Views on the Italian economy

Views on the Italian economy Research Department March 2007

Views on the Italian economy

Contents

•

Macroeconomic environment

3

•

Industrial activity and capital expenditure

7

•

Services and construction

8

•

The labour market

9

•

Consumer spending and saving

10

•

Inflation

11

•

Imports and exports

12

•

Banking sector

13

2 Research Department

Views on the Italian economy

Growth above potential in 2007 „ The detailed forecast for 4Q06 GDP has confirmed an acceleration to 1.1% q/q, following the slowdown of the previous quarter (0.3% q/q). The surprising performance of the Italian economy at the end of last year is due to much stronger than expected growth in exports, at 4.5% q/q, the best result since the end of 1999. Import growth was much lower, at 2.0% q/q. Foreign trade therefore contributed around six-tenths of a point to fourth quarter GDP growth. „ Domestic demand contributed around fivetenths of a point to GDP growth in the last quarter of 2006. „ Unexpectedly, household consumption slowed considerably, to 0.2% q/q, from 0.6% q/q the previous quarter. The downturn is largely attributable to the drop in spending (0.8% q/q) on durable goods. After the slow summer months, a recovery was expected, especially in light of data on new car registrations. The real reason for the downturn was a drop in spending on home appliances and phone services. However, spending on non-durable goods recovered somewhat, with an increase of 0.5% q/q versus a contraction of 0.2% q/q in the previous quarter. „ Capital investment saw a marked recovery, at 1.8% q/q versus the previous 0.3% fall. In particular, spending on machinery was up 1.6% q/q after a very slow summer. Spending on transport was stable after fluctuating in the two previous quarters, largely due to uneven comparison effects: in 2005, a car transporters’ strike resulted in a sharp drop in vehicle sales in the second quarter and a strong recovery in the third quarter. Construction investment also rose significantly (2.3% q/q versus 0.7% q/q the previous quarter), probably because of particularly good weather conditions (very little rain and mild temperatures). „ On the supply side, in 2006 there was a strong recovery in industrial output (+2.5%) after five years of consecutive falls. Services grew substantially yearon-year, by 1.9% versus 0.8%. Construction also made good progress year-on-year, at 1.8% compared to 0.8%. „ Detailed estimates from ISTAT confirm that 2006 was a very positive year for Italy, with a recovery of activity in all sectors. The year-end surge put average growth at 2.0%, about eight-tenths of a point above potential. This is the best result since 2000. Analysts were forecasting growth of 1.3% last January, and even updated estimates in November put the figure at only 1.7%.

„ But this is not an all-Italian miracle. If we look at last January's consensus forecasts for the eurozone and compare them with the actual result we can see that the big performer in 2006 was Germany, where growth hit 2.8% (versus forecasts of 1.0%), driving the eurozone average to 2.8% from an initial estimate of 1.9%. „ The dynamic end to last year led us to leave our forecast for 2007 unchanged at 1.5%. However, since the last edition of this publication, we have raised our estimate for this year to 1.7%, in line with the consensus. The slowdown at the start of 2007 should be less marked than we were expecting a month ago in both the eurozone and Italy. „ After the buoyant end to 2006, we expect growth in Italy of around 0.2% q/q in the first quarter of 2007. The country’s economic activity will receive less support from European demand, which will be reined in by the slowdown in Germany. The economic surveys are pointing to a modest downturn in growth at the start of the year. On average, between January and February, the PMI was close to 54.2, around one point below the end-2006 level (55.3). Industrial output data for January, and the downward revisions to the December figures reveal a less positive scenario, with production volumes stuck at last October's levels. The surveys also indicate that we may see improvements between February and March, although the weak start to the year means substantial growth is unlikely in 1Q07. „ The main contribution to growth will again come from domestic demand, which should rise by an annual average of 1.6% this year. „ We are still upbeat on investment, at least in the first half of the year. High plant utilisation, strong domestic demand for capital goods and financial conditions that are still favourable should sustain capital expenditure. „ However, we project a slight slowdown in household consumption growth to 1.9%, from the 2.1% forecast for 2006, given the expected dip in disposable income growth (from 1.3% to 1.2%) owing to fiscal policies. Some of the benefits arising from lower tax rates on incomes below EUR 40,000 could be eroded by higher regional taxes. According to a recent survey conducted by Il Sole 24 Ore (Monday 19 February), 43 of Italy’s 103 provincial capitals put up the IRPEF surtax, which the last budget increased from 0.5% to 0.8% (these are the maximum levels that can be applied). Employment growth too, which is expected to decline this year as the economy cools, will provide 3

Research Department

Views on the Italian economy

less support for disposable income. Real wages are likely to show a modest rise, however, while consumer spending will be given a slight boost by incentives on new car purchases this year. „ We are also more upbeat on investment in construction. According to ANCE, the national builders’ association, Italy’s budget for 2007 has set aside EUR 3.7 billion for public works. However, this will only become available if the social security fund set up Fig. 1 – After the end-2006 surge, the surveys point to a modest slowdown in early 2007 1.5

65

using the resources from staff severance funds becomes operational. The outlook for residential investment is fairly good despite the hike in interest rates, given that tax breaks for domestic renovation work are still in force this year, and that further incentives have been introduced for energy-saving initiatives.

