Executive summary 1

1. Scene setter: Economic situation and outlook 3

2. Imbalances, Risks, and Adjustment 11

2.1. High public indebtedness 13

2.2. Loss of external competitiveness 23

2.3. Special topic: Italy's banking sector in a protracted low-growth environment 37

2.4. Euro-area spillovers 47

3. Other structural issues 50

3.1. Public administration and business environment 51

3.2. Competition, infrastructures and innovation 57

3.3. Labour market, education and social policies 63

3.4. Taxation 71

3.5. Special topic: Regional disparities 75

AA. Overview Table 79

AB. Standard Tables 86

LIST OF Tables

1.1. MIP scoreboard indicators 9

1.2. Key economic, financial and social indicators - Italy 10

3.2.1. Type of award 58

AB.1. Macroeconomic indicators 86

AB.2. Financial market indicators 87

AB.3. Taxation indicators 88

AB.4. Labour market and social indicators 89

AB.5. Expenditure on social protection benefits (% of GDP) 90

AB.6. Product market performance and policy indicators 91

AB.7. Green Growth 92

LIST OF Graphs

1.1. Growth accounting, 2001-13 3

1.2. GDP and its components 3

1.3. Evolution and breakdown of Italy’s net international investment position 4

1.4. Real gross fixed capital formation, index (2000=100) 5

1.5. Real net capital stock, million Euros 5

1.6. HICP inflation and components 6

1.7. Italy’s inflation-linked swap rates 6

1.8. Headcount employment and unemployment rate 7

1.9. Wage supplementation schemes, million of hours authorised 7

1.10. Unemployment by duration, (thousands) 8

2.1.1. Italy — medium and long-term sovereign debt average yield at issuance ( %) 13

2.1.2. Italy — Gross debt-to-GDP 15

2.2.1. Breakdown of the year-on-year change in goods components of Italy’s trade balance 23

2.2.2. Italy’s export performance since mid-2010, intra and extra euro area breakdown 24

2.2.3. Share of tradable sectors in gross value added 25

2.2.4. Average annual growth rate of gross value added over selected periods 25

2.2.5. Shares of gross value added in manufacturing by technology intensity 25

2.2.6. Export propensity by technology intensity 26

2.2.7. Export propensity by manufacturing sector, 2012 26

2.2.8. Labour productivity by firm size (100 = average over total firm population) 27

2.2.9. Export propensity by firm size 27

2.2.10. Goods exports of manufacturing sectors, by shares and dynamics 27

2.2.11. Shares of goods exports by manufacturing sector, 1995 and 2013 28

2.2.12. Shares of manufacturing exports of goods, by technology intensity 28

2.2.13. Change in sectoral export market shares 2010-13, percentage points USD 28

2.2.14. Cost and price developments (2010-2014 average) 29

2.2.15. Unit labour cost index for selected countries, tradable vs. non-tradable sectors (1998=100, based on hours worked) 29

2.2.16. Unit labour cost index (based on full-time equivalents) by technology intensity, 1998=100 30

2.2.17. Indicators of competitiveness: producer prices of manufactures (December 2010 =100) 30

2.2.18. Export quality 31

2.2.19. The role of services in Italian non-cost competitiveness 31

2.2.20. Compensation per employee by sector 32

2.2.21. Actual and negotiated wages 32

2.2.22. Phillips curve for Italy: annual growth of compensation per employee 33

2.2.23. Phillips curve for Italy and euro area based on negotiated wages, 2008-2014 33

2.2.24. Age-earning profile, 2012 34

2.2.25. Incidence of over- and under-qualification ( % of workers), 2012 34

2.2.26. Growth of new contracts signed and contributions by contractual forms, y-o-y % change 35

2.3.1. Share of domestic bank loans in total financial debt of the non-financial corporate sector at end-2013 37

2.3.2. Financial leverage of the non-financial corporate sector 38

2.3.3. Number of bankruptcy and non-bankruptcy insolvency procedures and voluntary liquidations in Italy 38

2.3.4. Change in turnover and gross operating margin between 2007 and 2013 by firm size 39

2.3.5. Corporate non-performing loan ratio of Italian banks 39

2.3.6. Ratio of loan impairments to total operating income and return on equity of Italian banks 40

2.3.7. Credit supply and demand conditions for Italian non-financial corporates 40

2.3.8. Bank interest rates on new loans to Italian firms 41

2.3.9. Deleveraging and credit rationing of Italian firms per leverage quartile 41

2.3.10. Sales of impaired assets by Italian banks 44

2.3.11. Italian banks’ domestic sovereign exposure and Italian 10-year sovereign yield 46

2.4.1. Italy — Imports by county of origin (top 15 EU countries) 47

2.4.2. Italy — Exports by destination (top 15 countries) 47

2.4.3. Italy — Partner’s exposure to liabilities (top EU 15, excl. LU) 48

2.4.4. Italy — EU bank claims, by sector 48

3.1.1. Ratio of time-barred criminal cases to total resolved criminal cases per instance 54

3.3.1. Discouraged workers by age groups 63

3.3.2. General government expenditure on tertiary education (index 2007=100) 67

3.4.1. Tax wedge and recent changes for 100% average production wage (APW) earner 71

3.4.2. VAT gaps in the EU (2014) 73

3.5.1. Regional employment (1977=100) 75

3.5.2. Regional unemployment rate 75

3.5.3. Regional employment rate and labour costs 76

3.5.4. Labour productivity, labour costs and unit labour costs in Mezzogiorno relative to the North-centre, manufacturing sector 77

3.5.5. European Quality of Government Index 2013 (EQI) and the regional country variation 78

LIST OF Boxes

1.1. Economic surveillance process 9

2.1.1. Impact of fiscal consolidation and structural reforms on public debt 17

LIST OF Maps

No table of contents entries found.

After a long contraction, growth is expected to turn positive in 2015 but remains well below the EU average and the public debt-to-GDP ratio is set to increase further. Inflation is projected to turn negative due to the fall in oil prices. Unemployment remains historically high and domestic demand is weak. Increasing global demand, a lower euro and falling oil prices could support economic growth in the future. Current account surplus is expected to strengthen slightly. The government deficit is set to reach 3 % of GDP in 2014 and to decrease in 2015 and 2016. Italy's public debt-to-GDP ratio is expected to peak in 2015 at 133 % of GDP based on the Commission 2015 winter forecast. The current low growth and inflation outlook pose a challenge to its reduction.

In March 2014, the Commission concluded that Italy was experiencing excessive macroeconomic imbalances requiring specific monitoring and strong policy action. This Country Report assesses Italy’s economy against the background of the Commission's Annual Growth Survey which recommends three main pillars for the EU's economic and social policy in 2015: investment, structural reforms, and fiscal responsibility. In line with the Investment Plan for Europe, it also explores ways to maximise the impact of public resources and unlock private investment. Finally, it assesses Italy in the light of the findings of the Alert Mechanism Report published on 28 November 2014, in which the Commission found it useful to examine further the persistence of imbalances or their unwinding. The main findings of the in-depth review contained in this Country Report are:

· Persistently low productivity growth continues to perpetuate Italy's macroeconomic imbalances, namely the very high level of public debt and the weak external competitiveness. Italy’s real GDP has fallen to the early 2000s levels, while the euro area GDP is more than 10 % higher. The poor performance of total factor productivity accounts for most of the difference and is at the root of Italy’s declining competitiveness, while the low growth weighs on the sustainability of the high public debt. Structural reforms — implemented and foreseen — should reduce public debt-to-GDP ratio and improve competitiveness through their positive impact on productivity and GDP. Strong commitment to these reforms is crucial, also in the light of Italy’s past record marked by important implementation gaps.

· The very high government debt remains a heavy burden for the Italian economy and a major source of vulnerability, especially in a context of protracted weak growth. The fiscal adjustment and easing in market conditions have helped avert immediate sustainability risks. Past pension reforms should have a beneficial effect in the medium-to-long-term. However, public debt impact assessments show that strong growth-friendly consolidation, sustained nominal growth and ambitious structural reforms are key to a substantial debt reduction.

· Italy's competitiveness has not improved significantly yet: sluggish productivity growth continues to push up unit labour costs, while non-cost factors remain unfavourable. Italy’s export competitiveness remains weak. Unit labour costs have been rising relative to trade partners, driven by the slow productivity growth. Italy’s product specialisation and high share of small firms with a weak competitive position in international markets further hamper its competitiveness.

· The protracted crisis has exposed the risks inherent in the Italian banking sector’s close relationship with the domestic corporate sector and the sovereign. Corporate non-performing loan ratio has increased to just over 27 %. Bank credit to corporates continues to contract, driven by weak demand and tight supply to SMEs with a high credit risk. Italy has also taken several measures to reform the banking sector and diversify firms’ funding sources. The banking sector’s exposure to domestic government bonds is expected to remain high, and so its vulnerability to unfavourable market developments in the Italian sovereign debt market.

· Investment was particularly hard hit during the crisis aggravating the long-run deterioration in its quality. Since the crisis, productive investment in Italy has declined significantly and it is now 1.5% below the EU average as a share of GDP. The decline in the amount of investment is compounded by a long-term deterioration in its quality.

· The Italian economy’s size makes it a potentially important source of spillovers to other Member States while its recovery depends on propitious external conditions. The trade, financial and bank funding links harbour the potential to cause spillovers in other EU countries. At the same time, external demand and the inflation environment are paramount to Italy’s export-led recovery, the debt-to-GDP reduction effort and to recovering competitiveness.

The Country Report also analyses other macroeconomic and structural issues and the main findings are:

· Weaknesses in public administration and justice system hamper the quality of the business environment and reduce the capacity to implement reforms effectively. Despite marginal improvements, inefficiencies in the public administration and justice remain. According to several national and international sources, corruption is high, which damages the economy.

· Lack of competition in product markets, infrastructure gaps and low spending on research on development, particularly in the business sector, are hampering productivity growth. Restrictions on competition and infrastructure bottlenecks in important sectors of the economy remain present, while a very high number of inefficient companies owned by local authorities weigh on the country’s public finances and economic performance. Investment in research and innovation is low.

