TCS Daily


Ciao, Italia

By Constantin Gurdgiev - August 24, 2005 12:00 AM

Over the years, the Italian economy, sliding further into stagnation, has grown accustomed to bleak reports. Recently the national association of industrial enterprises, Confindustria, issued a damming forecast for one of the most dynamic exporting regions of Italy, Friuli-Venezia-Giulia. It showed that 63 percent of enterprise managers in the region were expecting stagnant demand and 70 percent saw no potential for increases in employment over the next 12 months. Overall, Italian production has been in a decline over the last year, with industrial output shrinking by 2.3 percent in annual terms between June 2004 and June 2005. With such a gloomy mood taking hold of the more productive parts of Italy, how bad are the expectations in the forever-sick regions of the Southern Mezzogiorno?

Yet leafing through the Italian press, one gets a feeling that all of the country problems are either due to some external factors or the cause of insufficient fiscal spending. If only by a miracle, the US, Germany and France were to grow at a faster pace... or the Euro were to be replaced by the Lira... or the evils of globalization were to vanish by a wave of a magic wand... or the Left-Centre coalition were to come back into power and spend its way out of the recession... the jobs and the demand for Italian goods will mushroom. Playing ostrich -- a favorite pastime for many Europeans -- is becoming a rival sport to Italian soccer.

Despite an affinity for denial, the ailments afflicting the Italian economy are Italian-made. From a regional development perspective, two major problems plague Italy: fiscal recklessness of government and the structure of ownership in the economy.

Built by a Family, Perish with a Family.

Since the age of Rinascimento, the Italian economy was dominated by small family-owned companies. Currently, only eight Italian corporations are listed in the Fortune 500 -- a number that is lower than in South Korea, Switzerland, Holland and China and only marginally above India and Russia. In addition, top Italian companies are smaller than their counterparts. For example, measured by the 2003 annual turnover, Italian Fortune 500 companies had only a quarter of the turnover of their French and German counterparts.

Characteristic of the more industrialized regions of Italy, in Friuli-Venezia-Giulia, only about 9 percent of total employment is generated by joint-stock companies, with a further 18 percent coming from private partnerships. Family enterprises or sole proprietorships account for over 71 percent of all non-agricultural jobs in the region. A full 87 percent of all companies in the region fall under the category of small firms with less than 50 employees. These figures attest to the high concentration and general underdevelopment of Italian stock exchanges.

Originally, the family-owned enterprises, protected from competition by higher costs of trade, were able to develop and secure their market shares by reinvesting earned profits. In response to this, the Italian banking system evolved along the lines of providing insurance coverage to the private SMEs in the cases of adverse shocks. High rates of savings and short-term loans backed by personal guarantees provided investment funds for development.

At the same time, partnership share dilution through expansion of ownership structure, securitization and mergers and acquisitions are rare. With little or no changes in ownership and with the tendency of the small-medium private companies to centre on the family regardless of the availability of requisite talent, Italian SMEs lack both physical and human capital to attract, retain and absorb innovation, both in management and technology.

It is common today to observe SMEs managed and owned by the same individuals, with limited executive experiences. Some of the management has no tenure in the industry outside the family firm, being hired into the company immediately after completion of their college studies. Most of the management structure remains highly concentrated in the hands of the members of the ossified professional elites: lawyers, accountants and engineers. This implies that in many cases, marketing and strategic development are last in the chain of priorities - the oldest son serves as a financial director, the youngest daughter as a marketing manager - replicating the family farm hierarchy within an enterprise shell.

Among other things, the closely-knit ownership structure makes Italian SMEs unsuitable for foreign direct investment (FDI), further reducing their growth capacity. In terms of capital inflows, Italy's 2 percent global share of FDI is significantly lower than that of France and Germany (5.3 percent and 6.6 percent, respectively), making it tenth lowest FDI recipient amongst the developed nations.

Today, with the advancement of globalization, the majority of family-owned enterprises dependent on higher margins for financing innovation, entrepreneurship and expansion of the market shares, can no longer sustain the required rates of investment in new technology and product development, identification of new markets and strategic evolution of the core business along the value-added chain.

The problematic nature of the family-owned enterprises extends beyond the issues of investment financing. Since 1990, Italian manufacturers have been steadily loosing ground in international trade. In terms of decline in world export shares, Italy competes with Japan for the honor of being the worst performer in the world rankings. This problem is exacerbated, but by no means caused, by the strengthening of the euro. Over the last 15 years, Italian manufacturers, facing competitive pressures in the global markets were slow to reduce profit margins, resulting in the long-run deterioration of their competitiveness. In reality, this was a necessary response considering that the majority of Italian exporters are privately owned SMEs with little room to reduce profit margins due to heavy indebtedness, high operating costs and dependence on short-term financing.

From Family Ownership to Banks.

The weaknesses of family-based business structures translates into an underdeveloped and poorly managed financial system. In a world dominated by personally backed loans, close lender-borrower ties and links between the state, big business and the banking sector, the scandals like the recent ABN Amro-Banca Antonveneta attempted takeover debacle are not surprising. The fact that the chairman of the Bank of Italy felt compelled to place a midnight call to the chief executive of the private bank to inform him of a favorable decision to prevent a foreign bank buying a smaller competitor is a telling sign that the sector has a deficit of transparency and a surplus of cronyism.

