Mr. Fazio discusses Italy and Europe in a world of global finance Address
by the Governor of the Bank of Italy, Dott. Antonio Fazio, at a conference jointly organised by
AIOTE - ASSOBAT - ATIC - FOREX - AIAF and held in Naples on 24/1/98.
The expansion of trade and the globalization of markets have maintained the rate
of growth of the world economy at a high level in the last ten years. The pace has been
particularly rapid in the countries where labour is most abundant and least costly and in the
industrial countries whose economies are marked by a high degree of flexibility and rising
productivity.
The liberalization of trade in goods and services, the improvement in
communications and the reduction in transport costs increase the efficiency of the allocation of
resources in the world. The gains from trade, the new wealth created are unequally divided
among the countries involved; they also result in a redistribution of productive capacity and an
increase in specialization and concentration.
The globalization of finance allows saving to be allocated and managed more
efficiently at world level; it has made a significant contribution to sustaining productive
investment in the fastest growing economies.
In the six leading industrial countries the volume of financial assets rose between
1982 and 1995 from $30 trillion to $124 trillion and from four to six times their annual GDP at
current prices. In the industrial countries the huge rise in public debt contributed to the increase
in the supply of financial instruments. Stock markets have grown very rapidly in recent years,
especially in the emerging countries. The activity of non-bank intermediaries operating on a
global scale and investing primarily in shares and bonds and other widely traded assets has
developed, rapidly reaching a very substantial volume.
Financial intermediaries, including banks, tend to behave according to operating
models that are based on the same theoretical paradigms; sometimes, however, by reacting
uniformly to important new information or to changes in expectations concerning individual
economies, they shift funds very rapidly from one economy to another; they can take positions
with very-short time horizons in foreign exchange or securities of a size that heavily influences
countries with less solid financial structures.
1. The Asian crisis
Foreign investment in the emerging markets by banks and institutional and private
investors rose from $50 billion in 1990 to $240 billion in 1996.
In mid-1997 the foreign debts of eight emerging Asian economies, including
Hong Kong, Singapore and China, amounted to $900 billion or about 40 per cent of the area's
GDP; some two thirds of the total was due to mature within one year.
The crisis, which has affected five countries in particular -- Thailand, Indonesia,
Malaysia, the Philippines and South Korea -- is basically the result of the persistence of large
external current account deficits ranging from 3 to 6 per cent of GDP and the consequent rapid
accumulation of foreign debt.
These countries' budgets are generally close to balance and their public debt is
limited. The disequilibria are attributable to an excess of private and public sector investment in
relation to the albeit high rate of saving. The returns on investment projects have not always
been adequate in terms of profitability and exports, partly owing to inefficiencies in the
allocation of credit. Competitiveness was eroded by the 40 per cent devaluation of the Chinese
currency in 1994.
Firms' growing dependence on foreign loans, denominated mostly in dollars, the
preponderantly short-term nature of the debt and shortcomings in the supervision of financial
intermediaries made financial systems more fragile. The uncertain performance of the Japanese
economy and financial system exerted a negative influence.
The crisis started and spread when market participants came to recognize the
difficulty of sustaining exchange rates in the face of the sharp and continuing appreciation of the
dollar and expectations of increases in interest rates in the United States. The possibility
emerged of heavy losses by firms; growth prospects were scaled back, with further adverse
effects on stock markets.
It is surprising, in this crisis as well, how fast the climate of opinion changed
among investors; it suggests a formation of expectations based on the performance of the
macro-economic variables only in the short run and on the attitudes of other market participants.
The extrapolative nature of expectations compounds fluctuations in exchange rates and securities
prices.
Once again there was a failure to make a thorough analysis of the underlying
conditions of each economy. To be sure, the shortness of the average maturity of the debt
indicated uncertainty among investors regarding long-term growth prospects; nonetheless, until
mid-1997 the flow of capital to the area remained substantial.