· Labour market participation remains low and active labour market policies are weak. The participation of women, although growing, remains among the lowest in the EU. Youth unemployment has increased dramatically with the crisis. Employment services, fragmented across the country, are inadequate to match the supply of labour to demand.

· The Italian education system continues to suffer from long-standing problems. The early school-leaving rate is well above the EU average and school education in Italy produces mixed results in terms of skills attainment.

· The taxation system hinders economic efficiency. The tax burden on labour has been reduced considerably in the past year but remains high. Tax compliance is low and time-consuming for Italian taxpayers, posing risks to fair competition in the market and a fair burden sharing.

· Social and regional disparities are growing wider. Poverty and social exclusion have greatly increased while the social protection system is fragmented and fails to address these challenges properly. The southern regions have suffered a sharper fall in employment due to their long-standing structural weaknesses.

Overall, Italy has made some progress in addressing the 2014 recommendations. A significant shift of the tax burden away from labour has been undertaken. The ongoing reform of the labour market has potential to address long-standing rigidities and improve the allocation of labour resources. Some progress has been made to improve the education system as well as the governance and resilience of the banking sector. Initial steps have been taken to streamline institutions and administration. A draft law for competition has been adopted by the government in February 2015. However, progress has been much more limited, and sometimes delayed, in several important areas. The spending review is not yet part of regular budgeting procedures, and the privatisation programme also incurred delays in 2014. Only limited progress made in addressing corruption and infrastructure bottlenecks.

The Country Report shows the policy challenges stemming from the analysis of macroeconomic imbalances. Italy's main challenges regard growth-friendly fiscal consolidation and the implementation of structural reforms to improve productivity growth. Other challenges concern infrastructure bottlenecks, the efficiency of the tax system and the efficiency of the public administration, including justice.

Macroeconomic developments

Italy’s real GDP is back to levels seen at the start of this century, given also the sluggish productivity performance. This stands in sharp contrast with the euro area GDP, which is more than 10 % higher than its early 2000 levels. Breaking down Italy’s GDP growth between 2001 and 2013, the poor performance of total factor productivity accounts for most of the difference (Graph 1.1), whereas the contributions of the other components have been broadly in line with those in the euro area. As the crisis hit, not only did Italy’s GDP contract significantly more than the euro area average, but Italy’s potential output also declined. An ageing population and weak labour market participation have also contributed negatively to potential growth. In addition, the government’s fiscal consolidation effort combined with private sector deleveraging has had a detrimental impact on capital accumulation.

Graph 1.1: Growth accounting, 2001-13

Source: European Commission

The Italian economy is still struggling to come out of recession. In the first three quarters of 2014, the Italian economy underperformed the euro area and it contracted further by 0.4 % year-on-year. While private consumption has been stabilising since mid-2013, the saving rate has increased as waning inflation and new income support measures sustain real disposable income. Investment – both in equipment and construction –contracted substantially over the course of the first nine months of 2014, reflecting uncertain demand prospects as well as tight financing conditions. Exports have continued to sustain GDP growth, albeit only moderately (Graph 1.2).

Graph 1.2: GDP and its components

w

Source: ISTAT

Financing conditions remain tight, although they gradually loosened over the course of 2014. Following completion of the Single Supervisory Mechanism’s comprehensive assessment of euro area banks, overall credit supply tightness has decreased. Bank lending to Italy’s corporate sector, and small firms in particular, continued to contract by 2.6 % year-on-year in November 2014, but the contraction has slowed in recent months. However, small firms continue to face funding constraints due to high risk premiums. Credit demand remains weak due to subdued investment prospects related to economic uncertainty and spare capacity, firms’ need to deleverage, and increased bond issuance by medium-sized and large firms (see Section 2.3). The cost of credit has been declining further for both households and firms, driven by lower policy rates. However, the very low inflation rate implies high real interest rates and Italy’s financing cost (both for the sovereign and the real economy) remains above the euro area average.

Looking ahead, external demand is expected to trigger a slow and gradual recovery. The indicators currently available point to a further slight fall in output in the last quarter of 2014 driven by the manufacturing sector, while the service sector is expected to have stabilised. Overall, the Commission 2015 winter forecast projects a contraction of GDP by 0.5 % in 2014 and a gradual recovery in 2015 and 2016. Real GDP is forecast to expand by 0.6 % in 2015, supported by exports and only moderate improvements in domestic demand. The recovery is projected to strengthen in 2016 as financing conditions normalise and external demand reinforces triggering an increase in investments.

Italy’s current account surplus has further increased, mirroring public and private sector deleveraging. On the external side, the 12-month cumulative balance recorded a surplus of EUR 27.7 billion (1.7 % of GDP) in November 2014, almost double the EUR 15.2 billion surplus recorded one year before. The ongoing correction in Italy’s current account is driven by the further improvement of the trade balance (see Section 2.2), which in turn is caused by an expanding non-energy goods surplus ([1]) in combination with a shrinking energy goods deficit due also to falling oil prices. From a savings-investment point of view, the trend in Italy’s current account is primarily due to a contraction in investment on account of deleveraging by the public and private sectors (the corporate sector turned into a net lender in 2012), while households are restoring their savings.

Graph 1.3: Evolution and breakdown of Italy’s net international investment position

Source: European Commission

Italy has turned into a net lender to the rest of the world, but its net international investment position has slightly deteriorated. The recovery in foreign net portfolio investment in Italy seen since mid-2012 continued and was mirrored by a downward trend in foreign net other investment related to the gradual decline in reliance on Eurosystem liquidity. In the second half of 2014 however, this trend was interrupted by the reduced government bond issuance due to the Treasury’s strong liquidity position, and by Italian banks’ participation in the Eurosystem’s targeted long-term refinancing operations. Although overall Italy has become a net lender to the rest of the world, its net international liabilities increased somewhat in 2014 as a result of net negative valuation adjustments related to the substantial decline in risk premiums on its own debt instruments. At around 30 % of GDP in 2014, Italy’s negative net international investment position does not pose sustainability concerns, but the bias in its composition towards interest-bearing debt – reflected in the higher net external debt level – remains a vulnerability (Graph 1.3).

Graph 1.4: Real gross fixed capital formation, index (2000=100)

Source: European Commission

Since the crisis, productive investment in Italy has declined significantly and by more than the euro area average. As a share of GDP, investment fell from 21.6 % in 2007 to 17.8 % in 2013, 1.5 percentage points below the EU average (19.3 %). As shown in Graph 1.4, following a period of subdued growth, the non-residential component of investment was the hardest hit, reaching a level in 2013 that was 15 % below that in 2000 in real terms. Investment also continued to fall in the first nine months of 2014 (by 2.2 % in real terms year-on-year), particularly in construction (-3.4 %), but also in machinery and equipment (-1.7 %).

The fall was common to both the public and the private sectors. In nominal terms, investment by the government sector fell by 18 % over the 2008-13 period, with its share of GDP declining from 2.9 % in 2007 to 2.4 % in 2013. Investment by the corporate sector fell by nearly as much and accounted for 9.5 % of GDP in 2013, down from 11.3 % in 2007. Investment by the household sector and non-profit sector serving households was also affected, although to a lesser extent, with a share of GDP of 6 % in 2013 (-1.3 percentage point from 2007).

Graph 1.5: Real net capital stock, million Euros

Source: European Commission

The persistent fall in investment is hindering Italy's future prospects. The significant and protracted fall of gross capital formation led to the stabilisation of Italy’s capital stock, net of depreciation (Graph 1.5). Specifically, the fall in new investment was particularly marked in the manufacturing sector, leading to a significant depletion of net capital stock in this sector of the economy. The insufficient capital accumulation ultimately hampers Italy's potential output.

The decline in the amount of investment is compounded by a long-term deterioration in its quality. The marginal efficiency of capital – a proxy for the impact of investment on growth – has been dropping since the early 1990s and has been consistently below the euro area average. While capital deepening continued to have a positive impact on labour productivity, the observed accumulation pattern did not lead to rapid technological change and total factor productivity growth (Graph 1.1). This may reflect a limited ability of the economy to reallocate resources to more productive firms and sectors.

Graph 1.6: HICP inflation and components

Source: European Commission, ISTAT

HICP inflation has been falling since mid-2012, driven by sluggish domestic demand and falling oil prices. HICP inflation averaged 0.2 % in 2014, less than in the euro area. The price adjustment has been substantial, particularly considering that inflation in Italy had been above the euro area average since the creation of the Economic and Monetary Union. In fact, since the end of 2012, inflation has been steadily declining driven down by the appreciation of the euro and lower import prices, in particular for energy products (Graph 1.6). The sluggish domestic demand contributed to the decline in core inflation. In the final months of 2014, the significant slump in oil prices pushed down HICP inflation to extremely low levels which turned negative in December 2014 and January 2015.

Inflation is expected to be slightly negative in 2015. According to the Commission 2015 winter forecast, the fall in oil prices is expected to feed quickly into the energy component of HICP inflation. This is projected to be negative on average over the year and to increase very gradually afterwards as economic prospects improve and oil price rise marginally. The increase in Italy’s VAT rate by 2 percentage points as of January 2016, enshrined in the 2015 Stability Law, is set to increase HICP inflation in 2016 to 1.5 %.

Graph 1.7: Italy’s inflation-linked swap rates

Source: European Commission

The expansionary monetary stance reduces the risk of a deflationary spiral. Inflation expectations, measured in terms of inflation-linked swap rates, have been declining (Graph 1.7). The current context of i) the zero-lower bound on official interest rates in the euro area, ii) very low inflation and iii) high unemployment have heightened the risks of medium-term inflation expectations deviating substantially from the ECB target and of second round effects of the lower oil price on other prices and wages. However, the measures recently announced by the ECB are set to reduce substantially these risks and ultimately avoid a deflationary spiral.