Fig. 2 – We expect a less substantial contribution from foreign trade in 2007 1.5

1.5 Contribution to GDP growth q/q %

60

1.0

0.3% = quarterly growth in line with the annual trend of 1.2%

1.0

1.0 Forecast

0.5

0.5

0.0

0.0

-0.5

-0.5

0.5

55

50

0.0

45

-0.5

Final domestic demand

-1.0

2000

2001

2002

2003

GDP q/q % (rhs)

2004

2005

2006

2007

Composite PMI

GDP -1.5

-1.5 2001

Source: NTC research, ISTAT, Reuters and Intesa Sanpaolo research

„ Looking now at consumer prices, we expect inflation to hover around 1.7%, from 2.1% in 2006. The fall is largely due to more benign energy prices. Our scenario incorporates only a slight fall in crude prices in 2007, to USD 62 per barrel, from USD 65 last year. We believe, however, that core inflation (excluding foodstuffs and energy) is less likely to slow down, and will probably remain above 1.6%. Falling energy prices mean that inflation in Italy is likely to decline by less than the European average, given that the Italian excise duty is higher than in the eurozone as a whole. Despite this, Italian inflation will remain below the European average, which will be affected by the VAT rise in Germany. „ The Italian economy is unlikely to surprise the markets again with anything like the 1.1% q/q growth registered in late 2006. Potential growth remains at a low level of 1.2% and, barring drastic reforms, the economy will certainly not continue to grow at a rate of around eight points above trend, even assuming that the international economy holds firm. This was also the reaction (and the warning) of the IMF and the OECD,

-1.0

Net exports

2002

2003

2004

2005

2006

2007

Source: ISTAT and Intesa Sanpaolo research

even while they acknowledged the excellent result for 2006. The emphasis will remain on kick-starting productivity in order to regain competitiveness and claw back market share internationally. At the same time, efforts to increase competition on the domestic market, especially in services, are crucial. „ The government will also need to make greater efforts to reduce its debt in the years to come. Bank of Italy estimates put the debt/GDP ratio at 106.8% in 2006. This is better than the forecast of 107.6% contained in last December’s stability programme, but is still higher than the 106.2% registered in 2005 (which was revised downwards from 106.4%). The better than expected 2006 figure and the downwards revision of the 2005 result were due to the review of GDP growth figures. Although the debt situation has improved at central government level, it has worsened significantly at the local level. This is a clear sign of the cracks in the internal stability pact. „ Italy’s forecast and planning report (RPP) projects the budget deficit at 2.3% of GDP, little 4

Research Department

Views on the Italian economy

different from the 2.4% that was registered in 2006, not counting one-off measures worth 2% of GDP. The report also sees a sharp improvement in the primary balance. The deficit estimate is lower than the 2.8% figure given in December's stability programme. Here too, the improvement is due largely to higher growth estimates than before (2% vs. 1.5%). The RPP sees debt rising further, to 106.9% of GDP. Our net debt estimates are more cautious, given our lower growth forecast (1.7%) and in view of concerns over the implementation of some of the measures introduced in the 2007 budget. These concerns are shared by a number of international bodies, including the ECB, which in its March bulletin expressly stated

that Italy needs to reduce the imbalance in its public finances, but that there are doubts over the implementation of measures relating to 2007 and 2008. This is not an insignificant problem given the fragility of the governing coalition which, in the Senate, has only very limited – if any – room for manoeuvring. Improving public accounts and negative opinion poll results related to the government’s popularity could lead to an easing in fiscal discipline. We also have to note that much of the improvement this year will come on the revenue side: expenditure net of interest is expected to dip by only 0.2% of GDP, after reaching its highest point since 1983 last year, while tax revenues are seen up by around EUR 8-10 billion in 2006.

5 Research Department

Views on the Italian economy

Italy – summary of macroeconomic forecasts Macroeconomic Forecasts GDP (constant prices)

2004

2005

2006

2007

2008

1.2

0.1

1.9

1.7

1.7

0.7

0.6

1.5

1.4

1.3

- q/q change Private consumption

2006

2007

1

2

3

4

1

2

3

4

1.7

1.7

1.6

2.8

2.2

1.8

1.8

1.0

0.8

0.6

0.3

1.1

0.2

0.2

0.3

0.4

0.5

0.4

0.6

0.2

0.3

0.4

0.4

0.2

Government consumption

0.6

0.3

-0.3

0.5

0.6

-0.3

-0.1

0.2

0.0

0.2

0.2

0.2

0.2

Fixed investment

1.6

-0.5

2.3

2.5

2.1

1.7

0.4

-0.3

1.8

0.3

0.6

0.5

0.4

Export

3.3

-0.5

5.3

3.7

4.1

2.2

1.4

-1.8

4.5

-0.5

1.4

0.5

0.7

Import

2.7

0.5

4.3

4.0

4.1

1.0

0.3

2.2

2.0

-0.5

1.7

0.7

0.6

Contrib to GDP% External trade

0.1

-0.3

0.2

-0.1

0.0

0.3

0.3

-1.1

0.6

0.0

-0.1

-0.1

0.0

Final domestic demand

0.9

0.1

1.3

1.4

1.3

0.6

0.3

0.3

0.5

0.3

0.4

0.3

0.2

Stockbuilding (% of GDP)

0.0

0.0

0.4

0.4

0.4

-0.2

0.0

1.1

0.0

-0.1

-0.1

0.0

0.1

-0.9

2.3

1.5

2.3

0.7

1.5

0.0

0.6

1.3

-0.3

0.4

1.8

0.7

Production activity Industrial production Prices, wages and income CPI (y/y)