Notwithstanding the interventions organized by the IMF, the crisis deepened in
December and the early days of this year. The falls in share prices and exchange rates against the
dollar in the five countries mentioned since early 1997 have reached respectively 40 and 50 per
cent on average; expressed in dollars, share prices have fallen to less than one third of the initial
level. The markets, and especially the stock markets, of Singapore, Taiwan and Hong Kong have
been caught up in the crisis.
Events in the markets and the poorer prospects for the economies of the countries
hit by the crisis have adversely affected the already delicate balance of Japan's capital market
and the quality of its banking system's assets.
The Chinese economy has not been drawn into the crisis, owing to its initially
strong competitive position, relatively underdeveloped financial system and the preference given
to direct inward investment over portfolio investment.
The volume of financing mobilized by the IMF, other international organizations
and the nations working to cope with the crisis is without precedent. The World Bank and the
Asian Development Bank have been called upon to contribute to objectives beyond the scope of
their respective institutional mandates. Total disbursements of around $110 billion have either
been made or are envisaged.
will have to help in containing the effects of the crisis by rolling over
existing loans.Banks
The intensity of the crisis and the fear of systemic repercussions have produced a
disarray in the measures and decisions adopted that suggests the present arrangements for
international cooperation are inadequate in the face of the challenges posed by the globalization
of markets.
2. International monetary developments
The backdrop to the Asian crisis is the persistent problem of the uncertain
performance of the Japanese economy and the excessive burden placed on monetary policy.
This situation is an inheritance from the Mexican crisis in the early months of
1995, which led initially to an abnormal appreciation of the yen and to fears of a prolonged
decline of the dollar.
The lowering of interest rates in Japan to near zero led in the second half of 1995
to a fall on the order of 20 per cent in the effective exchange rate of the yen. The economy did
not benefit sufficiently in terms of growth, while the imbalance associated with Japan's large
external credit position was aggravated. The weakness of the exchange rate tended to depress
share prices, thereby contributing to the contraction in domestic bank credit.
Fiscal policy, even after the recent announcement of a small reduction in taxation,
continues to be directed towards the undeniably desirable objective of containing the public debt
in the long term. A further reduction in the budget deficit is expected in 1998; there does not
appear to be sufficient concern about the deflationary implications of this course in the short
term.
The measures now before the Japanese Parliament provide for a limited stimulus
to domestic demand based on tax reductions that should amount to around half a percentage
point of GDP. The package also includes a plan for shoring up and rescuing the financial and
banking system involving very substantial resources, some $240 billion or 6 per cent of GDP.
The long period of expansionary monetary policy in Japan, especially from the
spring of 1995 onwards, has substantially increased the supply of yen and lowered the cost of
yen financing. Japanese banks have considerably increased their supply of credit to international
markets; their external liabilities have fallen substantially and they have become large net
creditors.
The expansion in the credit provided by the Japanese banking system has
occurred in a period which has been marked by a very large US current account deficit, at
present on the order of $180 billion a year, coupled with a persistently high level of direct
investment abroad by American firms. The relatively slack economic conditions in most of the
industrial countries made it easier to finance the external deficits of the countries affected by the
crisis.
In a context of low inflation, both actual and expected, the supply of money at
very low interest rates has been reflected in long-term yields in Japan and the other leading
markets. The yields on long-term Japanese securities fell to 2.1 per cent in 1997. Japanese
overseas portfolio investment amounted to more than $80 billion in 1994 and 1995, twice the
level of the preceding years; it rose further in 1996 and the early part of 1997; around one fifth
of the outflow goes directly to the US market.
Foreign investment in US securities amounted to more than $300 billion in 1996,
an increase of 50 per cent on 1994 and 1995; compared with three years earlier it more than
doubled. Annual disinvestment is on the order of $100 billion. The yield on ten-year US
securities fell from 6.4 per cent in 1996 to 5.8 per cent at the end of 1997.
The European financial system also received much larger portfolio investment
inflows in 1996 and 1997 than in the preceding years. More than $200 billion flowed into
Germany in 1996, compared with $125 billion in 1995 and $76 billion in 1994. In 1997 the
yields on medium-term securities fell faster in Germany than in the United States, reaching 5.3
per cent.