Employment has broadly stabilised. Following significant labour shedding in 2012 and 2013, headcount employment has broadly stabilised over the course of 2014 (Graph 1.8). Another signal that most of the labour adjustment has already occurred comes from the slight reduction in the number of wage supplementation hours (Cassa Integrazione Guadagni) ([2]), as Graph 1.9 shows. Moreover, in the third quarter of 2014, the total number of hours worked returned to growth compared with the previous quarter driven by the manufacturing and private services sectors.

Graph 1.8: Headcount employment and unemployment rate

Source: European Commission, ISTAT

Graph 1.9: Wage supplementation schemes, million of hours authorised

(1) Ordinary wage supplementation scheme (CIGO) is a short-term working scheme granted to firms to avoid labour shedding during period of temporary shortfalls of sales. The special wage supplementation scheme (CIGS) is granted to restructuring firms or those initiating a bankruptcy procedure. The under-waiver component of CIG is for employees excluded from CIGO or CIGS. Source: INPS

The unemployment rate has reached historically high levels as more people joined the labour force. The unemployment rate increased to the historically high level of 12.8 % in 2014 from 12.2 % in 2013, driven almost entirely by the growth in the participation rate (See also Section 3.3 and Section 3.5). Women contributed most to the increase in the labour force, possibly because household economic needs became more pressing. The Commission 2015 winter forecast projects the unemployment rate to remain above 12 % over 2015-16 due to the ample room for a recovery of hours worked and more people joining the labour force as economic prospects improve. As shown in Graph 1.9, the rise of the extraordinary wage supplementation scheme (CIGS) points to the risk of unemployment rising further, inasmuch as the 2012 and 2014 labour market reforms aim at limiting the use of this wage supplementation scheme to allow for labour reallocation (see Section 2.2). This would result in workers previously eligible for the scheme to become unemployed. Still, the recent measures taken to support job creation ([3]) may foster new hirings and therefore provide an upside risk to the forecast central scenario.

Long-term unemployment has been rising with potentially damaging effects on job finding rates and labour market matching. Persistently low job finding rates due to a weak demand for labour have resulted in rising long-term unemployment, which reached 63.1 % of unemployment in Q3-2014 (7.4 % of active population). In that quarter, almost 2 million people had been jobless for more than a year – most of them for between 18 and 47 (Graph 1.10). Despite the increase in unemployment duration does not yet point clearly to a deterioration of matching efficiency ([4]), prolonged cyclical weakness and lingering unemployment may turn a temporary increase in unemployment into a structural problem, especially if the long-term unemployed get discouraged and reduce job search intensity. The proportion of the young population that has experienced spells of unemployment longer than 12 month increased from about 38 % in 2008 to 60.6 % in Q3-2014. (See also Section 3.3).

Graph 1.10: Unemployment by duration, (thousands)

Source: Eurostat

Poverty and social exclusion continued to grow. Between 2008 and 2013 there has been an increase by 2 227 000 of people at risk of poverty and social exclusion (+14.7 percentage points). Children have been those characterised by the highest risk. Hence, Italy faces serious social challenges in this respect (see Section 3.3).

Public finance developments

The government deficit is expected to be 3 % of GDP in 2014 and 2.6 % in 2015, with overall no further improvement in the structural balance over these two years. The deficit is anticipated to have remained within the 3 % of GDP Treaty threshold in 2014, implying a marginal deterioration from the 2.8 % recorded in 2013. Overall primary expenditure is expected to have increased by around 1 % in nominal terms year-on-year despite the significant increase of around 3 % in social spending due to the tax credit of 80 EUR per month since May 2014 to employees with low or medium income. Despite the flat nominal GDP, revenues increased slightly mainly thanks to higher VAT and property taxation intakes. Lower yields reduced the debt service bill by more than 0.1 percentage point of GDP. The 2015 Stability Law projects a reduction of the headline deficit to 2.6 % of GDP. The Commission Winter 2015 forecast is in line with this projection. Thanks to the planned savings (especially at local level) and the extension of the public sector wage freeze in force since 2010, nominal primary expenditure is forecast to record only a mild increase. Revenues are forecast to grow at broadly the same pace as nominal GDP, as the enacted cut in the labour tax wedge is largely compensated by measures to improve VAT collection (reverse charge and split payment for the public sector) and by the expected pick up in the corporate income tax after the fall recorded in 2014. The Commission forecast also factors in a further reduction in interest expenditure (-0.4 percentage point of GDP) thanks to the significant drop in yields over recent months. The structural balance is forecast to remain broadly stable over 2014-2015, with a small deterioration in 2014 followed by a similar improvement in 2015. Negative economic conditions, with an estimated negative potential growth and very low inflation, make more difficult the needed adjustment towards a balanced budgetary position in structural terms (i.e. Italy’s Medium Term Objective).

The government debt-to-GDP ratio is still increasing. Negative economic conditions re also weighing on debt developments through their impact on the primary surplus and an unfavourable denominator effect, which are only partially compensated by lower interest expenditure (see Section 2.1). In 2014, the debt-to-GDP ratio is expected to have risen to around 132 % (from 127.9 % in 2013). This was also due to the ongoing settlement of trade debt arrears, further support to euro area programme countries, and a new increase in the Treasury’s liquidity buffer. The debt-to-GDP ratio is projected to increase again in 2015, to around 133 % of GDP, despite some privatisation proceeds incorporated in the forecast (0.5 % of GDP) and the expected reduction in the Treasury’s liquidity buffer. In 2016, the higher nominal GDP growth and primary surplus (forecast on a no-policy change basis) is expected to allow for a small reduction in the debt ratio.

Table 1.1: MIP scoreboard indicators

Flags: b: break in time series. p: provisional. Note: Figures highlighted are the ones falling outside the threshold established by EC Alert Mechanism Report. For REER and ULC, the first threshold concerns Euro Area Member States. (1) Figures in italic are according to the old standards (ESA95/BPM5). (2) Export market shares data: the total world export is based on the 5th edition of the Balance of Payments Manual (BPM5). Source: European Commission

Box 1.1: Economic surveillance process The Commission’s Annual Growth Survey, adopted in November 2014, started the 2015 European Semester, proposing that the EU pursue an integrated approach to economic policy built around three main pillars: boosting investment, accelerating structural reforms and pursuing responsible growth-friendly fiscal consolidation. The Annual Growth Survey also presented the process of streamlining the European Semester to increase the effectiveness of economic policy coordination at the EU level through greater accountability and by encouraging greater ownership by all actors. In line with streamlining efforts this Country Report includes an In-Depth Review — as per Article 5 of Regulation no. 1176/2011 — to determine whether macroeconomic imbalances still exist, as announced in the Commission’s Alert Mechanism Report published on November 2014. Based on the 2014 In-Depth Review for Italy published in March 2014, the Commission concluded that Italy was experiencing macroeconomic imbalances, requiring specific monitoring and strong policy action, in particular, the very high level of public debt and the weak external competitiveness, both ultimately rooted in the protracted sluggish productivity growth. This Country Report includes an assessment of progress towards the implementation of the 2014 Country-Specific Recommendations adopted by the Council in July 2014. The Country-Specific Recommendations for Italy concerned public finances, taxation, public administration, access to finance, labour market, education, market opening and business environment, and infrastructure.

Table 1.2: Key economic, financial and social indicators - Italy

1 Domestic banking groups and stand-alone banks. 2 Domestic banking groups and stand-alone banks, foreign-controlled (EU and non-EU) subsidiaries and branches. 3 Real effective exchange rate * Indicates BPM5 and/or ESA95 Source: European Commission, 2015 winter forecast; ECB

Overview and trends

High public debt is a major source of vulnerability for the Italian economy and, given its large size, it is considered of primary importance for world markets. Italy’s public debt holds back growth through the high present and expected level of taxation needed to service it, the high interest bill limiting the room for productive public expenditure and the constrained ability to respond to economic shocks. Conversely, slow growth keeps the indebtedness level high. Furthermore, the large stock of public debt implies substantial refinancing risk and makes the country vulnerable to sudden rises in sovereign yields and financial market volatility in periods of increased risk aversion. Risks to the financial and economic stability of the euro area and beyond (spillovers) are considerable due to the variety of institutions and investors holding Italian sovereign securities across the world ([5]) (see Section 2.4 on spillovers).

Since Italy joined the euro, growth dividends have not been sufficiently earmarked to public debt reduction. Indebtedness decreased only by 11 percentage points from 111 % GDP in 1998 to 100 % in 2007 and then ballooned to 132 % in 2014 despite strong fiscal consolidation undertaken in response to sovereign debt market turmoil. In addition, pension reform, once fully implemented will have a beneficial effect on the medium-to-long term sustainability of public finances. Italy’s general government debt-to-GDP ratio is now expected to peak at around 133 % in 2015, and decline slightly in 2016 thanks to the higher primary surplus and nominal GDP growth.

More recently, negative growth and low inflation are key factors explaining the increase in the debt-to-GDP ratio, while the fiscal stance and the composition of the consolidation have kept the evolution of the nominal debt in check. The nominal debt level at the end of 2014 was lower than planned, thanks also to low interest expenditure and the fact that part of the resources earmarked for the settlement of trade debt arrears was not necessary. Indeed, financing costs hit an all-time low (see Graph 2.1.1).

