of monetary
policy. To this end, it is essential to preserve the credibility of the process for
consolidating the public finances.
The debt-to-GDP ratio could return to below 100 per cent over the next
ten years by gradually achieving a primary surplus of between 3 and 4 per cent
of GDP, two percentage points above the current level and consistent with a
broadly balanced budget net of cyclical effects (Figure 7). The fall could be
more rapid if the improvement in the primary surplus and the consolidation
and continuation of structural reforms encouraged growth and lowered the
risk premium on Italian government securities.
Reducing the debt ratio is indispensable. At a time of growth and with
monetary policy still highly accommodative, increasing the deficit is not the
answer. While there might well be a temporary positive impact on demand,
though even this is rendered uncertain by possible financial tensions, it would
have persistently negative repercussions on debt and on interest expense. The
moderately restrictive effects of a rise in the primary surplus can be offset by
a tax reform to make taxation less distortive and by a restructuring of public
spending aimed at boosting production capacity.
Spending on public investment has been falling almost without
interruption since 2010. Aside from the limited availability of financial
resources, contributory factors include inefficient and slow processes for
selecting and completing public works. More recently, investment may have
encountered difficulties in adapting to the new Public Contracts Code; the
total amounts involved in tenders for public works nonetheless returned to
growth last year. But there is still work to be done on reducing the length and
complexity of the procedures.
In the long term, curbing the deficit and debt rests largely on the ability
of the public finances to cope with the increase in social expenditure caused
by population ageing, particularly on social security and healthcare. The
reforms introduced in the past have made spending on pensions manageable;
they have responded to the need to take account of the increase in average
life expectancy when determining the relationship between contributions
paid and the size and duration of pensions; they have also placed Italy in a
favourable position by international standards.
Any turning back would be risky. Targeted interventions to reduce
specific rigidities are possible, and some have already been made, but they
must always be adequately offset so as to ensure the actuarial balance of the
pension system. Great care must be taken in modifying the basic rules that
shape long-term trends in public spending. The sustainability indicators,
calculated at European level, have recently worsened for Italy owing to the
fall in potential GDP growth forecast for the next few decades, which is in
turn partly due to the decrease in the active population connected with the
downturn in expected migration flows.
The financial sector
The international financial industry is undergoing momentous change.
Since the end of the last decade the role of banks in funding the economy has
gradually declined, and there has been an increase in the relative importance
of the capital market and of non-bank operators that perform some functions
typical of traditional credit intermediation. The volume of bonds placed on
the international markets by non-financial groups has more than doubled
over the last ten years, reaching $6.5 trillion in 2017. At the end of 2016 the
assets of non-bank intermediaries amounted to $160 trillion, nearly half of
those held by financial intermediaries as a whole.
The rapid developments in technology are opening up credit and
financial intermediation markets to competition from new operators, both
in the advanced economies and in emerging countries. Several Fintech firms
are already offering innovative, low-cost services in the electronic payments
sector, in asset management and in brokerage. The biggest international
technology companies are also starting to operate in credit and finance.
Experience teaches us that a diversified financial sector, with multiple
funding channels and many different operators, can favour investment and
growth and can bolster the resilience of the economy to adverse events. In
the United States, firms have reacted to the restrictions on bank credit caused
by the financial crisis by replacing it with bond issues, thereby mitigating the
severity and duration of the recession.
However, the development of non-banking intermediation, if not properly
supervised, can also be a source of risk. The strategies of large fund managers
can have significant effects on the prices and liquidity of the underlying
instruments. The spread of high-frequency trading could give rise to sudden
increases in price volatility, especially if several intermediaries were to react in
a similar way to market movements. Indirect links between banks and other
intermediaries are also potential risk factors. The Financial Stability Board
is working on defining regulatory measures for non-banking intermediation
with a view to limiting the risks associated with the opportunities opened up
by the changing financial landscape.
New technologies are increasing productivity and giving users greater
choice, but due care must be taken as regards the potentially negative
consequences. In a financial system by now steeped in digital technology,
the damage caused by cyberattacks can go beyond individual operators and
become systemically important. The central banks and supervisory authorities
are committed, together with the other authorities and intermediaries, to
safeguarding cyber security in the financial sector. The unregulated spread of
crypto-assets could also put consumer protection at risk and encourage illegal
activities; going forward, it could pose a threat to financial stability.
Italy's financial market is also evolving. On the eve of the crisis, Italian
firms had a high debt-to-equity ratio and made very limited recourse to bond
issues, factors which helped lengthen and deepen recessions. Nowadays firms'
leverage (calculated as the ratio of financial debt to the sum of financial debt
and net equity at market prices) is ten points below the peak of 50 per cent
recorded in 2011. This decrease is attributable both to firms with high debt
levels exiting the market and to the influx of new capital, partly as a result
of tax incentives. The gap with respect to the euro-area average has narrowed
markedly.