2.2

2.0

2.1

1.7

1.9

2.1

2.3

2.1

1.9

1.8

1.7

1.7

1.9

Unemployment (%)

8.0

7.7

7.0

6.9

7.0

7.2

6.9

6.8

7.1

7.0

6.9

6.9

6.9

-0.5

-0.1

0.8

1.1

-0.1

0.0

-0.2

0.3

Employment (%)

0.4

-0.2

1.6

0.6

0.7

Productivity

1.0

-0.2

-2.0

1.1

0.0

Compensation per employee

3.6

4.6

4.6

4.3

2.6

Unit labour costs

2.2

5.0

2.5

2.6

0.0

Contractual wages

2.9

3.1

2.8

2.8

2.6

Real disposable income

1.8

0.1

1.3

1.5

1.4

Saving rate

0.1

0.1

0.1

0.1

0.1

-0.1

-0.8

-1.3

0.7

Balance of payments Current account (% of GDP)

0.5

Government accounts Budget balance (% of GDP)

3.4

4.1

4.4

2.6

-3.5

Debt (% of GDP)

103.9

106.4

106.8

107.1

108.0

PSBR (-= deficit)

-49.9

-60.0

-35.2

-39.5

Financial Variables EUR/USD

1.2

1.2

1.3

1.3

1.26

1.2

1.3

1.3

1.3

1.3

1.3

1.3

1.3

3-mths Euribor

2.1

2.2

3.1

4.0

3.90

2.6

2.9

3.2

3.6

3.8

4.0

4.1

4.1

4.00

3.7

4.2

4.2

4.0

4.2

3.9

3.8

3.9

0.2

0.3

0.3

0.3

0.2

0.2

0.2

0.2

Long term (10Y) rate (%)

4.2

3.5

4.0

4.0

BTP/Bund spread

0.2

0.2

0.3

0.2

0.20

NB: 1) Annual figures on GDP growth and its components relate to new ISTAT annual accounts for the period 2001-2006. 2) The change to index numbers means that the contributions to GDP growth are not added to total growth. 3) GDP figures for 2007-2008 are the averages of the quarterly figures.

6 Research Department

Views on the Italian economy

Not just a correction: industrial output disappoints „ Industrial output was -1.4% m/m in January, far short of the consensus figure of -0.7% m/m. This, together with the revision of the December figure from 2% m/m to 1.4% m/m, put output back at its November levels and highlighted a sluggish start to 2007. Every sector (Fig. 4) registered a decline. The January correction dragged durables production down to its September levels, while non-durables and capital goods suffered less. „ In February the PMI output index rose by two points to 57.2. Looking at new orders, the PMI went up slightly last month to 54.9 while, despite a decline, the ISAE index approached its highest point since 2000

(Fig. 5). There may have been an upturn in activity in February, as shown by the ISAE, Confindustria and PMI surveys. The January figure puts output on track for a fall of 0.3% q/q at end-March, following the 1.3% q/q rise posted in December. This suggests a slowdown in GDP growth at the start of this year after the unexpected 1.1% q/q spurt seen in 4Q06 (Fig. 3). „ The trend in domestic orders for capital goods, coupled with the high level of capacity utilisation (Fig. 6) indicates that capital expenditure may have held up in early 2007, despite January’s dip in output.

Fig 3 – Output contradicts the economic surveys

Fig 4. – Correction hit all sectors

2.5

4.5%

2.0

3.5%

1.5

2.5%

1.0

1.0

1.5%

0.5

0.5

0.5%

0.0

0.0

-0.5

-0.5

-1.0

-1.0

2.5

PMI st. dev. from long-term average ISAE st. dev. from long-term avg. Ip % q/q, rhs

2.0 1.5

carry over gorowth 2007.T1

-1.5 -2.0

-1.5

-0.5% -1.5% -2.5% -3.5%

-2.0

-4.5% -2.5 -2.5 1999.1 2000.1 2001.1 2002.1 2003.1 2004.1 2005.1 2006.1 2007.1

2004 2004 2004 2005 2005 2005 2006 2006 2006 2007 Consumption Goods

Intermediate Goods

Capital Goods

Source: ISTAT, NTC Research, ISAE Source: ISTAT

Fig. 5 – Demand slows, but remains high 30% Orders % yy ISAE - assessment on orders 3-month averages

25% 20%

Fig. 6 – Investments still rising in early 2007

15

10

10

8

5

6

0

4

-5

2

2.0 1.5 1.0

15% 10%

-10 5%

-15

0%

-20

-5%

-25

-10%

-30

-35 -15% 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

0.5

0

0.0

-2

-0.5 Forecast

-4

-1.0 -6

Investment in Machinery Domestic Orders of Capital Goods, st. dev. (rhs) Capacity Utilisation Rates st.dev. (rhs)

-8 -10

-2.0

1996

Source: ISTAT and ISAE

-1.5

1998

2000

2002

2004

2006

Source: ISTAT, ISAE and Intesa Sanpaolo.

7 Research Department

Views on the Italian economy

Confidence higher in services, but not in large-scale retail „ The services PMI continued to gain ground in February, reaching 56.2 from its earlier level of 55.4. The average for the first two months of the year was 55.8, higher than the 4Q06 average of 55.1, thus putting an end to the decline that started in August 2006. Current situation and new orders surveys showed a particular improvement, and we therefore think that services could well continue to grow at least at the pace seen at end-2006 (0.7% q/q). With industrial output making a zero or slightly negative contribution, and services adding 0.4 points, our GDP growth forecast of 0.3% q/q for 1Q07, following the 1.1 q/q posted late last year, can be considered cautious. „ Retail confidence hit new highs in February (Fig. 8), while the climate in large-scale retail worsened further, to 97.9. Actual sales growth dipped to 1.2% y/y, from 1.6% y/y in September.