Graph 2.1.1: Italy — medium and long-term sovereign debt average yield at issuance ( %)

Source: European Commission

Despite the large decline in Italy’s sovereign risk premium in recent months, low inflation raises the real implicit interest rate on outstanding government debt, thereby worsening debt dynamics. In addition, low inflation expectations would weigh on the real cost of financing for the economy, worsening growth prospects in turn. To illustrate the importance of the risk of deviation of medium-term inflation expectations from the 2 per cent target for price stability, it is worth noting that a 1 percentage point decrease in inflation per year over the 2014-17 baseline would mechanically increase debt-to-GDP ratio by about 5 percentage points at the end of the forecast period, other things being equal. ([6]) At the same time, price-competitiveness adjustment requires Italy to run inflation at below the euro area average. Counteracting the impact of possibly lower inflation on debt ratios would require even lower interest rates and further improving the primary balance in a growth-friendly manner (e.g. by focusing cuts on government consumption, limiting tax hikes and preserving productive investment, as well as spending on education and research and development). Indeed, despite decreasing nominal interest rates, the implicit cost of servicing debt increases in the short term because this lower cost of financing is reflected in the outstanding debt stock only gradually (given the maturity of the Italian debt and the roll-over period). This entails that the debt-increasing impact of the implicit real cost of debt (i.e. net of the impact of inflation) rises from around 3 % of GDP over 2011-2013 to around 4 % foreseen over 2014-2015. This more than offsets the debt-reducing effect of the positive primary surplus (1.8 % of GDP over 2011-13). The debt-to-GDP ratio has also increased because of low or negative GDP growth (1.5 % of GDP over 2011-13). This trend should be reversed as growth becomes positive again, while the primary surplus also contributes to debt reduction. A fiscal framework supported by the on-going spending review, expenditure rationalisation programmes and the action of the newly-created Parliamentary Budget Office, should be conducive to an appropriate multiannual fiscal stance, and thus help put public debt on a downward path (see Section 3.1 for further details). Regarding the impact of monetary policy, the European Central Bank purchase programme of sovereign debt announced on 22 January 2015 will cover a wide range of medium to long-term maturities, thus supporting the lengthening of debt maturity, while reducing the risk deviation of medium-term inflation expectations from the 2 per cent target for price stability.

Against this challenging background, Italy’s public debt management office continues to deliver in terms of risk management and anchoring of market expectations. The average maturity of public market debt currently stands at 6.4 years (against 7 years back in 2011) and given the currently large liquidity buffer and relatively smooth redemption profile, the refinancing risk remains rather low. Auctions are usually met with high demand, as the successful issuance in mid-January 2015 of EUR 6.5 billion 30-year bonds at an average yield of 3.29 % shows. The investor base is very stable, with about 60 % of government securities held domestically, a third of which by Italian banks (see Special Topic: Financial Sector). Demand is solid in a number of market segments and international investors are increasing their exposure. Market conditions allowing, some issuances are also planned in 2015 on the dollar market.

The privatisation programme of some state-owned enterprises and the sale of public real estate should contribute to the debt-reduction effort. While there have been some delays in implementation, the privatisation programme should accelerate in 2015 and targets generating proceeds amounting to 0.7 % of GDP per year over the period 2015-17. More precisely, this year should see the privatisations of Poste Italiane (up to 40 %) and ENAV (up to 49 %), through initial public offerings as well as the sale of Grandi Stazioni. Administrative procedures for dismissals, privatisations and valorisation of public real estate have been accelerated. Invimit and Cassa Depositi e Prestiti, both state-owned, are involved in the valorisation and sale of unused public real-estate assets. Sale of local real-estate assets generated proceeds of some EUR 600 million in 2014. Until 2017, one should expect yearly proceeds of around EUR 1 billion from the sale of real estate assets of local governments and of the Ministry of Defence. These funds can then be directed to the Sinking Fund for the Redemption of Debt Securities to buy back public debt, though with no significant impact expected, given current figures.

Assessing Italy’s debt sustainability

Bearing in mind that there is no fixed threshold for debt sustainability, a number of criteria should be considered for its analysis. Italy’s scoreboard on variables relevant for debt sustainability shows a mixed picture. The high level of indebtedness and the large financing needs of the country exert upward pressures on the refinancing costs and the roll-over risk. But on external debt, the current account and the net international investment position, which are also very relevant for investors, Italy has a relatively good record and stands out against south European countries with a negative net international investment position of only 30 % GDP as of end-2014. One should, however, bear in mind that this does not make Italy immune to a reversal of foreign capital inflows as experienced in mid-2011.The larger share of domestic creditors (about 60 % for Treasury bonds) can also be seen as an asset which shelters the Treasury from volatility in international market sentiment.

There are three channels through which a decrease in public debt over GDP can be achieved: higher GDP growth, lower interest rates on government debt and a higher primary surplus. Bearing in mind that a country’s debt is generally considered sustainable if its public debt, as a percentage of GDP, declines over the medium term under plausible macroeconomic assumptions, a debt sustainability analysis for Italy is presented in what follows. ([7]) Debt projection results are presented under alternative scenarios, aimed at assessing the possible future evolution of debt under different macroeconomic conditions.

Graph 2.1.2: Italy — Gross debt-to-GDP

Source: European Commission

Baseline debt projections presented below are based on European Commission forecasts ([8]) and the assumption of no fiscal policy change beyond the forecast period (after 2016). Debt projections are additionally presented under an alternative scenario reflecting the macro-fiscal context reported in Italy’s 2015 Draft Budgetary Plan. ([9]) The government structural primary balance is kept at 3.5 % - 3.7 % of GDP beyond 2016 for the two scenarios respectively. Under this condition, the Italian public debt is put on a decreasing path, as shown in Graph 2.1.2.

Additional scenarios run around the baseline provide an assessment of the impact that changes in the macro-fiscal context would have on projected public debt dynamics. Given the persistently disappointing growth performance of the Italian economy over the seven-year long crisis, a scenario (scenario 3 in Graph 2.1.2) is run to capture risks from lower GDP growth and inflation. Under this scenario, the indebtedness level would peak in 2017 at 136.4 % GDP and then stay broadly flat over the remaining projection period. Investor confidence is underpinned both by fiscal performance and macroeconomic prospects. In a protracted low-growth, low-inflation environment, an increase in sovereign yields, especially for countries with high indebtedness ratios, could take place. An alternative debt projection scenario (scenario 4) is therefore run in which lower growth and inflation are combined with an increase in sovereign bond yields (an increase by 2 percentage points phased in over 2015-17, followed by a gradual return to baseline assumptions on the interest rate). Under this scenario, the increased debt service would lead to a debt-to-GDP level that keeps increasing, reaching almost 143 % of GDP in 2025. Assuming a persistent accommodative monetary policy response to low growth and inflation, the interest rate on government debt would be brought down. This is represented in scenario 5 (where a gradual and permanent 1 percentage point decrease in the interest rate is assumed). In this case, public debt over GDP would again be slightly decreasing after 2017.

Box 3.1.1: Impact of fiscal consolidation and structural reforms on public debt DSGE simulations (using QUEST) allow carrying out an impact assessment on debt of fiscal and structural policies, in a dynamic way ([1]). The interactions between policy and macroeconomic variables are indeed embedded into the model. Simulations combining and macroeconomic shocks with different fiscal-structural policies show the latter’s potential impact on debt-to-GDP. The elements of the simulations are detailed individually below before assessing their combined effects. Macroeconomic risks: below-target inflation and financial market pressures Two macroeconomic risks are considered. First, the risk of very low inflation, decoupled from the euro-area average. This is modelled by a negative demand shock which confines inflation in Italy to 1 % for first two years of the simulation period, the baseline level for the rest of the euro area being 2 %. The second risk is that of financial market turmoil that translates into a protracted period of higher sovereign spreads (meaning higher borrowing costs for the government). Currently the implicit interest rate on debt is 3.6 %, while the sovereign interest bill stands at some 5 % of GDP. This financial market risk is modelled by a shock that increases by 2 % the effective government interest rates and which is phased out once it has gone over the whole debt stock (assuming a 6-year average maturity). Fiscal stance: increase or reduction of the primary surplus by 1 % of GDP As fiscal consolidation is of primary importance to put public indebtedness on a downward path, the impact of an increase or reduction by 1 percentage point of the primary surplus is considered. In light of the recent tax cuts and spending review, consolidation is assumed to be implemented in a growth-friendly way (2), opting for expenditure cuts rather than tax increases. Structural policies: tax shift, simplification, deregulation, and labour market reforms Structural reforms affect economic activity and, through the related denominator and tax-base effects, debt dynamics. These policies usually generate negative (nominal) GDP effects in a first phase, as prices decline, before yielding positive growth benefits in the medium term. Some of the main reforms fully legislated in Italy in 2013-14 are considered here: -Tax shift: while the VAT rate has already been raised in 2013, 2014 saw the enactment of three reforms to shift the tax burden away from productive factors: (i) the cut in IRAP (regional corporate income tax) through the deduction of labour component from the tax base, (ii) the IRPEF (labour income tax) reduction for low-income earners or € 80 bonus, (iii) the strengthening of ACE (aid to economic growth measures) leading to a deduction of notional cost of equity from the corporate income tax base. The quantification of the impact and financing of these measures are translated by negative shocks on the implicit tax rates on labour (-1.5 p.p.) and capital (-0.2 p.p.). -Administrative simplification: several measures have been taken to simplify the administrative framework for citizens and business in 2012-14. To capture their effect, overhead labour costs are reduced by 3%. Reductions are phased in for a full effect within 3-4 years. ([1]) In the model, current debt is a function of debt in the previous period, related interest payments and the current primary budget deficit. Both the real GDP and the GDP deflator that make up the denominator in the deficit-to-GDP and debt-to-GDP ratios are endogenous variables, as are tax revenues and benefit payments for given tax and replacement rates. Hence, structural reforms affect economic activity, which then feeds back to budgetary variables and debt dynamics. (2) Here the fiscal multiplier is about 0.5. For an illustration of the effects of fiscal consolidations according to their composition see In't Veld, J., ‘Fiscal consolidations and spillovers in the Euro area periphery and core’, European Economy, Economic Papers 506, October 2013, http://ec.europa.eu/economy_finance/publications/economic_paper/2013/ecp506_en.htm.