While the latter puts brakes on improving the efficiency of the Italian banking, the former restricts the possibility for developing new products and services in the banking sector. This overall detachment of the Italian financial sector from the reality of modern banking can be exemplified by comparing Trieste and Dublin as two international financial centers - the latter one real, the former one fictional. In 1987, Ireland's International Financial Services Centre (IFSC) and the Trieste Offshore Financial Centre (OFC) were established under the same EU legislation. Since then, the IFSC grew to become the second largest tax revenue contributor to the Irish exchequer, home to more than 18,000 high quality jobs, providing back-office administration to almost a half of the world's hedge funds and an emerging world-class financial services market. In the meantime, it took the Italian government over ten years to fully administer Trieste OFC, by which time the facility was restricted to serving the low value-added South-Eastern European real-estate markets.

A combination of an inefficient banking sector and family-owned SMEs dominance in the economy also contribute to the lack of foreign direct investment (FDI) from Italy to the rest of the world. In fact, Italian business culture still perceives outflow of investment from Italy abroad as a betrayal of the country instead of an opportunity for expansion of the product markets. Currently Italy holds only 2.9 percent global share in the outbound FDI, consistent with extremely low degrees of international capital mobility and diversification.

A recent study of the effects of close familial-business relations with the banks compares global performance of the financial systems based on short-term personal guarantee-backed relationship-based lending with the diversified system of financing in which loans are arranged on the basis of company information and the portfolio of loans is well hedged across several competitive institutions. The study shows that only in the case where a private banking system is fully monopolized, do the two systems yield equivalent efficiency of lending. In cases where competitive banks are present, firms' access to financing improves dramatically both in the case of strategic investment borrowing and shock insurance.

From Financial System to Fiscal Wreckage

Limits on Italian growth are intimately related to the economic environment of regulation and fiscal spending which are responsible for a general shortage of fiscal and financial incentives for growth, entrepreneurship, investment and evolution of the ownership structures in the Italian economy.

The problems of distorted incentives and the shortage of instruments available to the Italian state to stimulate more efficient allocation of human and physical capital are, to a large extent, the issues of fiscal insolvency and misappropriation that characterize the modern-day Italian economy. In the 10 years between 1992 and 2002, government expenditures increased by 35 percent, with the largest increases in health, social protection, education, recreation and cultural protection categories. Amongst large OECD economies, Italy occupies the last place in terms of government expenditure increases net of economic growth -- a record that is further undermined by the fact that in 1992 Italy was the worst performing state among the top 5 EU15 states in terms of its fiscal imbalances.

A weak fiscal position coupled with rising expenditures on discretionary programs implied that there was little room and political will for enacting business and consumer relief. Over the years, corporate income tax rate stayed at a high level of 33 percent, while the effective tax on distributed profits was 44.8 percent. This meant that in terms of the burden of taxation Italy was sliding down the OECD rankings from 10th place in 1999 to 14th in 2005. At the same time, employment rates remained low, especially amongst the young, while long-term unemployment continued to be a serious problem.

With Italy facing severe long-term constraints in terms of its ownership structures, private and public finance sectors, there is little hope for any change for the better in the years to come. In fact, current political debate between the traditional Italian Right (e.g. corporatist supporters of the "big business, big government" power axis) and the traditional Italian Left (e.g. socialist supporters of the "big unions, big government" power arrangements) spells an ever-worsening predicament for the economy. In line with these expectations, the Standard & Poor's ratings of prospects of the Italian economy recently went from the stable to negative. Italy is expected to fall below the forecast for China in the forthcoming 6-24 months in terms of its long-term public debt risk. Last month, the Royal Bank of Scotland issued a similar warning to the Italians by cutting its 2005 growth forecast from 0.8 percent to -0.2 percent, citing rising labor costs and poor productivity. According to the EU fiscal watchdogs, Italy will remain in recession through 2005, with a possibility of zero growth in 2006-2007.

These problems are further exacerbated by the fact that Italy's demographics are deteriorating at a faster pace than anywhere else in Europe. The country faces the lowest population growth rate in the OECD, increasing emigration of educated young Italians (with estimated 10 percent of the top graduates leaving Italy for the US, UK and other countries annually) and a rapidly ageing population. This translates into a growing army of retirees and a shrinking pool of qualified young labor to support the elderly. Within the next few years at the current rates of taxation, Italy's fiscal imbalances may reach double the Stability and Growth Pact limits, while the country's public debt levels can rise to catastrophic rates not seen since the mid 1990s. By 2050, Italy may actually be a bankrupt state with its debt valued at the level of junk bonds and the state defaulting on its pensions and healthcare commitments.

In the meantime, instead of trying to slash fiscal spending and boost the economy through tax cuts and regulatory streamlining, Italian politicians are engaged in finger-pointing. According to the ruling Center-Right coalition, the problem of fiscal imbalances is an inheritance from the Center-Left. In return, the Center-Left Union is quick to accuse the current government for abandoning the Italian economy. As political sparks went flying, neither side of political spectrum offers any serious analysis or reforms aimed at restoring the long-term health of economy. Worse than that -- given the current state of political leadership in the country, there is little hope that any side will be ready to offer the real solutions any time soon. Its head in the sand, Italy is heading for a potentially deadly spiral of economic and demographic decline.

The author is an economist and Research Fellow with Trinity College, Dublin and the Director of the Open Republic Institute (www.openrepublic.org)

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