Of the more than 250 non-financial firms now on the stock exchange,
around 80 were listed between 2013 and 2017. In many cases, using SPVs
to raise the capital required to purchase unlisted companies has allowed
firms, including small and medium-sized ones, to access the stock market
more quickly compared with traditional IPOs. Nonetheless, the market
capitalization of non-financial companies remains well below that of the
other main economies: in Italy it amounts to around 25 per cent of GDP, in
Germany to just over 60 per cent, in France and in the United Kingdom it
exceeds 70 per cent, in the United States, 125 per cent. In Italy the share of
capital provided by intermediaries specializing in private equity is also limited.
Growth in firms' capitalization has gone hand in hand with a rebalancing
in debt instruments. Between 2013 and 2017, gross bond issues rose to a
yearly average of €35 billion, from €25 billion in the previous five-year
period. The introduction of tax incentives encouraged around 150 firms that
had never previously made bond placements to issue mini-bonds. Overall,
over the last ten years the ratio of bonds to total financial debt has risen from
6 to 13 per cent, a slightly higher figure than that for Germany, but about
9 points lower than in France and the United Kingdom and more than 25
points lower than in the United States.
Broader access to market funding is possible above all for the largest firms.
Small and medium-sized firms may derive significant benefits from the growth
of individual savings plans, which were introduced at the end of 2016 with
the objective of promoting investment in the financial instruments issued by
Italian firms through tax incentives. For smaller firms, however, bank credit
is likely to remain the main source of funding. Also in light of the tightening
of prudential measures on non-performing loans, these firms' financial needs
must be supported by banks with strict criteria to assess creditworthiness and
by exploiting the opportunities provided by the new technologies. In order
to facilitate access to credit for small and medium-sized firms, it is crucial to
promote their capital strengthening.
Banks
Banks hold a large amount of information on firms, which they can
either use to raise barriers to competition from other operators - in a fruitless
defence of their positions - or instead, with foresight, leverage it to offer new
services, including to facilitate firms' direct access to the market. Resolute
strategies, however, are needed to tackle the challenges of technological
development, competitive pressures and the new approaches to banking
regulation and supervision. As well as limiting administrative expenses and
staff costs, banks must diversify their sources of revenue. They have already
set out on this path and must proceed without hesitation.
The finalization of Basel III reforms has improved the quality of
the rules by ensuring that banks can no longer use their own internal
models to excessively reduce their capital requirements, particularly in
relation to trading. The new rules include a lowering of the requirements
for loans to small and medium-sized businesses, on top of the existing
provisions of European legislation.
Among the challenges facing banks are those of ensuring correct conduct
vis-à-vis customers and compliance with the rule of law. In a number of
instances, a lack of attention to transparency requirements and the sale of
products unsuited to investors' financial needs - already serious problems -
have amplified the effects of crises. Banks have a duty to preserve their
customers' trust, which is also a means of improving competitiveness and is
vital for the sustainability of their strategies in the new business and market
environment. The banking system has shown a growing commitment to
preventing money laundering and combating terrorist financing; it must
continue in this direction in order to effectively counter the risks posed
by continuous developments in financial crime, which also exploits new
technologies.
Italian banks strengthened capital in 2017. Common equity increased
by €23 billion, of which €4 billion was provided by the Government for the
recapitalization of Monte dei Paschi di Siena. The CET1 ratio rose by more
than 2 percentage points on average, to 13.8 per cent, compared with 7.1
per cent a decade ago. For the significant banking groups, the gap with the
euro-area average has narrowed by 2 percentage points, to 1.3.
In recent years there has been a reduction in both banks' exposure to the
public sector and in the volume of non-performing loans. The former has
decreased by more than a quarter from the peak recorded in early 2015 and
now amounts to about €300 billion. NPLs, net of loan loss provisions, have
diminished by about a third with respect to the end of 2015, to €135 billion.
The coverage ratio, i.e. the ratio of the stock of loan loss provisions to gross
NPLs, has reached 53 per cent, a much higher level than the average for the
leading European banks.
According to data published by the ECB, at the end of 2017 the ratio
of Italian significant banks' gross NPLs to total lending, including interbank
exposures and those to central banks, was 11.1 per cent, compared with an
average of 4.1 per cent for other Eurozone significant banking groups; net of
loan loss provisions the ratios were respectively 5.9 and 2.4 per cent. While
still large, the gap has narrowed significantly in the last two years.
The decrease in the stock of NPLs is partly due to the sharp rise in sales
on the secondary market, facilitated by the favourable economic situation
(€35 billion in 2017 against a yearly average of €5 billion in the previous
four years). This year sales are expected to reach €65 billion for the banking
system as a whole. According to the plans submitted to the Single Supervisory
Mechanism in March, by the end of 2020 the NPLs of Italy's significant
banking groups should be almost half the level recorded at the end of 2017;
in relation to total lending, net of loan loss provisions, they should fall to
about 4 per cent for significant groups, and to an estimated 5 per cent for the
system as a whole (Figure 8). On more than one occasion we have