This Selected Issues paper applies a range of methods to assess Italy’s competitiveness gap versus other euro area members. All indicators point to a clear erosion of competitiveness in recent years, with related market share losses. Nonetheless, the estimated competitiveness gap, while appreciable, still remains quantitatively contained. The results suggest that the unwinding of the competitiveness gap will require reforms that boost productivity growth and continued wage moderation, as well as an adjustment by export firms in Italy.

Abstract

This Selected Issues paper applies a range of methods to assess Italy’s competitiveness gap versus other euro area members. All indicators point to a clear erosion of competitiveness in recent years, with related market share losses. Nonetheless, the estimated competitiveness gap, while appreciable, still remains quantitatively contained. The results suggest that the unwinding of the competitiveness gap will require reforms that boost productivity growth and continued wage moderation, as well as an adjustment by export firms in Italy.

I. Italy : How Large is the External Competitiveness Gap?1

Objective: To apply a range of methods to assess Italy’s competitiveness gap versus other euro-area members.

Results: All indicators point to a clear erosion of competitiveness in recent years, with related market share losses. Nonetheless, the estimated competitiveness gap, while appreciable, still remains quantitatively contained (up to 8 percent).

Policy implications: Reforms that boost productivity and promote wage moderation are key to restoring competitiveness.

1. Italy’s persistent loss of market share and weak export growth in recent years have raised concerns about its external competitiveness. Broad-based measures of competitiveness which include non-price indicators (such as business efficiency) also suggest Italy’s competitive position is weak and has deteriorated sharply. For example, in the World Economic Forum’s global competitiveness ranking for 2006, Italy was placed 42nd out of 125, while under the International Institute for Management’s methodology, the Italian economy ranked 56th out of 60 countries in the 2006 listing, dropping some thirty places since the late 1990s.

2. A number of analysts have associated the loss of export markets with a range of structural factors. These include the unfavorable specialization of the Italian economy (Felettigh et al, 2005) in relatively slow-growing sectors of world demand, with rapid changes hampered by low levels of R&D investment, human capital, and competition (Faini and Sapir, 2005); comparatively weak inward FDI, with low and decreasing shares in high technology industries (Mariotti et al., 2002); and insufficient competition in domestic markets which provide inputs and services to export sectors (Isae 2005; and Allegra et al., 2004). These structural factors have been accompanied by a marked slowdown of productivity growth (Bassanetti et al, 2006; and Bassanetti and Zolino, 2004), with an ensuing deterioration in cost competitiveness, which seems to be at the core of Italy’s weak export performance.

A. Constant Market Share Analysis

3. Italy’s exports have been falling behind. Based on the UN’s COMTRADE database, the Italian share of the world export market, in value terms, has declined by about 20 percent since the mid-1990s (Figure 1). In volume terms, based on national accounts data for real exports of goods and services including cross border intra-euro area trade, Italy’s market share declined some 38 percent since 1993, compared to a fall of some 2 percent for the euro area as a whole. In the more recent period (2000–05), real export growth (goods) averaged about 1 percent compared to overall growth in the Italian export market of some 6 percent per year according to World Economic Outlook (WEO) data.

Figure 1.
Figure 1.

Export Share in World Market

(In percent)

Citation: IMF Staff Country Reports 2007, 065; 10.5089/9781451820003.002.A001

4. Constant market share analysis can pinpoint the causes of export market growth. It entails decomposing the change in Italian exports between any two periods into four effects:

  • The global market growth effect. This indicates the part of export growth that is due to the expansion of overall world trade. The magnitude of this effect shows the potential growth of Italian exports when its share of world export market is kept constant.

  • The commodity composition effect. This is the weighted sum of values of exports of different commodities. The weights are the deviations of the growth rates of individual commodity exports from the growth rate of aggregate world exports. For instance, the commodity composition effect would be negative if Italy had concentrated its exports on commodities with relatively slow global growth.

  • The market distribution effect. This measures the change in exports due to market distribution and depends on trade policy and income growth of the countries that are recipients of Italian exports. In general, this effect would be positive if Italian exports had gone to countries where demand growth was faster than the global average.