In some respects the abundance of liquidity in the international market appears to be a replay of
the situation in the early 1990s, up to the beginning of 1994, following the prolonged US
monetary expansion. The Federal Reserve held short-term rates close to 3 per cent for nearly two
years. In these circumstances the yields on medium and long-term securities in the leading
markets declined steadily and substantially until the last few months of 1993. Those on ten-year
US Treasury bonds fell from 7 per cent at the beginning of 1992 to just over 5 per cent in
October 1993; the yields on German securities fell from 8 per cent to below 6 per cent at the end
of 1993. The yields on ten-year Italian Treasury paper fell from over 14 per cent in the autumn
of 1992 to below 9 per cent in the early months of 1994, after reaching 15 per cent during the
EMS crisis.
From February 1994 onwards, in connection with the shift in the stance of US
monetary policy, interest rates rose rapidly everywhere; securities prices fell to their level of two
years earlier.
After the Mexican crisis, medium-term interest rates declined gradually again in
all the main markets from the spring of 1995 onwards. Monetary policy was tightened
moderately during 1997 in all the industrial countries except Italy and Spain. The upward
pressures on interest rates are now being neutralized by the need to facilitate the solution of the
Asian crisis and the expectations of slower growth in the United States.
The funds that have been withdrawn from the Asian economies have flowed to
the financial markets of the industrial countries, above all that of the United States, providing
support for share and bond prices and the exchange rate of the dollar.
The yen has been constantly weak, but in general outside Asia the pattern of
exchange rates has remained orderly.
On several occasions during the 1990s the Japanese government announced plans
for fiscal expansion. Although they were substantial, the composition of the measures, their
temporary nature and incomplete implementation meant that they produced effects of limited
size and duration. The Japanese economy appears to be dominated by negative expectations for
the medium and long term connected with the prospective ageing of the population. The large
fall in property and share prices at the beginning of the 1990s created difficulties for the banking
system, which have now been aggravated by the crisis of South Korea and the countries of
South-East Asia, which have close commercial, financial and entrepreneurial ties with Japan.
The way to overcome the impasse -- given the size of the Japanese economy and
its actual and potential strength in terms of productive capacity and saving -- appears to be to
provide an effective stimulus to domestic demand. Monetary policy, with interest rates close to
zero, appears to have shot its bolt.
The plan now under discussion, if it is approved by Parliament in its entirety,
appears to be on a sufficiently large scale as regards the rehabilitation of the financial system. By
contrast, the stimulus for economic activity appears still to be small. More incisive budgetary
measures, possibly with short time horizons, could improve the outlook for growth in Japan
without having adverse long-term effects on its public finances.
The levels reached by share prices in the economies affected by the crisis, in
conjunction with the stabilization plans drawn up for some of them with the support of the IMF,
mean that there are likely to be profitable investment opportunities.
In the present phase the international economy is exposed to the risk of systemic
instability, with consequent widespread deflationary effects. International portfolio investment
flows have been of unprecedented size in the last few years; it is necessary at least to monitor
them and to some extent to govern them.
A recovery in domestic demand and an improvement in the prospects for growth
in Japan would also underpin the yen; they would bring direct benefits for the Asian countries
and indirect benefits for the world economy. There is an increasingly urgent need for a new
comprehensive approach to these problems conforming with the configuration of global markets
and today's international financial system.
3. Europe in the global market
Europe's markets are increasingly integrated with the international market in
finance.
The international opening of the Italian and French financial systems has
proceeded apace in the 1990s. Germany had already been playing an important role in
international markets; at the same time the share of finance coming from abroad has steadily
grown and the large net external credit position built up above all in the 1980s is tending to
diminish. The international openness of the United Kingdom remains pronounced, reflecting the
presence of the world's leading financial centre.
