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### Viewing cable 09ROME395, ITALY DODGES FINANCIAL MELT DOWN, BUT GLOBAL

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Reference ID | Created | Released | Classification | Origin
--- | --- | --- | --- | ---
09ROME395 | 2009-04-06 14:02 | 2011-02-28 11:11 | CONFIDENTIAL | Embassy Rome

`

    VZCZCXRO0626
    RR RUEHFL RUEHNP
    DE RUEHRO #0395/01 0961450
    ZNY CCCCC ZZH
    R 061450Z APR 09
    FM AMEMBASSY ROME
    TO RUEHC/SECSTATE WASHDC 1883
    RUEATRS/DEPT OF TREASURY WASHDC
    INFO RUEHBJ/AMEMBASSY BEIJING 1346
    RUEHRL/AMEMBASSY BERLIN 1922
    RUEHLO/AMEMBASSY LONDON 1588
    RUEHMO/AMEMBASSY MOSCOW 4532
    RUEHOT/AMEMBASSY OTTAWA 1892
    RUEHFR/AMEMBASSY PARIS 2552
    RUEHKO/AMEMBASSY TOKYO 1996
    RUEHFL/AMCONSUL FLORENCE 3561
    RUEHFT/AMCONSUL FRANKFURT 7509
    RUEHMIL/AMCONSUL MILAN 9948
    RUEHNP/AMCONSUL NAPLES 3738
    RUCPDOC/DEPT OF COMMERCE WASHDC
    RUEHBS/USEU BRUSSELS 4784
    RUCPDOC/USDOC WASHDC
    RUCNDT/USMISSION USUN NEW YORK 0982

` `

    C O N F I D E N T I A L SECTION 01 OF 03 ROME 000395

    SIPDIS

    DEPT PLEASE PASS TO USTR

    E.O. 12958: DECL: 04/06/2014
    TAGS: ECON EFIN ETRD IT
    SUBJECT: ITALY DODGES FINANCIAL MELT DOWN, BUT GLOBAL
    DOWNTURN HITS HARD

    REF: ROME 320

    SUBJECT: ITALY DODGES FINANCIAL MELT DOWN, BUT GLOBAL
    DOWNTURN HITS HARD

    REF: ROME 320

    Classified By: Classified By: Economic Minister Counselor Tom Delare fo
    r reasons 1.4 (b) and (d)

    ¶1. (C) Summary:   Conservative, risk-averse  practices and
    tight supervision allowed Italy's banking system to avoid the
    worst of the financial melt-down that hit the United States
    and other countries.  But the worldwide recession sparked by this
    financial crisis is now beginning to hit Italy's
    export-dependent economy very hard.   GDP is expected to drop
    by between 2.5 and 4% in 2009, and unemployment to rise to
    8%.  The government has set up a system to bolster the
    capital of Italy's banks, but its ability to give a stronger
    fiscal stimulus to the economy is constrained by Italy's
    already enormous public sector debt.  Looking ahead, exports
    to the rest of Europe and the United States will likely pull
    Italy out of recession soon after global growth resumes, but
    unfortunately Italy will then find itself back in the same
    economic mess that it was in before the recession:  the sick
    man of Europe, condemned by demographics and bad policies to
    growth rates significantly lower than its EU partners.  END
    SUMMARY

    ITALIAN BANKS DODGE THE BULLET, BUT WHY?

    ¶2. (C) Italy's banking system for the most part avoided the
    catastrophe that has engulfed financial markets in the U.S.
    and elsewhere.  Before the current crisis, Italian business,
    policymakers and the public criticized the Italian financial
    system frequently for its failure to embrace innovative
    financial systems and to spur entrepreneurship.  The U.S.
    Embassy was a leader in this criticism.  But it was this
    aversion to innovation and Bank of Italy-mandated leverage
    limits on derivative instruments that kept the Italians out
    of what now appears to be round one of the global economic
    crisis.