Fig. 7 – Services: confidence up again in February 6.0%

64 62

5.0% 60 58

4.0%

„ Construction (Fig. 9) – investment in construction went up by 2.3% q/q in 4Q06. This was a sharp upturn, with growth well above the average seen in the previous five quarters. Investment in big projects and infrastructure grew by 2.4% q/q, the best result since December 2002. Although the downturn in 3Q has been fully erased, confidence is struggling to pick up (Fig. 10). This, coupled with the slowdown in mortgage growth and the recent weather, could presage a slowdown in activity in early 2007. Some support to residential investment will come from tax breaks on domestic renovations and on energy-saving measures. However, the prospects for large public works and infrastructure investment remain uncertain. Around EUR 3.7 billion has been earmarked in the 2007 budget (EUR 14 billion for 2007-2009). Among the most significant investments are those involving the national roads body ANAS (EUR 1.12 billion) and FS, the state railways (EUR 1.56 billion), which will also be extended to 2008-2009. Fig. 8 – Large-scale retail confidence plummets 2.0

120

1.5

115

1.0

110

0.5

105

56 3.0%

0.0

100

-0.5

95

-1.0

90

54 52

2.0%

50 1.0% 48

85

-1.5 2004

46

2005

0.0% 1999 2000 2001 2002 2003 2004 2005 2006 2007 Added Value, constant prices, y/y (rhs)

Source: European Commission, Reuters, ISTAT and Intesa Sanpaolo research

PMI Services (lhs)

Source: NTC, ISTAT

Fig. 9 – Residential mortgages slow 28%

14%

26%

2005 2006 2006 Confidence, small retailers (rhs) Retail sales, 3m av., y/y (lhs) Confidence, large retailers (rhs)

12%

Fig. 10 – Construction: confidence struggles to pick up 5%

10

4%

8 6

24%

10%

3%

22%

8%

2%

2

20%

6%

1%

0

0%

-2

4%

18%

2%

16% 14%

0%

-1%

-2%

-2%

12% -4% 2000 2001 2002 2003 2004 2005 2006 2007 Home Loans y/y (lhs) Residential Investments y/y (rhs)

Source: ISTAT, Bank of Italy and Intesa Sanpaolo research

4

-4 -6 -8

-3% 2001

-10 2002

2003

2004

2005

2006

2007

Investment in Construction q/q% (lhs) Confidence in the Construction Sector

Source: ISTAT, ISAE

8 Research Department

Views on the Italian economy

Employment likely to flag in 2007 as real wages accelerate „ The creation of 9,000 new jobs in 4Q06, mostly in the building sector, was a small recovery following the loss of 127,000 jobs in 3Q. „ Nonetheless, the unemployment rate fell to 6.9% in 4Q06, from 7.5% at the end of 2005, the lowest level since the ISTAT series began in 1991. The trend is due to people retiring later, and immigrants acquiring legal status. Even unemployment among the young has fallen – from 24.3% at the end of 2005 to 22.6% in 4Q06. Another contributing factor is the growing popularity of atypical work contracts (part-time and/or temporary), which increased to 17.9% of the total in 4Q06 and explain most of the y/y increase in employment. Fig. 11 – In 2007, unemployment should remain stable after precipitous fall in the last five years 1.2 1.0 0.8

„ We expect unemployment to remain broadly stable slighlty below 7% in 2007 (Fig. 11), since the drop in the PMI employment index in the past four months, from 55.98 in November to 53.32 in February, highlights a slowdown in job creation which will translate into a stable unemployment rate. „ The most recent monthly data available show wage growth at 3.3% y/y. The moderate inflation expected in 2007 (seen in the 1.7%-2.2% range) is likely to prompt a rise in real salaries this year (Fig. 14).

Fig. 12 – New jobs created only in construction in late 2006

9.5

250

9.0

200 150

8.5

0.6 0.4

100

8.0

0.2

50 0

7.5

0.0 -0.2

-50

7.0

-0.4 -0.6 2001 2002 2003 2004 2005 2006 2007 Labour Force % q/q (lhs)

-100

6.5

-150 -200 2003 2003 2004 2004 2005 2005 2006 2006

Employment, % q/q (lhs) Unemployment %,(rhs)

Industry

3.0

6.0

6.0

2.5 2.0

55

Real Wages (rhs)

5.0

Contractual Wages var % y/y

5.0

1.5

4.0

4.0

1.0

3.0

3.0

2.0

2.0

1.0

1.0

0.0

0.0

-1.0

-1.0

-2.0 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

-2.0

0.5 50

Services

Fig. 14 – Real wages rising in 2007

Fig. 13 – Employment growth slightly lower in 2007

60

Construction

Source: ISTAT and Intesa Sanpaolo research

Source: ISTAT and Intesa Sanpaolo research

65

thousands

0.0 -0.5

45

-1.0 -1.5

40

-2.0

2000

2001 2002

2003 2004 2005 2006

2007

PMI job index lag 2, (rhs) Employment yy%, (lhs)

