Economic Bulletin No. 61 - 2011

The prospects for growth and the performance of the financial markets are weighed down by the sovereign debt crisis in the euro area. In recent weeks the tensions have increased and spread, now also involving Italy.

The world economy continues to grow, but more moderately - The world economy slowed in the first quarter of 2011, restrained by the slackening of growth in the United States and the sharp contraction in Japan, where the economic repercussions of the earthquake have proved worse than expected. In the emerging countries output has continued to expand at a rapid pace, although signs of a slowdown have been observed in some.

Inflation increases, especially in the emerging economies - Commodity prices, which had risen in previous months, declined in the second quarter, although not below the levels obtaining at the beginning of the year. In the advanced economies core inflation remains fairly low; the rise in raw material prices has not significantly affected inflation expectations. In the emerging countries, on the other hand, higher commodity prices are driving a sharp rise in inflation, which is being countered with measures to make monetary conditions less accommodating.

Euro-area growth strengthens in the first quarter, and continues at a more moderate pace in the second - The acceleration in euroarea GDP in the first quarter of the year reflects the recovery of investment in construction - which had contracted in earlier months, especially in Germany, owing to bad weather - and faster growth in expenditure on capital goods. The expansion in output appears to have continued in the second quarter at a more moderate pace. The €-coin indicator developed by the Bank of Italy, which estimates quarterly economic growth net of the most volatile components, fell slightly in June.

The ECB Governing Council raises official interest rates - Inflation as measured by the harmonized index of consumer prices in the euro area rose to a twelve-month rate of 2.7 per cent in June. To contain the risk of an increase in inflation and to prevent a worsening of expectations, in July the Governing Council of the ECB increased its minimum rate on main refinancing operations by 25 basis points to 1.50 per cent. The main government and private forecasters estimated that inflation would fall back below 2 per cent in 2012.

Tensions in the financial markets increase ... Volatility in the financial markets began to increase again in spring, as a result of mounting uncertainty about the strength of the international recovery and renewed pressures on euro-area sovereign debt. Despite the fact that Greece's Parliament approved a new package to adjust the public finances, and the Eurogroup decided on 2 July to disburse a further tranche of the loan to Greece, since the start of June pressures on the financial markets have increased and spread as a result of the persistent uncertainty about the outlook for the public finances in some countries.

... and also affect Italy - In the last few days, these tensions have also affected Italy. This is reflected in share prices and the spread between 10-year BTP yields and those of the corresponding German bonds, which reached its highest level since the beginning of the Monetary Union, making consolidation of the public finances even more urgent.

The Government presents its package to balance the budget - On 30 June the Government drew up a package for the public finances to achieve a balanced budget in 2014 and to rapidly reduce the debt/GDP ratio. This took the form of a decree law and a draft enabling law for fiscal and social welfare reform. In the original draft, the measures of the decree law were valued at almost €18 billion in 2013 and more than €25 billion in 2014; the measures to be defined with the implementation of the enabling law would have reduced the deficit by almost €2 billion in 2013 and €15 billion in 2014. The amendments to the decree law introduced during parliamentary discussions strengthened the package and further improved the budget outturns for the four-year period 2011-14.

The budgetary adjustment is in addition to the measures approved in 2010, which in 2012 were already officially estimated to bring the deficit below the threshold of 3 per cent of GDP and achieve an initial reduction in the debt ratio.

Growth in Italy continues to be modest in the first quarter ... In the first quarter of this year growth in Italy was barely positive. Compared with the last part of 2010, an improvement in exports was offset by stagnant domestic demand. Households' spending decisions were affected by the weak growth in real incomes, which are held back by conditions in the labour market and accelerating consumer prices.

... but catches up with the euro-area average in the second - According to Bank of Italy estimates, growth nonetheless gathered pace in the second quarter and proceeded in line with the euro-area average. It was sustained by the recovery in industrial production, which ended the stagnation dating back to the previous autumn. The latest cyclical indicators suggest that the strength of the recovery is uncertain: after accelerating in April, industrial activity weakened.

Inflation has risen but should fall gradually towards the end of the year - In June inflation, as measured by the consumer price index, rose to 2.7 per cent. Excluding the energy and food components, it amounted to 2.0 per cent. Consumer price inflation is expected to decline to below 2 per cent in 2012 as the effects of the rise in commodity prices wear off.

The growth in lending remains strong and bank profitability improves - Bank lending to the private sector continues to expand at a rapid pace, faster than the euro-area average. Credit institutions' fundraising has accelerated significantly. Their profitability has improved, thanks to increased operating profit and a reduction in provisioning and value adjustments for deterioration in loan quality. Largely as a result of capital strengthening, the capital ratios of the largest Italian banking groups have risen significantly. The core tier 1 ratio rose from 7.4 in December to 7.8 in March and is estimated to have risen further, to about 8.6, thanks to recapitalizations completed since then.

Italian growth will remain moderate - We project Italian GDP growth of 1.0 per cent his year and 1.1 per cent in 2012. The main contribution to growth will continue to come from exports, but given the simultaneous expansion of imports the net contribution of foreign trade will be practically nil in 2011 and slightly positive in 2012. The recovery in investment will strengthen gradually. Consumption will grow less than GDP.

The risks - The macroeconomic scenario is subject to considerable uncertainty. The main risks involve the possible slackening of the global recovery and developments in the sovereign debt crisis within the euro area. In the short term the cost of the recent widening of yield spreads on Italian government securities will be limited, but if the current spreads were to persist they would entail very substantial costs for the public finances and have repercussions on the cost of finance to the economy. The consolidation of the public finances is essential to foster a fall in risk premiums, a decline in long-term interest rates, and hence the expansion of economic activity. The Government's budget package is a step in this direction. Recourse to increased taxation must be limited. The public finance correction must be accompanied by credible and effective structural measures to raise the potential growth rate of the Italian economy.

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