The recent monetary developments have had a significant effect on all the
markets of continental Europe. The last three years have seen substantial flows of portfolio
investment into Germany, France and Italy as well as smaller countries. The fall in long-term
yields, which occurred simultaneously everywhere, has reflected the stability of prices and the
reduction in government deficits within Europe; more immediately it is the consequence of the
large inflows of funds that have been a feature of all the European markets.
Policies must be designed to maintain in the European Union financial
investments that tend to be of a temporary nature. The small inflow of direct investment into
some continental European countries, coupled with growth in EU outward direct investment, is a
cause for concern. There is a need to develop conditions of competitiveness and profitability in
productive systems that will attract the funds of international investors on a permanent basis.
The competitiveness of the financial industry in continental Europe is relatively
low. Costs are high; the quality of the services provided is still inadequate. Small markets and
the chronic weakness of some currencies have been a brake on the development of a more
modern financial industry able to compete in the global market.
In 1996 the current account of the European Union's balance of payments showed
a surplus of $86 billion or 1 per cent of the area's GDP. From 1990 onwards the external
accounts of the EU countries fluctuated between deficit and surplus against a background of
rapid growth of the world economy and moderate growth of domestic demand within the area.
The limited increase in output, the steady decline in industrial employment and
the rise in unemployment are indicators of insufficient competitiveness with respect to the rest of
the world. The markets for goods and above all the market for labour are more rigid in
continental Europe; unit labour costs in industry are comparable with those of the United States
and Japan, but much higher than those of newly industrialized countries in Asia, Latin America
and eastern Europe. The tax burden, and especially that relative to employee workers, is high.
Population ageing will profoundly alter the balance between the economically
active and inactive members of society. The low level of economic growth depresses the
propensity to invest.
The prospect of economic and monetary union has forced European countries to
take determined action to put their public finances back on a sound footing. To a large extent the
effort required to adjust budget deficits has been made. A high degree of monetary stability has
been restored. In several cases however, the tax burden has increased further.
Monetary stability is the primary objective of the unification; it serves to create
conditions conducive to investment and growth.
The parameters for government deficits and public debts are playing a key role in
achieving monetary stability in the area; they were nonetheless conceived in a context in which
the implications of the globalization of commerce and finance were still not sufficiently clear; it
is also necessary to try and reduce the burden on the economy of some items of the public
finances and the ratio of taxes and social security contributions to GDP.
To seek to enhance the Union's competitiveness through the exchange rate would
be in contrast with the objective of monetary stability. Competitiveness is in the first place a
reflection of the share of resources absorbed -- directly in the form of wages, indirectly via some
items of public expenditure -- by labour. It must therefore be enhanced through a cost of labour,
a flexibility in its use and a level of direct and indirect taxation that are compatible with today's
greater international openness of the markets for goods, services and especially finance.
Increasing the size and diversification of the capital market can make a decisive
contribution to monetary stability and ultimately to the prosperity of the economy.
Europe as a whole is a net creditor with respect to the rest of the world. The
creation of a single financial market that is no longer segmented by different currencies, in a
context of price stability and greater competitiveness, will offer considerable scope for growth in
the issue and trading of corporate bonds and shares, and for the development of related capital
market activities, benefiting enterprises and economic activity and supporting their extension to
world markets.
Looking ahead, the international monetary system will increasingly be divided
into three large blocs: those of the dollar, the yen and the European currency. The currencies of
smaller countries will tend to be grouped around, and refer to, the three of greatest importance.
The strength of each currency will depend on the credibility of the monetary
policies adopted. In the background there will be a tendency for the productivity and
competitiveness of the real economy to take on renewed importance. It is necessary to foresee a
recomposition of the area's value added in the medium term at the expense of more traditional
industries and to the benefit of more advanced services, especially financial services.
Important opportunities are opening up for Italian and European operators that
they must succeed in grasping by updating strategies and professional skills and by correctly
assessing the related risks through the application of more advanced and complete models.
4. Italy
Italy recorded another surplus on its external current account in 1997, of the order
of 60 trillion lire or just over 3 per cent of GDP.