Source: NTC Reuters, ISTAT and Intesa Sanpaolo research

Source: ISTAT

9 Research Department

Views on the Italian economy

Consumer spending disappoints in 4Q06 „ After rising by 0.6% q/q in 3Q06, household consumption growth slowed to 0.2% q/q in 4Q. Growth was due mainly to spending on non-durable goods (+0.5% q/q) and services (+0.3% q/q), while expenditure on durables dropped by a hefty 0.8% q/q (Fig. 15) owing to a decline in sales of furniture and electronic goods, which more than offset the sharp upturn in new car purchases (Fig. 16). Based on January and February data, we expect auto purchases to rise by around 7.4% in 1Q, which could boost spending on durables. Growth in consumer credit, although easing, will remain in the double digits. „ The consumer confidence index has risen from 110.3 to 111.7 while, according to the ISAE, spending

Fig. 15 – The slowdown in consumption at end-2006 is due to a disappointing performance from durable goods 0.8

intentions for the next 12 months have weakened: the index fell to -12.7 in February, from -11.6 in January (Fig. 17). Even so, employment and real wages should continue to support consumer spending, while the reform of personal income tax will have only a slight impact on the trend. Aside from this, a boost to new car purchases should come in 2H07 from a new regional law in Lombardy. „ Current propensity to save fell to 109, from 120 in January. As for future intentions, the index went up to -55 in February (the highest point since February 2006), from -68 in January, continuing the uptrend from the lows seen in October. The optimism shown in the index is in line with the expected trend in real wages.

Fig. 16 – New car registrations indicate a fall in auto expenditure in early 2007 1.0

5

QoQ% Change

4

0.6

3 0.5

2

0.4

1

0.2

0

0.0

-1 -2

0.0

-3

-0.5 -0.2

-4 2007.Q1 Forecast

-0.4 2005.1 2005.2 2005.3 2005.4 2006.1 2006.2 2006.3 2006.4 Durables Non durables Services Private consumption

Source: EcoWin, ISTAT

-6 2004

2005 2006 2007 Private consumption % q/q (lhs) Car registrations (rhs)

Source: ISAE, EcoWin

Fig. 17 – Spending intentions fell in early 2007 -5

120 115

-5

-1.0

3-mth Moving Average

Fig. 18 – Large gap between present and future savings intentions 140

-20

130

110

-30

120

-10

105

-40

110 100

100

-50

90

95

-15

70

85

60

-20

80 2003

2004

2005

2006

Confidence (lhs) Purchase intentions in the next 12 months (rhs)

Source: ISAE, EcoWin

-60

80

90

-70 -80

50

-90 40 2003 2003 2004 2004 2005 2005 2006 2006 2007 Current savings, balance (lhs) Savings expectations, balance (rhs)

Source: ISTAT, EcoWin

10 Research Department

Views on the Italian economy

Inflation below 2% for much of 2007 „ According to the national calculation method, inflation hit 1.8% y/y (0.3% m/m) in February, while HICP inflation stood at 2.1% y/y, from 1.9% y/y in January (0.1% m/m, from -1.1% m/m in January). Compared to the average of the past twelve months, the most significant pressures came from food (3.5% y/y), furniture (1.9% y/y) and recreation (1.7% y/y), while the contribution from energy (1.9% y/y) fell significantly. The picture is therefore different from last month, when there was lower than average pressure from almost all components. However, healthcare and communications continue to dampen inflation, as they did in January. „ Outlook – this year we expect inflation to remain between 1.7% and 2.1%, hitting the lower

Fig. 19 – Italy: inflation

end of the range in May and then heading back up towards 2.1% as year-end approaches. We then see it declining gradually throughout 2008. The slowdown in consumer price growth is largely due to a more favourable trend in energy: we expect oil prices to rise only slightly this year. However, core inflation (ex food and energy) is unlikely to slow: going by the trend of the first two months of 2007, this is likely to be above 1.5%. Nonetheless, Italian inflation will remain below the European average. „ The PMI, which recently showed a more moderate trend in producer prices paid, shot up by around two points to 61.9 in February. Conversely, the PPI fell to 3.9% y/y, its lowest point since November 2005 (Fig. 21).

Fig. 20 – Breakdown by component (% y/y)

2.6 Other goods

2.4

Hotels Education

2.2

Recreation Communications

2.0

Trans ex Energy

1.8

Healthcare Furniture

1.6

Housing ex- energy Clothing

1.4

Alcohol and Tobacco Food

1.2 2004

2005

2006

Inflation

2007

2008

Energy

Core Inflation

-6

Source: ISTAT

-4

-2

0

12-m moving average

2

4

6

8

Jan-2007

Source: ISTAT

Fig. 22 – 12-month inflation expectations

Fig. 21 – Producer prices, y/y 75

8

6

65

29

3.1

28

2.9

27

2.7

26

4 55

2.5

25

2.3

24

2

2.1

23

1.9

22

45

0

35 -2 2004 2004 2004 2005 2005 2005 2006 2006 2006 2007 PPI % y/y (rhs)

Source: EcoWin, ISTAT

PMI - prices (lhs)

1.7

21 20 2002

1.5 2003

2004

2005

Inflation expectations (lhs)

2006

Actual inflation (rhs)