    ¶3. (U) The reasons Italian banks dodged the bullet, however,
    are not all good.  Italian bankers and economic policymakers
    say, with some hubris, that banks here avoided trouble by
    sticking to their core business and practices of lending to
    known, trusted firms and households with adequate security
    and high prospects of repayment.   This is to some extent
    true.

    ¶4. (C) Caution kept Italian banks out of sub-prime lending
    and the market for derivatives built on top of sub-prime
    mortgages and exotic credit default swaps. Also keeping
    Italian banks out of high-risk, high-return investments was a
    high-margin domestic market, where financial institutions
    still enjoy loan/deposit margins that are 2 to 3 times those
    in other advanced economies.  Because there are relatively
    few foreign banks operating in Italy, Italian consumers and
    businesses were denied the competition dynamic that would
    reduce the high cost of banking services.  The end result is
    a plodding financial sector in an already plodding economy.

    BUT RECESSION NOW HITTING HARD

    ¶5. (U) Banks, avoidance of toxic assets notwithstanding,
    Italy's export-dependent economy will not escape the global
    recession sparked by the financial crisis.  The effects of
    that recession are now being felt here as export orders dry
    up, unemployment increases and new business investment
    screeches to a halt.  As per ref A and newer data, estimates
    of GDP contraction in 2009 range from 2 percent to over 4
    (OECD).  (Italy's worst post-war economic performance came in
    1993, when the economy shrunk by 2.5 percent.)  Rising
    unemployment concerns policymakers, who fear unemployment
    will top 8 percent by end of 2009.  Curiously, consumer
    confidence surveys in the first two months of 2009 revealed
    that consumers expect things to worsen in general, while
    indicating that their own personal economic situation remains
    favorable.  Businesses, on the other hand, remain quite
    pessimistic - this is likely the result of dramatic declines
    in industrial production (-4.3% in 2008) and exports (down
    26% in January 2009).   Business confidence surveys remain at
    all-time lows, explaining a drop of 1.9 percent in gross
    fixed investment during the third quarter of 2008.

    BANKS BOLSTERED...

    ¶6. (U) Italian government policy makers remain focused on
    ensuring that bank capital is adequate, seeking to bolster it
    through the issuance of hybrid capital instruments informally
    named after Economics and Finance Minister Giulio Tremonti.
    The government has pointed to the banking system's financial
    health as key to economic recovery and suggested that an
    insufficiency of capital is holding back banks from
    lubricating the economy adequately.   More recently,
    policymakers and bankers are claiming that the hybrid bond
    scheme is meant to address  level playing field, concerns
    with respect to state aid provided by other EU governments to
    their financial sectors.   The plan to beef up capital
    unveiled in early March is technically sound, but
    controversial in that banks wishing to participate in it must
    sign on to as yet vague conditions constraining compensation
    for executives and ""traders"", and to agree to additional,
    unusual oversight of their lending practices and portfolios.
    This last sparked a tiff between Minister Tremonti and the
    Bank of Italy's governor Mario Draghi, who has asserted
    firmly and publicly his institution's primacy in supervising
    banks.

    ¶7. (C) Under the scheme, participating banks (applications so
    far total about 8.5 billion euros) will issue convertible
    instruments to which the GOI will subscribe fully.  The
    convertible instruments pay interest, but only if the bank
    distributes dividends to all its shareholders.  The interest
    rate and the premium for converting the instruments from
     bonds, to common shares (thus repaying the taxpayers) grow
    over time.  In neither form (debt or equity) do the
    instruments confer voting rights to the government.