Towards the end of the year the country's net external position returned to near
balance. Some 470 trillion lire of net government liabilities vis-à-vis non-residents (mostly short
and medium-term lira paper purchased on the Italian market, but with about one fifth consisting
of foreign currency bonds issued abroad) were matched by net assets of more than 350 trillion
held by the non bank private sector, about 100 trillion held by the Bank of Italy and smaller
amounts held by banks and other financial operators.
The Bank of Italy's gold reserves amount to 2,500 tonnes; in addition the central
bank's external position improved from 51 trillion lire at the end of 1995 to 96 trillion at the end
of last year.
Households and firms have converted Italy's substantial current account surpluses
into external financial assets. They first repaid foreign currency debts taken on in earlier years
and then increased their holdings abroad. Their overall position in foreign currency improved
from near balance in 1993 to a surplus of more than 200 trillion lire last September.
Capital outflows in the form of portfolio investment increased from a monthly
average of 4.5 trillion lire in 1996 to one of about 9 trillion last year. This reflects a propensity
for portfolio diversification aimed at achieving a better combination of risk and return, a process
that is structural and that is bound to become more pronounced over the next few years.
Increasingly, these outflows are being channelled through Italian and foreign intermediaries
specialized in asset management.
Despite the large volume of capital outflows in 1997, the net supply of foreign
currency in exchange for lire remained very substantially positive, enabling the Bank of Italy to
achieve the build-up in its foreign exchange reserves referred to earlier at stable exchange rates.
The supply of foreign currency derived not only from the trade surplus but also
from a large volume of inward portfolio investment by institutional investors, banks and private
operators. In response to more favourable domestic conditions and abundant international
liquidity, the foreign investors continued to make very large purchases in 1997: 118 trillion lire,
in line with the previous year. At the same time, the improved climate of confidence was
reflected in a sharp reduction in the share of purchases foreign investors financed in lire in order
to hedge the exchange risk.
Net purchases of Italian government securities by non-residents exceeded issues
by a wide margin. The economy's regained credibility, the prospects for the consolidation of the
public finances, low inflation and the upward trend in bond prices encouraged investment and
accentuated the decline in yields on medium and long-term securities, which are now
comparable to those in the markets with the most stable currencies.
Italian savers directed the bulk of their investment to the various forms of
managed savings; through this channel they increased their purchases of foreign assets and
Italian shares. Problems may arise in this connection with respect to the risks that households
and firms may sometimes run with this new configuration of their portfolios. The declining
yields on Italian government paper and the lower liquidity of these alternative instruments also
strengthened the demand for money, and in particular for current account deposits.
The climate of confidence that has prevailed in the markets has also been
reflected in the surge in share prices, which has continued even after the outbreak of the Asian
crisis. Financial conditions facilitated major privatizations of public sector banks, coupled with
their recapitalization, along lines we had frequently suggested.
Economic activity remained weak in the first half of 1997, bearing out the
forecasts we made at the end of 1996 and early last year. In 1997 the growth in GDP, which had
been a disappointing 0.7 per cent in 1996, would have been just over 1 per cent. Incentives for
the purchase of consumer durables stimulated economic activity despite the further fiscal
tightening and permitted annual growth estimated at about 1.5 per cent.
Investment in plant and machinery has shown signs of picking up, partly in
response to favourable conditions in Europe; by contrast, the construction sector continues to
stagnate.
The situation with regard to employment is not improving, however; in fact, in
the more depressed regions it is deteriorating further. Growth in consumer spending is still
hesitant, owing to the uncertain prospects for employment and the slow increase in households'
income.
Monetary policy has continued to be firmly directed to stabilizing inflation.
Consumer price inflation fell below 1.5 per cent on a seasonally adjusted annual
basis in the second half of 1996 and remained at that level until the summer of 1997. In the
fourth quarter of last year it rose to around 2 per cent, reflecting the upturn in producer prices
that had occurred in the second.
The expectations regarding inflation have improved continuously and now
indicate a rate of 2 per cent for 1998 and 1999.