  • The competitiveness effect. This residual term can be used to measure export competitiveness, the gain or loss in export growth that cannot be attributed to global growth, growth of trade partners or growth in demand for the products in which Italy specializes.

5. The results suggest the bulk of export market loss was associated with deteriorating competitiveness (Table 1). The world trade effect, after allowing for the commodity composition and market distribution effects, would have implied annual export growth of 8.6 percent in the period 1994–2004. But actual exports only grew at 6.4 percent, the difference being due to weak competitiveness. Had the competitiveness contribution been neutral, Italian exports in 2004 would have been 20 percent higher.

Table 1.

Italy: CMS Analysis of Export Changes 1/

(in percent; unless otherwise indicated)

article image
Source: IMF Staff estimates.

Constant market share analysis based on the commodity composition of exports as of 1994.

B. Aggregate Measures of Competitiveness

Real effective exchange rate (REER) measures

6. Italy has experienced significant CPI-based and ULC-based real appreciation since the mid-1990s, against both euro-area and non-euro-area competitors. This reflected a significant rise in unit labor costs and the impact of the euro’s sharp appreciation in 2002 and 2003. Most of Italy’s real appreciation took place between 2000 and 2005, when Italian unit labor costs in the manufacturing sector rose close to 20 percent faster than for euro-area competitors and some 15 percent faster than for competitors in the rest of the world (Table 2 and Figure 2). In 2005, unit labor costs in Italy again rose rapidly, driven by a decline in labor productivity.

Table 2.

Italian Unit Labor Costs, Total Economy, 1998–2005

(Annual changes in percent)

article image
Sources: Ameco database, OECD; and Fund staff calculations.
Figure 2.
Figure 2.

Manufacturing Unit Labor Cost

Citation: IMF Staff Country Reports 2007, 065; 10.5089/9781451820003.002.A001

Source: OECD, Analytical Database.

7. While REER analysis is useful to assess changes in competitiveness, it provides only limited insight into the level of competitiveness. For a start, assessing the level requires determining an equilibrium base period. For Italy, the late 1990s are generally considered “benchmark” years—based on current account and export developments. From 1998 until the end of 2005, Italy’s unit labor cost-based real effective exchange rate has appreciated by some 20 percent (Figure 3). However, changes in the quality and composition of production, entry into the euro area, and the margin of uncertainty about determining an equilibrium base period, preclude definitive statements about Italy’s current competitiveness gap on the basis of this approach. Another caveat is that comparator countries are weighted by actual trade shares, with possibly too little weight on actual and potential third country competitors.

Figure 3.
Figure 3.

ULC-based Real Effective Exchange Rate

Citation: IMF Staff Country Reports 2007, 065; 10.5089/9781451820003.002.A001

Source: IMF, International Financial Statistics.

Profit share indicators

8. Manufacturing profitability can shed light on competitiveness. The ratio of wage costs per employee to value added (in current prices) per person in manufacturing provides a measure of relative profit shares in the tradables-intensive sector of the economy. Alternatively, export margins can be derived by dividing the deflator of exports of goods by the unit labor cost in manufacturing. These measures improve on ULC-based REERs by taking into account variations across countries in the price of tradables output/exports, in addition to cost considerations (Lipschitz and McDonald, 1991), though caveats apply.

9. Italian exporters seem to have maintained profit margins. To the extent that comparisons of the levels of export margins across countries are meaningful (that is, production technologies are similar), 2005 data suggests that Italian firms have managed to maintain margins despite the deterioration in competitiveness (Figure 4), and they have done so by fully passing on to export prices the increases in unit labor costs (Figure 5).2 The deterioration in relative export prices for Italy corresponds with the deteriorating competitiveness and declining market shares. At the same time, the ratio of wage cost per employee to value added suggests no cost advantage for Italy relative to other euro area competitors (Figure 6).

Figure 4.
Figure 4.

Export Margins

Citation: IMF Staff Country Reports 2007, 065; 10.5089/9781451820003.002.A001

Figure 5.
Figure 5.