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-Product market reforms and deregulation: measures taken in 2012-13 aimed at deregulating and simplifying procedures for setting up a business. They have been quantified as leading to final goods mark-up reduction of 0.09 p.p.(3) compared to an initial level of 13%(4). In the model, these measures are captured by the respective mark-up reduction. -Labour market reforms: the June 2012 labour market reform lightened the employment protection legislation (among others). This is modelled by a gradual increase in labour-augmenting productivity by 0.7 %. Some reforms with a potential impact on GDP growth and, hence, the debt-to-GDP ratio are not included, either because of modelling limitations (justice reform described in Section 3.1, duration of work contracts reform described in 3.3), or because the final legal texts were still forthcoming at the time of writing (Jobs' Act, annual law on competition, education reform). Overall, the measures included here amount to only modest structural improvements, so that their impact on the primary balance and on government debt is a priori moderate. Privatisation programme In May 2014, the Italian government re-launched a privatisation programme with increased receipts targets, namely €30 bn over 2014-2017 that should be allotted to reduce public debt. None of the above-described measures is to be implemented on its own. Instead, a reforming government would rather adopt a combination of them. We develop five fiscal-structural policy combinations and show their respective impact in Graph 1. The simulation results for the debt-to-GDP level are displayed as percentage-point deviations from its baseline path. Hence, deviations indicate the additional effect of the measures considered (translated into shocks) and are in general combinable with different assumptions about the underlying baseline. In particular, the baseline could be the continuation of the status quo, or could already incorporate fiscal and structural measures other than the one analysed here (e.g. the baseline presented in the debt sustainability analysis). The simulations can hence also be seen as an assessment of positive and negative risks around a baseline projection for debt dynamics. (3) European Commission calculations based on Thum-Thysen, A., and Canton, E., ‘Service sector mark-ups and product market regulation’ (forthcoming) (4) ECFIN's methodology to estimate service sector mark-ups takes into account the level of product market regulation (PMR) as measured by the OECD's PMR indicators. With a 13% mark-up on the final goods sector, Italy is doing rather well, as the best euro area performers register a mark-up level in the final goods sector of 9.6 %.

Box (continued)

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Box (continued) Graph 1: Italy — Impact of fiscal-structural policy combinations on debt-to-GDP Source: European Commission, simulations carried out using QUEST.

• Combination 1: Primary surplus undershoot, tax shift, structural reforms This policy combination includes a loosening of the fiscal consolidation stance by 1 % of GDP combined with the implementation of the tax shift, product market deregulation, administrative simplification, and labour market reform. In this combination, despite the structural effort, the fiscal relaxation leads to an increase of the debt level of +10 % of GDP by 2028 relative to the baseline. In other words, the measures undertaken on the structural side have, given their limited size and scope, a limited positive impact on public finances through the denominator and tax-revenue effects, which does not compensate the negative impact of less ambitious discretionary fiscal measures on public finances. • Combination 2: Primary surplus overshoot, tax shift, structural reforms The only difference to combination 1 is the tighter fiscal stance. The opposite debt evolution with this combination (-19 % of GDP relative to baseline by 2028) shows clearly the pre-eminence of the fiscal stance in curbing public indebtedness in the set of policy measures considered. The simulation results do not address the question of the political palatability of protracted fiscal consolidation given consolidation fatigue and the electoral cycle, however. • Combination 3: Combination 1+ market confidence shock The sovereign crisis has shown that in times of high policy scrutiny, sovereign spreads are usually dependent on key fiscal variables such as the deficit or gross debt. Therefore, it seems more likely that a country would face higher borrowing costs if its fiscal stance is looser than expected. The shock increasing sovereign yields is therefore implemented with combination 1 (as opposed to combination 2). The effect of such a shock to financing costs is very large. Indebtedness rises to 10 % of GDP above the level in combination 1 by 2020. • Combination 4: Combination 3 + privatisation Adding privatisation to combination 3 shows that privatisation alone is certainly not a solution to the Italian high indebtedness as the contribution to lowering debt-to-GDP is incremental. • Combination 5: Combination 2 + negative demand shock leading to lower inflation

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Box (continued)

The latest data has shown very low inflation in Italy, prompting fears of a debt-deflation spiral, and so a policy response combining strong fiscal consolidation and structural reforms to counter act this adverse effect (combination 2). A negative demand shock that reduces inflation by 1 % below baseline implies an increase in the debt-to-GDP ratio relative to baseline: (i) nominal debt (numerator) increases given the reduction in tax revenues in response to lower domestic demand (deterioration of the primary balance), while (ii) nominal GDP (denominator) increases because of lower growth and inflation. This results in a 13 % of GDP increase in public indebtedness within three years, before the effects of the shock are gradually phased out and debt is put back on a downward path through strong and protracted consolidation. Should similar negative demand shocks occur in the entire euro area and put downward pressure on prices in a low interest environment, the impact on Italian output and debt would be even more adverse, because falling prices in Italy would not (or less) translate into real depreciation and competitiveness gains. Thus, net trade would contribute less to supporting economic activity amid weak domestic demand (5). (5) In the model, Italy has a trade openness ratio (sum of export and imports over GDP) of 58% and a trade openness ratio towards the rest of the euro area of 25%.

Finally, in a context of low growth and low inflation, it would be more difficult to pursue rapid fiscal consolidation. Scenario 6 shows the impact that this would have on debt dynamics. Fiscal fatigue in the form of a 1 percentage point decrease in the structural primary balance would lead the debt-to-GDP ratio to rise rapidly, reaching 148 % in 2025.

The analyses presented in this section show that the first lever determining the pace of debt reduction is fiscal consolidation but that the condition for its success is a growing GDP. To achieve a larger reduction of public indebtedness, the second and necessary policy lever is that of large-scope structural reforms. The current structural fiscal position — if further improved and maintained — will reduce the public debt imbalance. Keeping the structural primary balance at 3.5 % (as a minimum) is key to bringing public debt over GDP below 110 % by 2025. A large primary surplus could help preserve market confidence (and keep the risk premium low) even if growth prospects and inflation remain weak in the short to medium term. However, past experience suggests that achieving and maintaining such a high primary surplus is challenging and all the more when economic activity remains subdued and when there are deflationary pressures. Forceful consolidation to put debt on a downward path in a depressed macroeconomic context could indeed be self-defeating. Hence the only policy lever left is that of structural reforms large enough in scope and impact to push GDP significantly up in the medium-term (as the short-term effects of structural reforms are usually mixed and positive effects come in only with a few years' lag). In Box 2.1.1, these fiscal, structural and macroeconomic interactions are integrated in a dynamic model. Simulations show that some recently implemented reforms (on taxation, simplification, deregulation and labour market) bring about growth gains so that debt is also reduced thanks to the higher GDP and tax intake. Additional reforms, as those foreseen for instance on competition or on the labour market, would bring the debt-to-GDP ratio further down. (Privatisation can only be a complementary measure and would not suffice to bring public indebtedness significantly down in the medium term.) Following previous announcements by the Ministry of Finance and endorsed by the Italian Government on 20 February 2015, Italy committed to adopt and implement an ambitious agenda of structural reforms.[10] If implemented, these reforms should increase Italian GDP by a few percentage points over the medium-term, thereby contributing to the long-term sustainability of Italy’s public finances.

External position and export performance

The improvement in Italy’s current account balance is mostly non-cyclical, reflecting the decline of potential growth and thus import demand. Having returned to surplus in 2013, Italy’s current account is expected to have further increased to 1.8 % of GDP in 2014. The positive trend in the trade balance is primarily explained by shrinking nominal imports, whereas nominal exports have grown only moderately (Graph 2.2.1). In 2014, the gap between nominal growth of exports and imports is expected to have narrowed, but mainly owing to a smaller contraction of imports in the context of Italy’s slow exit from economic recession. The correction seen in Italy’s current account balance is mostly non-cyclical. The improvement in its cyclically-adjusted current account ([11]) by 3.3 percentage points between 2008 and 2013 mainly reflects Italy’s negative potential growth since the start of the crisis. The resulting decline in potential output constrains Italian domestic and thus import demand below pre-crisis levels. For export capacity to become the driver of significantly higher potential growth, Italy would need a reallocation of resources towards the tradable sectors but this shift does not seem to be happening so far.

Graph 2.2.1: Breakdown of the year-on-year change in goods components of Italy’s trade balance

Source: European Commission

Italy’s recent export performance has been largely driven by external demand developments. The contraction in demand from euro area trade partners over 2011-2012 was reflected in a similar fall in exports to those markets (Graph 2.2.2). In this period, falling demand from vulnerable euro area countries was in fact compounded by weak demand also from countries with no financial constraints in the euro area, like Germany. ([12]) With some lag, Italy’s exporting firms have taken advantage of the very gradual recovery in demand from the euro area, which started at the beginning of 2013. The fall in the euro exchange rate and steady demand had instead supported exports to non-euro area markets in 2011 and 2012. However, in 2013 and 2014 demand from some emerging markets faltered, while the euro appreciated again until the first quarter of 2014. As a consequence, Italy’s export performance towards non-euro area trade partners suffered. The depreciation of the euro boosted exports to outside the euro area again in the second half of 2014. Further favourable exchange rate developments together with strengthening external demand, are expected to be the main engine to restart a gradual recovery in economic activity in 2015 and 2016.

Graph 2.2.2: Italy’s export performance since mid-2010, intra and extra euro area breakdown

Source: Bank of Italy (based on national accounts ESA95-ESA2010)

The shares of tradable sectors in Italy’s gross value added and employment have fallen significantly over the last two decades, mainly driven by the declining share of manufacturing industries. Between 1995 and 2013, the share of Italy’s tradable sectors ([13]) in total gross value added declined from 53 % to 44.5 % (Graph 2.2.3). This decline has been common to most advanced economies, with the exception of Germany, and it reflects the reorientation of economic activity away from industry towards services. Since the onset of the crisis, the share has broadly stabilised in Italy. Overall, the decreasing importance of tradable sectors is mainly driven by the declining share of manufacturing industries, which in 1995 accounted for roughly 21 % of total gross value added and fell to 15 % in 2013. In particular, the evolution of the manufacturing sector’s gross value added slowed down already after Italy’s adoption of the euro in 1999 and turned strongly negative in 2008 when the crisis started (Graph 2.2.4). The declining importance of the tradable sectors is also visible in employment terms: over the period 1995-2013, the share of tradable sectors in Italy’s (full-time-equivalent-based) employment decreased from 53.8 % to 48 %. Again, the bulk of the shift is explained by manufacturing sector’ lower share of employment. Apart from manufacturing, other sectors which have contributed to the decrease in the gross value added and manufacturing’s share of employment between 1995 and 2013 are wholesale/retail trade and motor vehicle repair, as well as agriculture, forestry and fishing. Industries which somewhat offset the tradable sector’s share decline are accommodation and food service activities, information and communication (mainly computer programming, consultancy and information service activities) and transportation and storage. Given that the Italian manufacturing sector accounts for a rather stable 95 % of Italy’s goods exports, the subsequent analysis will focus on the export performance of manufacturing sectors. The decreasing importance of manufacturing within the Italian economy has been driven mainly by those firms dependent on the domestic market alone and which were not able to re-orient their production towards foreign markets. In addition, domestic market developments may adversely affect export growth. ([14]) Overall, the erosion of Italy’s manufacturing base may have a negative impact on the country’s export capacity.

