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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 
"