Relative Export Prices

Citation: IMF Staff Country Reports 2007, 065; 10.5089/9781451820003.002.A001

Figure 6.
Figure 6.

Ratios of Wage Costs to Value Added 1/

Citation: IMF Staff Country Reports 2007, 065; 10.5089/9781451820003.002.A001

Sources: OECD, STAN Database ; OECD, Analytical Database ; and IMF staff estimates.1/ Wage bill per employee in manufacturing, as ratio of value added per person employed.

Purchasing power parity (PPP) exchange rates

10. PPP measures can help shed light on fundamental exchange rate misalignment. In contrast to REERs, the ratio between the actual exchange rate and the PPP exchange rate aims to assess levels of current exchange rates against their long-term equilibria. The PPP exchange rate compares the cost (in national currency) of a similar basket of goods (typically that of GDP) in two countries. For countries at close to the same level of development, ratios of the market rate to the PPP rate above one indicate overvaluation and below one undervaluation. For such countries, this is a particularly powerful tool because it measures over or undervaluation directly, rather than indirectly via the presumption that any change in the real value of a currency is a movement toward or away from a static equilibrium.

11. PPP analysis suggest that Italy’s exchange rate is not currently misaligned, but has appreciated significantly. At end-2005, the actual PPP exchange ratio was 97 percent of that of the euro area, compared to 77 percent in 1995 and 91 percent in 1998. Using the PPP exchange rate ratio consistent with countries’ GDP per capita as a norm, the actual Italian PPP exchange rate ratio was the only one among large euro-area countries to deteriorate, as the ratio of the market rate to the PPP rate in these countries declined while in Italy it increased (Figure 7). Such appreciation also occurred in other Southern European Countries (Portugal, Spain and Greece), at varying rates, but in these countries it largely reflected a catch-up in terms of relative income, a process Italy is not subject to (Figure 8).

Figure 7.
Figure 7.

PPP Exchange Rate Ratio and GDP per Capita, 1998; 2005 in bold 1/

Citation: IMF Staff Country Reports 2007, 065; 10.5089/9781451820003.002.A001

Sources: OECD; IMF, World Economic Outlook; and IMF staff estimates.1/ The slopes of the illustrative regression lines resulted from panel estimation on data for 1980–2001 for the EMU countries and for 1993–2001 for the CEC countries. Regression 1 assumes no fixed-country effects; regression 2 assumes fixed-country effects. For both, the estimator was OLS on first differences.2/ Both relative to the euro area. A higher ratio indicates a more appreciated market rate.3/ Euro area average = 100.
Figure 8.
Figure 8.

Market Exchange Rate Compared to the PPP Exchange Rate, 1980–2005 1/

Citation: IMF Staff Country Reports 2007, 065; 10.5089/9781451820003.002.A001

Sources: IMF, World Economic Outlook ; and IMF staff calculations.1/ The market exchange rate as a ratio of the PPP exchange rate (relative to euro area). A higher ratio indicates a more appreciated market rate.

C. Macro Model-based and/or Econometric Estimates of Equilibrium Exchange Rate

Current-account based estimates

12. Reducing Italy’s current account deficit to its norm would require a real depreciation of some 7 percent. Using the methodology in IMF (2006),3 the macro approach which compares the underlying external current account with a norm or target, we derive the underlying current account by adjusting the actual current account for “transitory” elements, including the cyclical position. The norm is derived from medium-term savings and investment balances or from current account positions needed to achieve a certain net foreign asset position. The gap between the underlying current account and the norm is then mapped into a gap between the actual and equilibrium exchange rate. In the case of Italy, applying the coefficient estimates from panel regressions for the period 1973–2004 yields a mid-point estimate of the current account norm of 0.5 percent of GDP at end-2005 (compared to the actual underlying current account deficit of 2 percent of GDP in 2005), which maps into a mid-point estimate of overvaluation of 7½ percent.