Graph 2.2.3: Share of tradable sectors in gross value added

Source: European Commission, ISTAT

Graph 2.2.4: Average annual growth rate of gross value added over selected periods

Source: European Commission, ISTAT

Italy is endowed with a diversified manufacturing base, which has undergone a very slow shift towards more technologically intensive activities since 1995. In 2013, Italy’s largest manufacturing sectors (in terms of their share of manufacturing gross value added) were in basic metals (15.7 %), machinery and equipment (14 %), food products and beverages (11.9 %), textiles and leather (9.7 %), rubber and plastic products (8.7 %), and furniture and miscellaneous ([15]) (8.6 %). High-tech industries remain small in total manufacturing gross value added (8.4 % in 2013), while around 60 % of Italian manufacturing gross value added was still generated in low- or medium-low tech sectors, owing to the continued specialisation in 'traditional' sectors. Since 1995, however, a gradual shift away from low- and medium-low-tech sectors has taken place: the latter’s share in total manufacturing gross value added decreased by 5.3 percentage points (Graph 2.2.5), mainly owing to the textiles and leather, wood and paper, and rubber and plastics industries. However, the food products and beverages, basic metals, and furniture and miscellaneous industries recorded a gross value added share increase, against the general trend. The increase in the gross value added share of medium-high- and high-tech industries took place mainly thanks to machinery and equipment, pharmaceutical products, electrical equipment, and computers and electronics sectors. The chemicals and motor vehicles and transport equipment industries went against the general upward trend.

Graph 2.2.5: Shares of gross value added in manufacturing by technology intensity

Source: European Commission, ISTAT

Exposure to external markets has increased in manufacturing sectors. Over the 1995-2013 period, all manufacturing sectors have increased their propensity to export ([16]), with the exception of the computer and electronic products sector. The increase has been more pronounced since the crisis in almost all sectors, as shown in Graph 2.2.6. Aggregating the sectors by technology intensity, export propensity is higher in medium-high and high technology-intensive sectors. This suggests that firms producing these types of products are more exposed to demand from abroad, which could also be due to higher integration of these products into global value chains.

Graph 2.2.6: Export propensity by technology intensity

Source: European Commission, ISTAT

The demography of exporting firms is biased towards those with low export propensity. Aggregating firm-level data, Graph 2.2.7 shows that average export propensity ([17]) is close or above 50 % in five manufacturing sectors (i.e. leather and related products, machinery and equipment, other transport equipment, other manufacturing, and pharmaceutical), meaning that half or slightly more of the total output of these sectors is sold abroad. In addition, the graph shows that the distribution of firms’ export propensity is wide in almost all sectors. In particular, the export propensity of the median is on average 30 percentage points lower than that of the third quartile. This suggests that there is room to increase exports at the intensive margins in all manufacturing sectors.

Graph 2.2.7: Export propensity by manufacturing sector, 2012

Source: ISTAT

Italy’s export propensity and performance is being held back by the bias in the country’s firm demography towards small firms with low productivity. Italy’s firm demography is characterised by a high concentration of very small firms: in 2012, 99.9 % of Italian firms were small and medium-sized enterprises (up to 250 employees), whereas the share of micro-firms (up to nine employees) was 95.2 % of all companies. Micro-firms’ labour productivity is however significantly below the firm average (Graph 2.2.8). The literature suggests a strong positive correlation between firm size, productivity and export capacity and performance, with a presence in geographically more distant markets requiring a higher level of efficiency. Consequently, the dominant presence in Italy of very small firms with low productivity is holding back an increase in the country’s export propensity. This is reflected by the fact that Italian export propensity at firm level is clearly negatively correlated with firm’s size (Graph 2.2.9).

Graph 2.2.8: Labour productivity by firm size (100 = average over total firm population)

(1) Labour productivity calculated as gross value added at factor cost divided by the number of persons employed Source: ISTAT

Graph 2.2.9: Export propensity by firm size

(1) The bars represent the ratio of the value added accounted for by firms which belong to a specific export propensity and firm size class and the total value added accounted for by all firms which belong to that firm size class (irrespective of their export propensity class). Hence bars with the same colour add up to 100 %. Source: ISTAT

Export growth has varied quite significantly across sectors, the biggest exporting sectors being less dynamic. As shown in Graph 2.2.10, the sectors that experienced the fastest growth in exports over the 1995-2013 period were those producing coke and petroleum, and pharmaceutical products. However, these sectors accounted for a low share of total goods exports in 1995. The two sectors with the biggest shares then were textiles and leather, and machinery and equipment, which together accounted for one third of total goods exports in 1995. However, their export dynamics have been respectively below the average and broadly in line with it. The different dynamics of exports by sector has brought some changes in the composition of Italy’s goods exports.

Graph 2.2.10: Goods exports of manufacturing sectors, by shares and dynamics

Source: European Commission, ISTAT

Some change in the sectoral composition of exports has taken place since the early 2000s. Exports of machinery and equipment accounts for one fifth of the total – broadly stable over the period 1995-2013 – and are the largest category of exported goods (Graph 2.2.11). Textiles and leather has dropped significantly (by around 5 percentage points) as have furniture and miscellaneous, rubber and plastics, and computer and electronic products (by 5.5 percentage points all together). The fall in their share of total exports has been compensated by an increase in metal, food and beverages, pharmaceutical, and coke and petroleum products (by an overall 10.6 percentage points). This change in sectoral composition reflects a shift from low to medium-low technology-intensive sectors (Graph 2.2.12), with the latter accounting for almost half of the total exports of manufactured goods in 2013. High-tech sectors, however, have broadly remained stable over the period and represent a small share of the total, around 8.5 percentage points.

Graph 2.2.11: Shares of goods exports by manufacturing sector, 1995 and 2013

Source: European Commission, ISTAT

Graph 2.2.12: Shares of manufacturing exports of goods, by technology intensity

Source: European Commission, ISTAT

The marginal decline in Italy’s export market shares between 2010 and 2013 conceals a heterogeneous performance across sectors. While the sectoral growth of exports in absolute terms explains the changes in the composition of Italy’s goods exports, only the sectoral export market shares show which sectors have been exporting in line with or above total external demand. Over the 2010-13 period, export market share expressed in current prices and US dollars terms has declined only marginally (-0.2 percentage point). The performance by sectors ([18]) has been heterogeneous (Graph 2.2.13). Machinery and electrical products as well as metals, which accounted respectively for 26 % and 10 % of total goods exports in 2013, saw their export market shares stabilise over the period. The chemical products, leather and related products, and art and antiques sectors have been the only ones to experience some increase in their shares. However, these sectors together represented 12.5 % of total Italy’s total exports of goods in 2013 and they have been more than offset by the rest, whose export market shares declined. In particular, transport equipment – which accounted for 9 % of total exports – have lost slightly more than the average (-0.3 percentage points vs. -0.2). Traditional sectors such as textiles and footwear have continued losing market shares in recent years, suggesting that competition from emerging markets has remained intense.

Graph 2.2.13: Change in sectoral export market shares 2010-13, percentage points USD

Source: European Commission

Cost/price and non-cost competitiveness

Cost-competitiveness has been deteriorating primarily due to sluggish productivity performance. After the financial crisis Italy’s core inflation was on average well below 2 % (see Graph 2.2.14). The same applies to compensations per employee, which also reflected the freeze in public sector wages. Unit labour cost benefitted from those moderate developments. However, driven by the weak productivity dynamics, Italy’s cost competitiveness relative to the rest of the euro area did not improve as in other countries ‑ like Spain ‑ that had to embark on an aggressive cost adjustment due to a deteriorated external position.

Graph 2.2.14: Cost and price developments (2010-2014 average)

Source: European Commission

Graph 2.2.15: Unit labour cost index for selected countries, tradable vs. non-tradable sectors (1998=100, based on hours worked)

Source: European Commission, Eurostat

Recourse to labour hoarding has also played a significant role in the lack of adjustment in Italy’s unit labour cost relative to the rest of the euro area, as it affected the country’s already unfavourable productivity position of the country.

Unit labour cost in tradable sectors has grown less than in non-tradable ones; nevertheless its upward trend has been more sustained than in France, Germany and more recently Spain. In the pre-crisis period, the rise in Italy’s unit labour cost was more sustained in non-tradable sectors as labour productivity declined on average (Graph 2.2.14). However, as the crisis hit, the non-tradable sectors limited the growth in unit labour costs thanks to a much slower pace of increase in compensation per full time equivalent, which can also be explained by the public sector wage freeze. However, from a cross-country perspective, the increase in unit labour costs in both tradable and non-tradable sectors since 1999 has been more sustained in Italy than in Germany and France. Looking at the tradable sectors in greater details and grouping them according to their technology intensity, Graph 2.2.16 shows that unit labour costs has held broadly stable in high-tech sectors, while increasing in the others. In fact, high-tech sectors have seen higher productivity growth than the others over the whole period.

