Economic Bulletin No. 62 - 2011

The world economy slows down - The global economic outlook worsened abruptly in the course of the summer. Economic activity in the advanced economies slowed significantly, held back not only by temporary factors - the rise in energy prices and the consequences of the earthquake in Japan - but also by persistent slack in employment, a less expansionary stance of fiscal policies and widespread uncertainty over the successful resolution of the financial imbalances. In the emerging economies activity decelerated slightly but keeps growing at a sustained pace. The international organizations cut their global growth forecasts for this year and next significantly.

The cyclical slowdown leads to financial market instability - The sudden dimming of the prospects for growth resulted in pronounced instability on financial markets. The strains affected the sovereign debt of a growing number of euro-area countries, with repercussions on banks' funding capacity and share prices. Volatility increased. A broad-based "flight to quality" fuelled demand for US and German government securities and such safe assets as gold and the Swiss franc; it caused a slide in the prices of shares and corporate bonds, especially bank securities, and provoked an outflow of capital from the emerging countries.

Euro-area growth weakens significantly - The worsening outlook for global growth and the
spreading financial tensions sapped the strength of the economy of the euro area. GDP growth slowed in the second quarter. A further weakening is expected in the third. The monthly €-coin indicator of the underlying growth trend in the area's GDP fell steadily over the summer, and in September was at a level consistent with growth close to nil. Consumer price inflation, which rose in September, should decline over the next few months in response to lower raw materials prices and the global economic slowdown.

The ECB resumes government securities purchases and steps up liquidity support - The EC B Governing Council has taken a series of measures to bolster banks' liquidity and prevent the turmoil from upsetting the smooth functioning of financial markets and hence of the monetary policy transmission mechanism. In August the Eurosystem central banks increased their secondary market purchases of government paper under the Securities Markets Programme. The intervention prevented an aggravation of the tensions. At the start of October the Council further strengthened its tools to support banks' liquidity and therefore their lending capacity with the addition of auctions for one-year refinancing with full allotment and the revival of purchases of banks' covered bonds.

Uncertainty over the adequacy of the available crisis management tools persists - Slowness in setting up crisis management procedures fuelled doubts in the markets as to the adequacy of the euro-area authorities' toolkit. On 21 July a new programme of financial assistance for Greece was approved and measures were taken to enhance the EFSF's effectiveness; their ratification process was completed on 13 October. After narrowing in August, the yield spreads vis-à-vis the German Bund of the government securities of a number of member countries, including Italy and Spain, reached high levels again in September.

Italy is under particularly severe strain - The repercussions of the global economic slowdown and market turmoil were particularly severe in Italy. Despite the fundamental soundness of the banking system, the low level of household debt and the absence of significant property market imbalances, Italy was hit hard by the crisis as a consequence of its large public debt, dependence on world trade, and poor medium-term growth prospects.

Growth slows in Italy in the third quarter ... - Italy's GDP rose by 0.3 per cent in the second quarter after virtually stagnating for six months. Growth continued to be sustained principally by exports, while domestic demand remained feeble. During the third quarter the economic picture worsened. The latest indicators confirm the weakness of domestic demand, which is depressed by the poor employment outlook and mounting uncertainty over the general economic situation. Exports are languishing in a context of less lively world demand.

... while inflation rises temporarily - In September twelve-month consumer price inflation rose to 3.1 per cent. Prices may well have already partly incorporated the VAT increase enacted at the start of the month, which will continue to exert modest upward pressure through the autumn. Core inflation remains low. The pressure on input costs is easing, as the latest business surveys indicate.

The banks are sound, but market tensions are affecting their funding capacity - The fundamental conditions of Italian banks remain sound. In the first half of 2011 the profitability of the top five groups was unchanged from a year earlier, albeit at a low level. Capital ratios benefited from the capital increases carried out by some groups. Nevertheless, the financial market turmoil has affected banks' wholesale funding costs and capacity. Lending growth remained high, though decelerating, in August, but there is a risk that the protraction of the tensions may increasingly influence the terms of access to credit.

The Government passes two budget adjustments during the summer - In the summer, in response to the strains in the financial markets, the Government passed two public finance adjustment packages for the four years 2011-14. The first package, enacted in early July, was designed to achieve a budgetary position close to balance in 2014, in line with Italy's European commitments. In the face of aggravated market tensions, on 13 August the Government enacted a second decree law to bring forward to 2013 the achievement of a balanced budget. During its parliamentary passage, the decree was reinforced by a series of amendments, focusing chiefly on the revenue side. Together, the two packages provide for reductions of net borrowing officially estimated at €3 billion in 2011, €28 billion in 2012, €54 billion in 2013 and €60 billion in 2014. About a third of the adjustment in 2014 will come from spending cuts, a third from revenue increases, and a third from the enabling act for tax and welfare reform. In addition, some initial measures to foster economic growth were taken. They include rules liberalizing local public services and access to and exercise of economic activities. The rules on trade union representation and the possibility for company-level contracts to derogate from the terms of industry-wide collective bargaining agreements, introduced by a recent agreement between employer and trade union confederations and extended by Law 148/2011, broaden the scope for company-level bargaining, permitting closer alignment with the conditions of individual firms.

Now the provisions for growth have to be strengthened - The tensions affecting Italy make it all the more urgent to adopt economic policies that guarantee the consolidation of the public finances, thereby helping to contain interest rates, and tackle the country's structural deficiencies in order to sustain growth and facilitate fiscal adjustment.

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