13. Stabilizing Italy’s external indebtedness would require a similar real depreciation. Given the theoretical and practical difficulties associated with estimating current account norms, one can also look at the improvement in competitiveness (as measured by the REER) required to achieve a current account balance that would stabilize net external liabilities around current levels. The estimated midpoint REER overvaluation is close to 6 percent (within a range of 5 to 8 percent) assuming a real effective exchange rate elasticity of the trade balance in the range of 0.2 to 0.15 (derived from estimates of elasticities of export and import in Isard and Faruqee (1998), and taking into account Italy’s degree of openness).

Real exchange rate equilibrium based estimates

14. Equilibrium REER-based estimates suggest an overvaluation of about 8 percent. Equilibrium REERs are another tool to assess exchange rate misalignment (and can help address the underestimation in current account models). Using the methodology in IMF, 20064 the equilibrium exchange rate can be derived from reduced-form panel cointegration regressions, relating the real effective exchange rate to a set of underlying fundamentals (Figure 9).5 Both the productivity differential (a lower productivity growth in the tradables sector (than in the non-tradables sector) and lower terms of trade helped push the equilibrium real exchange rate down since the early 1990s. The real exchange rate overvaluation for Italy as of end-2005 is estimated at 8 percent for the 2005 fundamentals. Despite the usual shortcomings of such studies (large estimation errors and the fact that results are contingent on the assumptions of particular models), the current model estimates seem to be in line with earlier estimates of the equilibrium real exchange rate for Italy carried out following euro adoption, which also found only a slight deviation from equilibrium at the time of euro adoption, with most estimates in the range of 1 to 4 percent undervaluation at that time (Alberola et al., 1999; Couharde and Mazier, 2001).

Figure 9.
Figure 9.

Italy: Real Equilibrium Exchange Rate, 1980–2006

Citation: IMF Staff Country Reports 2007, 065; 10.5089/9781451820003.002.A001

Source: Fund staff estimates.

D. Conclusion

15. Italy’s persistent loss of market share and weak export growth since the mid-1990s coincided with deteriorating cost competitiveness. Constant market share analysis suggests that annual export growth since the mid-1990s was some 1.8 percentage points lower than it would have been in the absence of a competitiveness gap.

16. A range of indicators suggests an appreciable, albeit not large, competitiveness gap versus other euro-area members. Italy’sunit labor cost-based real effective exchange rate has appreciated by some 20 percent since 1998, generally considered a benchmark year. Complementary methodologies to estimate the real exchange rate misalignment at end-2005, including a current account (macroeconomic balance) approach, a reduced-form equilibrium real exchange rate approach using determinants drawn from cross-country panel data analyses (net foreign assets relative to exports, terms of trade, labor productivity, and government consumption), and an external sustainability approach, suggest a competitiveness gap in the range of 5 to 8 percent.

Summary Exchange Rate Assessment, 2005 (in percent, unless otherwise noted)

article image
Sources: National authorities; Eurostat; OECD; and IMF staff estimates.

The benchmark year is when the exchange rate was considered to be appropriately valued considering factors including the size of the current account deficit, export growth, and GDP growth.

ULC-RER, unit-labor-cost-based real exchange rate.

Ratio between the market exchange rate and the PPP exchange rate (both relative to euro area).

Norm is the PPP exchange rate ratio consistent with a country’s GDP per capita.

ERER Approach, using 2005 fundamentals.

Assumes an implicit trade elasticity of 0.18, reflecting Italy’s degree of openess.

As of end-2005.

17. The unwinding of the competitiveness gap will require reforms that boost productivity growth and continued wage moderation, as well as an adjustment by export firms in Italy, with a reorientation of the model of specialization toward more dynamic sectors, a process that may have already started in response to the measured loss of competitiveness.

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1

Prepared by Paulo Drummond (EUR), pdrummond@imf.org.

2

IMF Country Report No. 05/401.

3

“Methodology for CGER Exchange Rate Assessments” (http://www.imf.org/external/np/pp/eng/2006/110806.pdf).

4

Idem.

5

Lagged net foreign assets to trade, productivity of tradables versus nontradables relative to trading partners, commodity terms of trade, government consumption to GDP ratio, and an index of trade restriction.

Italy: Selected Issues
Author: International Monetary Fund