Graph 2.2.16: Unit labour cost index (based on full-time equivalents) by technology intensity, 1998=100

Source: European Commission, ISTAT

Most price-competitiveness indicators continue to show a better picture of Italy’s competitive position than the real effective exchange rate based on unit labour cost. For instance, the Bank of Italy’s competitiveness indicator based on producer prices of manufactured goods for a set of 62 countries indicates that since the financial crisis Italy’s competitiveness position has improved more than for Spain’s and by about the same as France and Germany (Graph 2.2.17). However the difference between labour cost and price indicators might also point to a squeeze in profit margins for Italian industrial firms, which are compressing their mark-ups in order to remain competitive in their markets. Both cost/price-competitiveness indicators will benefit from the recent euro depreciation.

Graph 2.2.17: Indicators of competitiveness: producer prices of manufactures (December 2010 =100)

Source: Bank of Italy, European Commission

Gains in non-cost competitiveness have not fully offset Italy’s loss of cost competitiveness. One aspect of non-cost competitiveness is export quality which – if increasing over time – may shelter a country from cost competition from emerging markets or rising product standardisation. For Italy, a modest further specialisation in exporting goods of medium-high quality can be observed between 2005 and 2011 at the expense of exporting low- and high-quality goods (Graph 2.2.18). A second aspect of non-cost competitiveness is the quality of 'forward' or 'supply' linkages of services with the rest of the economy, i.e. efficient service industries supplying inputs to the production process of (exporting) sectors, thus supporting the latter’s competitiveness. In Italy, forward linkages of services are rather strong, but their competitiveness-enhancing effect (as measured by labour productivity growth over the period 2007-11) on the rest of the Italian economy is negative (Graph 2.2.19). This is particularly the case for business services which are de facto still quite heavily regulated and protected from external competition. A third aspect of non-cost competitiveness is the degree of integration in global value chains. Compared with other large EU Member States like Germany and France, Italy participates to a similar extent in global value chains, as measured by the sum of backward and forward vertical specialisation shares. Within global value chains, Italian firms are mainly intermediate suppliers (i.e. occupying upstream positions), but their position may be relatively weaker because of the firms’ small size and low productivity (in spite of considerable firm heterogeneity). ([19])

Graph 2.2.18: Export quality

(1) The evolution of the quality of a country’s exports is shown here on the basis of the distribution of normalised quality ranks of individual manufacturing products exported to a specific destination market (here the EU-15 market) by a defined set of exporters. Shifts in the distribution of such ranks thus reflect changes in the quality dynamics of a country’s exports over time. Source: ‘Quality in exports’, European Economy – Economic Papers, no. 528, September 2014.

Graph 2.2.19: The role of services in Italian non-cost competitiveness

(1) The value of a services industry’s forward linkages is an indication of how much of its production contributes to the production of other industries. The horizontal-axis figure shows the share of the various services sectors in the total value of intermediate inputs used in the economy. Source: European Commission

Wages and productivity misalignments and the labour market reform

Nominal wage growth has slowed down. In 2014 (based on the first three available quarters) compensation per employee increased by 1.3 %, about the same rate as in the previous year (Graph 2.2.21). On an hourly basis, wage growth decelerated from 1.4 % in 2013 to 0.6 % in 2014. Aggregate wages conceal a different dynamic at the sectoral level (Graph 2.2.20). Wage growth is more moderate in market services and public administration than in manufacturing, which would support labour reallocation toward the tradable sector. The proportion of the labour force comprised by young people, by low-wage earners and by people with short tenure (probably on lower wages) in the private sector fell during the period, so that the adjustment of wages is likely to be stronger once these effects are taken into account. ([20])

Graph 2.2.20: Compensation per employee by sector

Source: European Commission, Eurostat

Graph 2.2.21: Actual and negotiated wages

Source: European Commission, Eurostat

Negotiated wages have started to respond to the prolonged weakness in the labour market. The Phillips curve, i.e. the relationship between nominal wage growth and the unemployment rate, is the standard tool to assess the response of wages to labour market conditions. Graph 2.2.22 relates actual wages to the unemployment rate for the periods 2000-08 and 2009-13. In both periods, the correlation between the growth of actual wages and unemployment rate is weak (as shown by the flat curve). However, during the crisis, the average growth in actual wages drops (i.e. in the second period the curve shifts downward). Graph 2.2.23 reports for the period 2009-14 on the relationship between the growth in contractual wages and unemployment for Italy and the euro area. The graph shows that on average contractual wages in Italy respond to changes in the unemployment rate in a similar manner to those in the euro area as a whole (the two lines are parallel). The differences in the response of contractual versus actual wages reflect a number of factors. First, actual wages include variable components of pay that have been increasingly squeezed since the start of the crisis, which make them less responsive to unemployment. Second, a framework agreement signed in 2009 (the 'Productivity Pact') set the duration of collective contracts to three years, while until then contracts has lasted for two years for the economic provisions and four years for the normative ones. The agreement also established that wage increases were linked to three years inflation forecast based on the HICP net of imported energy products. ([21]) The increase in duration of contracts for the economic provisions together with their staggered nature (i.e. sectoral negotiations occur at different point in time) may have contributed to delaying wage adjustments. With HICP inflation slowing down, newly signed contracts will incorporate the lower inflation rate. However, delayed wage adjustment in a context of low inflation and sluggish labour productivity growth may make it challenging to align real wages with productivity. More frequent renegotiation of collective contracts and greater coordination at different bargaining levels might improve the response of wages to cyclical developments.

Graph 2.2.22: Phillips curve for Italy: annual growth of compensation per employee

Source: European Commission, Eurostat, ISTAT

Graph 2.2.23: Phillips curve for Italy and euro area based on negotiated wages, 2008-2014

Source: European Commission, ISTAT, Eurostat, European Central Bank

There are indications that the allocation and rewarding of labour does not reflect skills and productivity. First, differently from Germany and the United Kingdom, in Italy earnings increase continuously with age, indicating that wages may not reflect the productivity of workers. ([22]) Second, among the countries participating in the OECD Programme for the International Assessment of Adult Competencies (PIAAC), Italy has a lower-than-average share of workers that are over-qualified for their job (13 % compared with 21 %), but it has the highest share of under-qualified workers (22 %). Given the Italian economy’s specialisation in low-to-medium technology products, one would expect the opposite. In terms of skill mismatches, Italy has rather high shares of both over-skilled and under-skilled workers. ([23]) Overall, these misalignments between wages, jobs, skills and productivity at the micro-level have both static and dynamic negative effects: they weigh on aggregated productivity, and reduce the returns to education for the young, and thus the rate of human capital accumulation. ([24])

Graph 2.2.24: Age-earning profile, 2012

(1) Wages are calculated from EU SILC data on yearly gross employee cash or near cash income, which includes salaries and other benefits (e.g. holiday and overtime payments). The yearly income is divided by the average hours worked to approximate an hourly wage. The lines are polynomial interpolation of actual data. Source: European Commission, EU-SILC

Graph 2.2.25: Incidence of over- and under-qualification ( % of workers), 2012

Source: OECD, PIAAC

Aligning wages with productivity and promoting the adoption of innovative solutions at firm level remain challenges for Italy. Decentralised bargaining can play an important role in strengthening the responsiveness of wages to productivity as well as to labour market conditions. Firm-level contracts on economic issues still concern a minority of firms, with the share being lower in southern regions. ([25]) In January 2014, the social partners signed a further agreement for the manufacturing sector, laying down the procedures for measuring trade union membership in line with the criteria for certification of trade unions’ representation defined by a previous 2011 agreement. The 2014 agreement is however not operational yet due to administrative and institutional issues, while a large majority of collective contracts in the manufacturing sector are coming to an end in 2015. Pending the implementation of the agreement, a number of obstacles continue to prevent firms and workers from engaging in firm-level negotiation. If properly implemented, the agreement could also make effective the possibility of derogating from national collective contracts, which was formally introduced by the 2011 intersectoral agreement but rarely implemented.

Building on earlier reforms, the current government has initiated a comprehensive reform to improve labour market functioning, while reducing segmentation. In December 2014, the parliament approved an enabling law, the 'Jobs Act' for the reform of the labour market. The act follows the pattern and direction of previous reforms. It makes decisive changes in employment protection legislation, the unemployment benefits system and wage supplementation schemes, and the governance and functioning of active and passive labour market policies. It also envisages action to reduce the administrative burden on firms, improve the effectiveness of the labour inspectorate and promote reconciliation between family and working life (see Section 3). Implementing legislative decrees have to be enacted within six months. Swift implementation of the 'Jobs act' should improve entry and exit flexibility, enhance labour reallocation and promote stable open-ended employment, most notably for the young.

The first legislative decree revises dismissal rules for new hires under open-ended contracts. The decree de facto revises for new hires the article of the Worker Statute (i.e. Article 18) that regulates unfair dismissals. The decree has completed the legislative process and will enter into force in March 2015. In particular, it substantially reduces the scope for reinstatement following unfair dismissals and expands the number of cases where the sanction leads to a monetary compensation, which rises with tenure. Reinstatement can be ordered only in case of discriminatory dismissal or if the disciplinary reason put forward by the employer is false. It cannot longer be ordered in case a dismissal motivated by economic reason is judged unfair. Compensation is also foreseen in case of collective dismissal procedures, thereby extending the scope of the new rules in case of restructuring. Compensation for unfair dismissal remains much higher than for fair dismissals (which is virtually zero in Italy), which may increase both the incentive to go to court and the cost of the litigation. To limit court cases, the decree further facilitates the settlement of dismissal disputes through conciliation, also through fiscal incentives. For workers laid off, the decree introduces, the “contratto di ricollocazione”, i.e. a voucher for laid-off workers. The government is accompanying the reform with hiring incentives for permanent contract (see Section 3.4).