Source: EcoWin, Bank of Italy

11 Research Department

Views on the Italian economy

Exports continue to surge „ Italy’s trade deficit widened dramatically in 2006, from EUR 9.9 billion to EUR 21.6 billion. This was due almost exclusively to non-EU trade flows, reflecting the dominant role played by energy products. Nonetheless, the upturn in domestic demand last year had negative effects on the non-energy trade balance as well. „ The dynamic growth in exports that began in 4Q06 continued into January, so much so that the year-onyear variation of the three-month average jumped to 14.1% and the balance was less negative than in the same month of 2006. All product groups increased their exports, especially energy and intermediate goods, with

Fig. 23 – Sharp upsurge in exports

the most vigorous growth seen in oil products and metals. A positive trend was also seen in all categories of imports except for energy, which was disadvantaged by the mild winter. The biggest changes were seen in metals and mechanical equipment. „ The overall PMI has weakened only slightly (Fig. 25), but the slowdown in global demand expected in the first half of the year could affect the performance of Italian exports. The appreciation of the nominal effective exchange rate (Fig. 26) has also had no effect on trade flows so far.

Fig. 24 – Non-EU trade deficit widens 5,000

16

2,948 0

14 12

629

-1,331

-481

-3,256

-763

-8,323

-5,000

10

-10,000

8

-21,436

Non-EU

6

EU

-15,000

Total

4

-20,000

2

€ bln

0 Mar-04

-25,000 Sep-04

Mar-05

Sep-05

Exports- var q/q%

Mar-06

Sep-06

2003

2004

2005

gen -dic 06

Imports-var q/q%

Source: ISTAT. Data for the period Jan-Oct every year. Source: ISTAT, Intesa Sanpaolo

Fig. 25 – Gap between PMI and exports widens 20

65

Fig. 26 – Effective exchange rate increases 90

25 Effective Nominal Exchange Rate (lhs) inverse scale

92

15

60

10 55 5

94

20

Italy Exports % yy (rhs)

96

15

98 100

10

102

50 0

5

104 106

45

-5 -10

40 2002

2003 Global PMI

2004

2005

2006

2007

Italy Exports - var % yy (rhs)

Source: EcoWin, ISTAT

0

108 110

-5

112 114

-10 2002

2003

2004

2005

2006

Source: ISTAT. Data for the first nine months of the year

12 Research Department

Views on the Italian economy

Banking sector Interest rates Sharp rise in loan rates „ 2007 began with a significant increase in lending rates, with the rate on overall loans to households and companies up 14 bp to 5.53%. The deposit rate was more sluggish, rising to 2.35%, a gain of 8 bp compared to December. The marked increase in lending rates has furthermore closed the gap that had opened with shortterm rates (Euribor 1m + 20 bp between November and January). „ We expect the upward trend in interest rates to continue for much of 2007, partly given that a further hike in official rates is likely. Nevertheless, lending conditions should be relaxed both in nominal and in real terms, particularly for companies. „ By sector, the average rate on household loans rose from 5.85% to 5.96%, while that on loans to nonfinancial companies advanced from 5.11% to 5.26%. This was mainly driven by the increases on loans with a

duration of less than one year and those with a duration of more than five years. Note too the significant rise in current account overdrafts, both for households (up to 8.65%) and companies (at 6.14%), which offset the slight drop at the end of 2006. „ The trend in new loans to companies has varied significantly from month to month, and the average rate fell by 20 bp in January, driven by the 32 bp drop in the rate for new loans of over EUR 1 million, which more than offset the 7 bp rise for smaller loans. „ The cost of new loans to households has however embarked on a clear upward trend. The price of new mortgages rose by 20 bp to 5.07%, while that of new consumer loans dropped slightly by 6 bp to 8.71%. The AER on this type of credit fell more sharply however, from 9.76% to 9.62%.

Real cost of new loans

Short-term spread and breakdown

4.0

6.0

3.0

5.0

2.0 4.0

1.0 0.0

3.0

-1.0

2.0

-2.0

1.0

-3.0 Jan 03

Jul 03

Jan 04

Jul 04

Jan 05

Jul 05

Jan 06

Jul 06

Jan 07

MLT rate corporations rate on households' mortgages

„ The estimated overall deposit rate began the new year with a rise to 2.35%, from the previous 2.27%. In particular, the deposit rate including repos gained 6 bp to 1.51%, thanks to a rise of 5 bp on household and corporate current accounts, and of 9 bp on the repo rate. At the same time, the rate on bonds rose from 3.56% in December to 3.62%. At the end of 2007 we expect the overall deposit rate to be around 25 bp higher than it is now, barring further upward pressure resulting from a possible (but not that likely)

0.0 Jan 03

Jul 03

Jan 04

Jul 04

mark-down

Jan 05

Jul 05

Jan 06

Jul 06

Jan 07

mark-up

increase in demand for certificates of deposit, following the proposed introduction of the harmonisation of tax rates on financial returns. „ Spreads have widened. The bank spread was an estimated 3.18% in January, up 6 bp. The short-term spread, meanwhile, widened to 4.85%, reflecting a significant increase in the mark-up from 2.28% to 2.44% and a small decline in the mark-down from 2.48% to 2.41%.