    ¶8. (C) Tremonti may see in his namesake instruments a vehicle
    to impose his eclectic economic world view to the benefit of
    economic actors he claims have been left behind by
    globalization, i.e., small businesses. Unfortunately, many of
    these firms appear to be unable or unwilling to change to
    meet the demands of a more dynamic market and global
    competition.  A former Socialist, like many in the ruling
    People of Liberty party, Tremonti does not have his own
    political constituency, but rather
    draws his power from his relationship with PM Berlusconi and
    support from the junior coalition partner, the Northern
    League.  A strong constituency of the latter are small family
    businesses, which claim to have suffered from the break-down
    of relationships with their local banks as these were
    absorbed by larger competitors during a recent consolidation
    wave.  Tremonti can emerge as their champion by spurring
    banks to lend more generously to them.  Also in play could be
    Tremonti,s desire to be seen abroad and at home as
    successfully balancing free market principles and social
    responsibility.

    ...BUT NO MONEY FOR STIMULUS

    ¶9. (U) Tremonti,s activism notwithstanding, the GOI has very
    little leeway to use fiscal policy to stimulate the economy,
    given the already high debt-to-GDP ratio (107% currently and
    projected to rise to 110% or more this year) - well above the
    Maastricht treaty guideline of 60% max) and an onerous tax
    burden (at 43% the corporate tax  rate is the highest in the
    developed world).

    ¶10. (U) Eleven percent of Italy's central government revenue
    already goes to service debt, while
    the lion's share of the budget consists of entitlement
    spending that is not easily reduced.   On the revenue side,
    the government has little ability to further squeeze more
    from taxpayers, given already high rates and rampant tax
    evasion.  Were the GOI predisposed to cut taxes to stimulate
    private investment or spending (of which we have not heard a
    whisper),  it might find it difficult, if not
    impossible, to finance its still growing deficit in the
    short-term.   All this results in a very modest Italian
    stimulus package (the smallest among Europe's major
    economies) that as yet continues to dribble out piecemeal as
    specific sectors succeed in their government lobbying
    efforts.

    LOOKING AHEAD

    ¶11. (U) Italy has built a strong export platform in niche
    products and a solid reputation for design and top
    craftsmanship among their EU customers.  Over forty percent
    of its exports go to wealthy markets in Germany, France, the
    UK and the US.  As those economies recover, they will pull
    Italy along.  Likewise, energy and commodity producers, who
    are also among Italy's export targets, should also help boost
    an Italian recovery as global demand for energy and raw
    materials recovers. A larger question mark in the short run
    is the performance of markets in central and eastern Europe
    that Italy also pegged for export growth and foreign
    investment.  Meanwhile, Italy's penetration of the monster
    emerging economies such as China and India remains weak.  One
    bank executive told us that Italian firms are not, for the
    most part, able (or interested?) to fill orders at the scale
    the new giants require.

    AFTER RECOVERY: SICK MAN OF EUROPE ONCE AGAIN

    ¶12. (C) However long the global downturn lasts, at the end of
    it Italy will remain hamstrung by an oversized public sector,
    an over-regulated economy, insufficient competition in key
    sectors such as financial services, inflexible labor laws,
    corruption and an aging, shrinking population.  All translate
    into a job-poor economy that will continue to drive its
    dwindling youth to emigrate.

    ¶13. (C) COMMENT: For the moment, Italian globalization
    skeptics and defenders of  The Italian Way, may feel smug
    about having avoided the global financial catastrophe.
    Government policymakers certainly seem to be doing a good job
    of monitoring and bolstering banks, capital and consumer
    confidence.  On fiscal stimulus, however, Italy hasn't gone
    nearly as far as we are asking our partners to go, because
    policymakers know there is little they can do in the shadow
    of their massive government deficit.   The deficit is
    emblematic (and the result) of the long term structural
    policy errors pursued by Italian
    governments of all stripes.  Unfortunately, the current
    crisis will embolden those calling for Italy to stay its
    failing economic course.  And they far outnumber those among
    the policy makers, such as Minister for Administrative Reform
    Brunetta, who have called for using the current crisis as an
    opportunity to make Italy more competitive.  At crisis-end,
    we unfortunately predict that Italians will face the same
    underlying problems with little appetite for serious (and
    painful) reform.  Italy will almost certainly
    find itself back in its pre-crisis malaise.
    DIBBLE
    "

`