The lowering of official interest rates from the middle of 1996 onwards was
calibrated in relation to actual and expected inflation and the outlook for the adjustment of the
public finances, the condition for a lasting return to stability, with constant attention to the
changes in residents' portfolios and the inflows of foreign capital.
We have kept the exchange rate consistent with the lira's central parity, with no
need for support intervention in the moments of tension of international origin or related to
domestic political developments.
The reduction in the official rates, the discount rate and the rate on advances,
decided at the end of last year is helping to sustain conditions that, thanks in part to the good
performance of exports, are likely to foster investment. The growth in GDP in 1998 could
exceed 2 per cent.
Italy is still faced with difficulties that will have to be overcome, thereby laying
the foundations for improvements tomorrow; there is a need for behaviour and policies that will
ensure the saving available is used to strengthen productive investment at home. Over the last
five years direct investment by Italian firms expanded substantially; the inflow remained
virtually unchanged; the balance showed a deficit of 30 trillion lire.
The quest for higher profits in a climate of renewed confidence in stability and
economic growth can be directed towards expanding the scale of production and investment,
with a view to creating employment.
Wage moderation must be maintained, thereby permitting a reduction in unit
labour costs; the albeit limited pressure on prices -- particularly producer prices -- must not be
allowed to increase.
Last year saw substantial progress towards the consolidation of the public
finances. On the basis of the latest data, general government net borrowing should be less than 3
per cent of GDP. A start has been made on reforms aimed at improving the working of the
public administration and rationalizing the tax system. Cuts have been made in some expenditure
items and transfers to non-state public bodies reduced.
What is needed now is action of a structural nature to consolidate the results
achieved. Public services must be made more efficient and provide effective support for
productive activity.
There is a manifest need for flexible formulas in the use of labour that will
enhance its productivity. Unit labour costs must be brought down substantially in the less
developed regions, where both youth unemployment and the underground economy are present
on a large and growing scale and where the labour force participation rate, particularly among
women, is very low. It is indispensable to eliminate the rigidities In the economic relations
between employers and employees, which prevent wages and salaries and other contractual
conditions from adjusting to the level of productivity and the demand for labour. Excessively
high labour costs lead to forms of hidden employment; they prevent most young people from
embarking on a career in the regular economy and, together with high tax rates, give rise to
evasion of abnormal proportions.
A lack of effective demand is increasingly evident. A low level of investment is
common to all the European economies; it lies at the root of the decline in employment in
certain sectors and the rise in unemployment. It is serious in the more depressed regions,
particularly in southern Italy; together with high labour costs, the fall in private and public sector
investment is adversely affecting the economic and productive fabric. Appropriate policies are
required to restore higher rates of investment. Lower unit labour costs and increased
competitiveness provide fertile ground for a recovery in investment.
I have spoken at length elsewhere of the potential and actual availability of
private saving in Italy. I have endeavoured to show that a higher level of economic activity and
faster growth, combined with monetary and wage stability, can accelerate progress towards the
lasting adjustment of the public finances.
The price stability that we have regained with a monetary policy that at times has
had to be extremely rigorous, must be bolstered by a competitive and expanding real economy.
By pursuing a stable policy from the summer of 1994 onwards we brought the
rate of inflation back into line with that of the leading industrial countries. Wage moderation, the
drastic reduction in the Treasury borrowing requirement in 1997 and the weakness of prices in
international markets have helped considerably in the curbing of inflation; as a consequence,
long-term interest rates have come down. These results, obtained through an unwavering
commitment, have made a major contribution to the convergence of Italy's economy towards
those of our European partners with a more firmly established tradition of stability.
The months from now until the decisions connected with the launch of Monetary
Union, but also the second part of this year, will prove especially delicate for the entire system
of European exchange rates. In these circumstances monetary policy, while it will continue to
guarantee moderate medium-term inflation expectations, is now focused more on the stability of
the exchange rate.
If economic agents' behaviour is consistent, Italy will be able to maintain the
international position it has so arduously regained, to the benefit of present and future
generations.