13 Research Department

Views on the Italian economy

Loans Corporate loans still on the up „ In early 2007, active loans posted year-on-year growth of 11%, the highest figure since July 2001. The largest contribution was again provided by the mediumand long-term component, up 11.8%, followed increasingly closely by the short-term segment, which grew by 9.6% y/y. „ The strengthening economic recovery, evidenced by the recent upwards revision of growth estimates for the current year, is helping to finance companies’ current activities and investment. Households’ demand for credit seems however more reactive to rises in interest rates. In general, in 2007, the pace of growth in bank loans is expected to slow, mainly as a result of weaker demand from households. While slowing, average growth is expected to remain at levels not too distant from those registered in 2006. „ In January total loans to the private sector rose by 10.8% y/y, from the previous 11%. This was the result of growth in loans to corporates and to financial companies remaining flat at 11.4% and 8.1% respectively, partly offset by a slight upturn in household demand (+10.4%). At the same time, growth in loans to the public administration slowed slightly, to 4.9%.

„ Demand from non-financial companies again mainly focused on loans with durations of over five years (+14.5% y/y), while there was further confirmation that short-term loans were strengthening (+10.5% for loans of less than one year and +9.7% for the 1-5 year segment). The strong rise in all loan maturities benefited from the favourable trend supporting activity in industry, services and construction, which, until a few months ago, seemed destined to slow. At the end of 2006, growth in loans picked up in all three of these sectors: +7,4% y/y in industry (manufacturing: +6.7%), +12.5% in services and +14,9% in construction. For 2007, we expect lending to companies to remain strong, but slow slightly from the middle of the year, in line with economic trends. „ Annual growth in loans to households remained stable in January , at 10.2% y/y (+9.8% at end-2006). This performance, while down on the highs of 1H06, reflected a slight upturn in growth in mortgages, which rose to 13.3% from its low at the end of 2006 (12.5%), flat consumer credit growth at 12.5%, and the confirmation of an upturn in other loans (+4.4%), which is probably due to the bank’s focus on expanding their offer to households.

Loans to residents (% chg y/y)

Sector contribution to loan growth (%)

21

12

18

10

15 12

8

9 6

6

3

4

0 -3 -6 Dec 00

2 Dec 01

Dec 02

Dec 03

ST loans

Dec 04

Dec 05

MLT loans

Dec 06

Dec 07

Dec 08

Dec 09

overall loans

0 Jan 06 Mar 06 May 06 Households

Jul 06

Enterprises

Sep 06 Nov 06 Jan 07 Other sectors

14 Research Department

Views on the Italian economy

Corporate loans and confidence (chg. % y/y; index)

„ Growth in household loans is also likely to slow in 2007, on the back of interest rate rises and the tax squeeze on property (i.e. higher land registry valuations and ICI property tax, restrictions on tax breaks for renovations), and more house price growth. However, households will still be able to obtain loans given the constant new developments in the credit industry aimed at providing greater flexibility and customised products.

10.0

63 60

8.0

57

„ Credit quality strengthened in 2006. In December annual growth in non-performing loans was 3.9%, with the NPL/total loans ratio at 3.4%, three tenths of a point less than at the end of 2005. Over the year, nonperforming loans grew by 4.7%, bringing the NPL/total loans ratio to 4.5%.

6.0

54

4.0

51 48

2.0 0.0 Dec 01

45 42 Dec 02

Dec 03

Dec 04

loans to corporations (lhs)

Dec 05 PMI (rhs)

Deposits and asset management Direct deposits register positive growth, much smaller advance for assets under management In January, despite slowing slightly, year-on-year growth in direct deposits (harmonised version) remained above 9%, in line with the very strong performance in monetary aggregates in all countries of the eurozone. Among the different types, further growth in bonds (+13.1%) was offset by a slowdown in deposits, from 8% to 6.7%. More specifically, current accounts rose by 5.3%, while growth in repo deposits remained above 20% a year. These performances seem to confirm that savers are looking for satisfactory returns, but are not prepared to risk losing their investment capital. „ Rising interest rates therefore seem to be having an impact on short-term forms of deposits, but not on bonds, which continue to register record growth. This should however slow during the year, in tandem with the performance of long-term loans. The possible harmonisation of the tax rate on financial returns could stimulate a temporary recovery in sight deposits and certificates of deposit.

„ In November 1 growth in indirect deposits was again limited, due to the particularly disappointing performance of asset management. More specifically, annual aggregate growth in nominal terms was 3.2%, vs. 3.3% in October, while the market value of assets under management (securities and funds) fell by 1.7%. „ The “flight” from investment funds also continued in February. Net inflows for the month were negative to the tune of more than EUR 4 billion, taking the debit figure for the first two months of the year to EUR 9.5 billion. At the same time, the value of managed assets fell 2.4% y/y. Net deposits to bond funds were again well in negative territory at EUR - 3.9 billion, as were those to equity funds (EUR -1.4 billion), which were probably affected by stock market volatility. Balanced funds (EUR - 0.5 billion) and money market funds (EUR - 0.7 billion) performed somewhat better. Inflows to the most popular categories at present, flexible (EUR 2.1 billion) and hedge funds (EUR 0.5 billion) were meanwhile in positive territory. The disappointing net deposits figures related to Italian funds (EUR - 4.9 billion), which are clearly increasingly disadvantaged by their uncompetitive tax regime compared to foreign funds.

1

To date, the Bank of Italy has not published figures for the end of 2006.