A complementary decree revises labour contracts and allows a more flexible use of labour within the firm. With a view to reducing duality, the enabling law foresees that the revision of dismissal rules is accompanied by a revision of labour contracts. The respective legislative decree has been tabled in February, and is now subject to the non-binding opinion of the Parliament. The decree provides a clear definition of dependent employment, under which all existing atypical contracts have to be brought back as from January 2016, with the exception of well-defined circumstances. This is an important step to reduce duality. The 2012 reform has already reduced the use of atypical contracts (Graph 2.2.26) and this was accompanied by an increase in the use of temporary contracts, especially of young people, also driven by further measures to liberalise temporary contracts introduced in 2013 and 2014. The decree also clarifies certain provisions for temporary contracts, seasonal work, part-time, agency work and job-on-call. It also reviews apprenticeship contracts, by reducing the costs for the employers and enhancing the scope of formal education, in the attempt of encouraging its uptake – so far very limited – and moving closer to a dual system. Finally, the decree enhances flexibility in the allocation of labour within the firm, by allowing workers to be assigned to different tasks during restructuring periods.

The new rules have several benefits for the labour market functioning and the potential for reducing duality. Overall, the new provisions reduce the uncertainty and costs associated with the dismissal procedure, including by further fostering pre-trial negotiation, and reduce the scope of atypical contracts. In the medium- to long-term, as the number of workers under the new regime increases, this could improve reallocation across sectors, promote stable employment prospects, not least for young people and encourage job-specific training. Its effects on total factor productivity growth are therefore likely to be positive. However, the labour judges’ interpretation of the new legislation will be important for the reform to have a rapid impact. Its effect on labour market duality will depend on the scale of the take-up of open-ended contracts, which will be influenced also by the effectiveness of rebates on social security contributions introduced by the 2015 Stability Law and available for three years for contracts signed in 2015.

Graph 2.2.26: Growth of new contracts signed and contributions by contractual forms, y-o-y % change

Source: European Commission, Ministry of Labour Comunicazioni Obbligatorie

A more integrated unemployment benefit system is being developed, based on unemployment insurance with broader coverage and stronger conditionality, and on a newly introduced unemployment assistance for long-term unemployed. A second legislative decree will enter into force in March 2015. The decree introduces a new unemployment benefit (Nuovo Assegno per l’Impiego – NASPI) targeting all employees in the private sector who become unemployed from May 2015 onwards. Compared to the previous system, NASPI provides for a longer duration of benefits (from 18 to 24 months) while broadly maintaining their level and reduces the contribution periods. Furthermore, it strengthens the conditionality with regard to job-search or training activities. In an experimental manner for 2015, two additional schemes are introduced. The first provides an unemployment insurance scheme (Indennita’ di disoccupazione per i lavoratori con rapporto di collaborazione coordinate e continuative e a progetto – DIS-COLL) to workers in atypical (collaboration) contracts who become unemployed in 2015. The second (Assegno di disoccupazione, ASDI) is an unemployment assistance scheme, means-tested and linked to activation measures, which provides an extra six months’ cover to unemployed workers with children or close to retirement who have exhausted their right to the NASPI. It is non-contributory and it may imply a positive step in providing some income support and activation measures to the long-term unemployed (see Section 3.3).

The new unemployment benefit system represents a substantial change supporting workers’ in transition from unemployment to employment, in particular in light of the envisaged revision of wage supplementation schemes. The measures introduced address the rigidities of dismissal procedure while securing workers’ transition between different jobs. Flexibility for workers to move between different occupations and location is combined with more secure transitions between different employment statuses. The risks of unemployment traps, in particular at low level of incomes, stemming from more generous unemployment benefits need to be addressed with cost-effective activation policies, for which new implementing legislation is needed. An additional important complementary provision is the revision of the wage supplementation schemes (Cassa Integrazione Guadagni), also due under the enabling law. Wage supplementation schemes provide an effective way to avoid wasteful labour shedding during recessions, but also delay economic restructuring and labour reallocation, with negative effects on productivity growth and workers’ employability. The government intends to review and substantially streamline these schemes, among other things by reducing their duration and the cases where they can be used and by improving the insurance dimension (firms using more frequently the scheme will contribute more to its financing).

Bank-corporate nexus

The protracted crisis has exposed the vulnerability inherent in the close intertwining between Italian banks and corporates. This mutual vulnerability is rooted in the significant presence of overleveraged bank-dependent companies, firms’ weaker financial health and creditworthiness due to the protracted crisis, the high stock of non-performing loans on banks’ balance sheets, and contracting bank credit to the non-financial corporate sector.

Italian banks are relatively more exposed to corporates through lending than banks in other euro area countries, while Italian firms are more reliant on external debt financing (bank loans) than their European peers. The former fact is due to their business models which are strongly focused on traditional intermediation through deposit-taking and lending. Regarding the latter fact, in 2013, bank loans represented 64.7 % of Italian firms’ total financial debt, more than 20 percentage points higher than the euro area average (Graph 2.3.1).

The demography of the Italian non-financial corporate sector is skewed towards very small businesses which explains the high incidence of bank loans in firms’ external funding. SMEs are the backbone of the Italian economy. In 2012, 99.9 % of Italian businesses employed fewer than 50 employees, generated almost 70 % of value added and accounted for just over 80 % of people employed. Micro-firms (with up to nine employees) — of which a substantial share are 'artisanal' firms — accounted for 95.2 % of all companies and were good for around 30.8 % of value added and close to 50 % of persons employed. As small firms — and especially micro-firms — tend to have only limited access to capital market funding, their high share in the total number of Italian firms helps to explain the high incidence of bank loans in corporates’ external funding. Other relevant factors include the strong presence of banks focused on traditional deposit-taking and lending, underdeveloped capital markets, the high incidence of family ownership of firms (implying reluctance to give up control) and a long-standing bias in taxation towards debt financing.

Graph 2.3.1: Share of domestic bank loans in total financial debt of the non-financial corporate sector at end-2013

Source: European Commission, European Central Bank

The financial structure of Italy’s non-financial corporate sector is characterised by relatively high financial leverage, where the latter is inversely proportional to firm size. In 2013, the average financial leverage ([26]) of the Italian corporate sector was 44.1 %, around 4 percentage points higher than the euro area average. This implies that Italian firms on average are less well capitalised than businesses in other euro area countries and thus less resilient to financial shocks. After 2011, the contraction of bank lending to firms and the increased recourse of medium-sized and large firms to capital markets caused financial leverage to start falling, a trend which began earlier in other large euro area economies (Graph 2.3.2).

Graph 2.3.2: Financial leverage of the non-financial corporate sector

Source: European Commission

The deep and protracted recession in Italy has severely affected the creditworthiness of Italian firms and has widened the gap between small and large companies. Over the period 2008-2013, the gross operating surplus of the Italian non-financial corporate sector has decreased by more than 10 %. Compared to before the crisis, the share of firms making a profit has declined by around 10 percentage points to around 55 %. The negative effect of the decline in sales and profits on firms’ financial health and creditworthiness is exacerbated by the high financial leverage of many Italian firms. A recent study by the Bank of Italy has found that a 10 percentage points increase in financial leverage implies a 1 percentage point higher probability of default, and that the adverse impact of a drop in sales on a firm’s solvency is almost four times greater for businesses in the highest quartile of the financial leverage distribution than for companies in the lowest quartile. ([27]) At the end of June 2014, the average interest expense coverage ratio of Italian firms ([28]) — a measure of debt-service capacity — reached a new peak of close to 22 %. A third of Italian companies are estimated to be financially fragile as their interest expense coverage ratio is above 50 %. The deterioration in Italian firms’ creditworthiness is also clearly visible in the number of bankruptcies which has increased steeply since 2008. In addition, recourse to non-bankruptcy insolvency procedures and voluntary liquidations has gone up (Graph 2.3.3). Furthermore, the long crisis has led to a polarisation of financial health by firm size. The turnover and gross operating margin of small firms — on average characterised by lower productivity, higher financial leverage and higher dependence on domestic demand — have been affected more severely than those of medium-sized and large businesses (Graph 2.3.4). The future financial situation of Italy’s corporates crucially depends on how soon the economy will return to growth.

Graph 2.3.3: Number of bankruptcy and non-bankruptcy insolvency procedures and voluntary liquidations in Italy

(1) Seasonally-adjusted data Source: Cerved Group, Rapporto Cerved PMI 2014, 2014

Graph 2.3.4: Change in turnover and gross operating margin between 2007 and 2013 by firm size

Source: Cerved Group, Rapporto Cerved PMI 2014, 2014

The deterioration in the quality of loans to firms has led to a sharp increase of non-performing loans and a substantial erosion of banks’ profitability. Since the end of 2008, the non-performing loan ratio of the Italian banking sector as a whole has more than tripled and stood at 16.6 % in the third quarter of 2014. Bad debts — the worst category of impaired loans in Italy ([29]) — amounted to EUR 177 billion (i.e. 9.3 % of total customer loans). The increase in the non-performing loan ratio is mainly due to banks’ corporate exposures. Considering only non-financial corporations and producer households, Italian banks’ non-performing loan ratio has risen from 6.8 % in the fourth quarter of 2008 to 27.3 % in the third quarter of 2014 of which more than half (i.e. 15.4 % or EUR 141 billion) was bad debt (Graph 2.3.5). The corporate non-performing loan ratio is significantly higher in southern Italy. Part of the increase in the non-performing loan ratio is denominator-driven (i.e. the contraction of outstanding credit to firms). In the course of 2014, the inflow of new corporate non-performing loans and of bad debts stabilised at around 7 % and 4 % of the stock of loans to firms respectively. The inflow is higher for small firms and those that are more dependent on bank loans. Despite this stabilisation, a further increase in the corporate non-performing loan ratio is likely as the transition dynamics of impaired loans to the corporate sector are still very much biased towards further deterioration. The dramatic increase in non-performing loans has significantly undermined Italian banks’ already weak profitability: in 2013, almost half of banks’ total operating income was absorbed by loan impairments (Graph 2.3.6). The recognition of loan losses by banks has been accelerated in recent years by the strict loan portfolio reviews conducted by the Bank of Italy and as part of the European Central Bank’s comprehensive assessment of euro area banks as well as the increased tax deductibility of loan-loss provisions and loan write-offs. This is reflected in the coverage ratio for non-performing loans ([30]) which increased from 37.7 % in June 2012 to 42.4 % in June 2014, and for bad