15 Research Department

Views on the Italian economy

Investment funds: net deposits in the last 3 months (EUR million)

Direct deposits (chg.% y/y) 14.0

3,000 2,000

10.0

1,000 6.0

0 -1,000

2.0

-2,000 -3,000

-2.0

-4,000 -6.0 Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec00 01 02 03 04 05 06 07 08 09 bank bonds

deposits

overall fundraising

„ In January 2007 new business in the life insurance sector was EUR 3 billion, down 13.6% on last year. Traditional policies experienced a particularly sharp decline, while premiums rose by 14.8% y/y in

-5,000 Dic 06 Equity Liquidity

Gen 07 Balanced Flexible

Feb 07 Bond Hedge

index-linked policies and by 16.1% y/y in open pension funds. Premiums were lower than in 2006 for all distribution channels except agents (+1.7%).

16 Research Department

Views on the Italian economy

Banking sector earnings Bank margins (% chg y/y)

Bersani effect on 2007 revenues? „ The outlook for bank accounts has not undergone any significant changes. We have not incorporated an estimate of the impact on 2007 revenues of the possible elimination of fees on maximum overdrafts (set out in the Bersani decree). ABI’s preliminary estimates put this at around 10% of interest income.

10.0 8.0 6.0 4.0 2.0 0.0 2005

2006

Net interest margin

2007

2008

Non-interest margin

2009 Operating costs

17 Research Department

Views on the Italian economy

Banking sector trends 2006-2008 Summaries Bank interest rates on euro-denominated deposits and loans by euro area residents (% per annum; outstanding amounts) 2006 2007 2008 average year end average year end average year end LOANS TO HOUSEHOLDS AND NON-FINANCIAL CORPORATIONS Short term loans (up to 1 year) Short term loans to non-financial corporations Medium and long term loans (over 1 year) Households - for house purchase Medium and long term loans to non-financial corporations

5,04 5,62 5,22 4,79 4,60 4,35

5,39 5,92 5,56 5,17 4,96 4,81

5,69 6,27 5,86 5,46 5,21 5,09

5,81 6,40 6,02 5,59 5,33 5,23

5,78 6,36 5,99 5,58 5,33 5,20

5,72 6,30 5,92 5,50 5,26 5,11

FUNDRAISING FROM HOUSEHOLDS AND NON-FINANCIAL CORPORATIONS Deposits Overnight Bank bonds

2,01 1,19 0,95 3,30

2,27 1,45 1,16 3,56

2,51 1,70 1,39 3,79

2,60 1,80 1,47 3,88

2,60 1,75 1,43 3,86

2,53 1,70 1,37 3,82

SPREADS Short term spread (rate on s/t loans - overnight rate) Overall spread (average rate on loans - average rate on fundraising)

4,67 3,02

4,76 3,12

4,88 3,17

4,93 3,20

4,93 3,19

4,93 3,19

MARKET RATES Refi rate 1m Euribor 3m Euribor 6m Euribor 3yrs Swap 10 yrs BTP

2,94 3,08 3,23 3,67 4,03

3,50 3,64 3,69 3,79 3,97 4,06

3,94 4,03 4,11 3,99 3,96

4,00 4,06 4,13 4,19 3,96 3,92

3,88 3,90 3,77 3,89 3,99

3,75 3,77 3,79 3,58 3,89 4,10

Source: Bank of Italy, Intesa Sanpaolo - Research Department

Bank Aggregates (y/y % chg.; residents; euro e other currencies) 2006 2007 2008 average year end average year end average year end FUNDRAISING Deposits Debt securities

8,3 5,5 10,9

9,0 5,1 12,5

7,1 4,4 10,1

5,8 3,8 8,0

5,3 3,8 7,2

5,1 3,8 6,7

LOANS to HOUSEHOLDS to NON FINANCIAL CORPORATIONS Short term loans to Households to non financial corporations Medium and long term loans to Households to non financial corporations

9,9 12,7 9,1 5,2 -0,3 5,6 12,8 14,9 12,2

10,8 10,4 11,7 9,3 0,2 9,1 11,7 11,9 13,9

9,0 8,3 9,3 7,4 0,5 8,0 10,0 9,4 10,3

7,6 7,3 7,7 6,3 0,8 6,8 8,4 8,2 8,4

6,3 6,8 6,4 4,4 0,9 5,0 7,5 7,5 7,5

5,8 6,3 5,7 3,9 1,0 4,4 6,9 6,9 6,8

Source: Bank of Italy, Intesa Sanpaolo - Research Department

18 Research Department

Views on the Italian economy

Italian banking system - Income statement (% changes y/y) 2005 Net interest income Net interest income with customers

2006

2007

2008

4,0 2,9

8,6 8,7

9,9 10,3

6,8 7,2

8,7 -48,6 11,2 13,2 7,5

5,9 -1,3 7,9 4,8 7,5

5,1 5,1 5,8 4,5 7,8

5,1 5,1 5,8 4,5 6,1

Total income

6,1

7,4

7,7

6,0

Overheads Staff costs (*) Administrative costs and depreciation

4,9 3,5 6,6

4,5 3,5 5,7

4,6 3,7 5,7

4,5 3,5 5,6

Gross operating income

7,7

11,4

11,9

8,0

Non-interest income Trading Services [A] Other financial operations (including dividends) [B] [A]+[B]

Source: Bank of Italy, Intesa Sanpaolo - Research Department

This publication was prepared by Intesa Sanpaolo. The information contained herein has been obtained from sources that Intesa Sanpaolo considers to be reliable, but not necessarily complete, and the accuracy of this information cannot in any way be guaranteed. This publication is provided to you solely for information purposes and is not intended as an offer or solicitation with respect to the purchase or sale of any financial products. This document may only be reproduced in whole or in part together with the name of Intesa Sanpaolo.

19 Research Department