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.

IV. Financial Intermediation and Growth in Italy25

Objectives: To examine whether greater financial market development can spur growth by surveying theoretical and empirical evidence and analyzing the effect of external bond and equity financing on productivity and profitability of Italian firms.

Results: That Italy’s growth prospects would benefit if its financial system moves beyond its currently bank-dominated structure, developing alternative sources of financing.

Policy implications: promote bank competition; reduce listing costs; strengthen and streamline corporate governance, accounting, and disclosure requirements for all corporations, especially groups; further enhance minority shareholder protection; discipline takeovers and insider dealing; level the playing field for companies; reduce the overall administrative burden of doing business, enhance investor protection, including through underwriter regulations and more disclosure in prospectuses, and creditor protection, including through bankruptcy code. Development of the private pension pillar and further public divestment could also help.

A. Financial Development and Growth: Theory and Evidence

1. The association between financial development and growth is well-documented, although the macro evidence is more nuanced at higher per capita income levels. A vast literature suggesting positive correlations between finance and growth dates as far back as (Schumpeter, 1911). More recent waves of cross-country empirical studies, starting from (King and Levine, 1993), indicate that financial development helps boost long-term growth26. Moreover, within-country, industry and firm level evidence links financial development with higher productivity and growth (see Bernstein and Nadiri, 1993, Rajan and Zingales, 1998, Guiso et al, 2004a). However, Favara (2003) challenges the robustness of this result at higher income per capita levels. This may suggest that other factors, such as structure and sophistication of financial intermediation, may be at play in advanced countries.

2. Financial intermediaries may play a key role in boosting innovation and productivity. The theoretical literature clearly establishes the ability of the financial system to allocate funds to highest return projects (i.e., Greenwood and Jovanovic, 1990; Bencivenga and Smith, 1991, and Saint-Paul, 1992), and select more promising innovators (King and Levine, 1993a, 1993b). However, there is little direct empirical evidence on this issue. (Beck et al., 2000) find a positive association between financial development and total factor productivity (TFP) growth, while (Wurgler, 2000) and (Alfranca and Galindo, 2003) find that financial development and reforms have a positive effect on the allocation of investment funds. In addition, sectors most dependent on external (to the firm) finance are found to grow faster in countries with more advanced financial systems (OECD, 2006 and references therein), and such sectors tend to be the most knowledge-intensive. The degree of financial development also affects country’s competitiveness (Rajan and Zingales, 2003).

3. Recent studies suggest that financial structure is an important determinant of country’s flexibility and ability to seize growth opportunities.27 In particular, (IMF, 2006) finds that industrial countries with financial systems dominated by a relationship-based (as opposed to arm’s length-based) lending are less able to change its productive structure to take advantage of growth opportunities, including from globalization.28 The effect is particularly pronounced in countries traditionally specialized in industries with low productivity growth, such as Italy. At the same time, a more arm’s-length financial system allows domestic industries to adapt better to a changing global environment by encouraging investment in new areas and by new firms. In addition, a greater degree of arm’s-length specialization is found to mitigate the impediments to growth stemming from the “low-growth” initial industry specialization. Studies also show a connection between stock market growth (or number of IPOs) and real growth (see Franzosi et. al 2003.)

4. In particular, more arm’s-length financial systems seem more efficient in fostering innovation and hence growth. A specific aspect of the relationship between financial systems and growth relates to the ability of entrepreneurs to develop new ideas, often through setting up a new company. Given the high-risk nature of such start-ups, the market for high-risk capital, in particular, venture capital and other less formal sources of finance, plays a key role in the financing of innovation (OECD, 2006). Thus, arm’s-length lending becomes especially important for knowledge-intensive industries that are critical for growth.29

5. In addition to direct lending channels, capital markets foster growth in other ways:

  • Multiple layers of financing provide a safety valve (Greenspan, 2000) as better diversified financial systems are more capable of providing an adequate degree of intermediation even if one of the components fails. An example is when U.S. banks seized up in 1990 as a consequence of a collapse in the real estate prices, the capital markets were able to substitute for the loss of bank intermediation.

  • The corporate bond market provides competition for the banking sector, forcing innovation and new services, increasing efficiency, better risk-sharing, and, ultimately, lower prices for consumers (Goodfriend, 2005).

  • Long-term, local currency corporate bonds can hedge future retirement, pension, life insurance and entitlement commitments (given monetary stability), while generally short-term bank deposits provide a poor hedge against such needs (Goodfriend, 2005; Sundaresan, 2005).

B. What about Italy?

6. In Italy, the share of external corporate funding—in particular, non-bank—remains low. Internal funding, which so many small firms still rely upon in Italy (Bianco, et. al. 1996), may be an optimal response of the Italian corporate system to inefficiencies in corporate governance, contract enforcement, legal procedures, but it may not be best for growth. Internal financing is usually more important for countries in the early stages of development (Sundaresan, 2005). At the later stages, when firms need more financing to grow, banks are usually the first to provide information-intensive external funding. As the economy develops, the need for external financing increases, especially in faster-growing sectors. At this point, firms with good reputations can lower their cost of capital and access lenders directly with corporate bond funding30. For lower-grade and newer firms, the high-yield bond market offers a less costly venue to raise funds with less collateral and covenant requirements31.

7. Against this background, Italy’s financial sector has expanded significantly, but capital markets remain relatively small (Figures 13). The banking sector remains a core source of funding, accounting for a lion’s share of total system’s financial assets. Stock market capitalization as a share of GDP almost tripled and corporate bond market doubled between 1990 and 2004 (from low bases), but both markets remain below OECD averages. Banks constitute a major source of external finance for the private sector, accounting for about half of all financial sources, above the average. At the same time, due to the rapid bond market expansion, this form of funding has gained importance over recent years, reaching almost 23 percent, above the OECD average.32 Securities markets benefited significantly from the introduction of the Euro (Nierop, 2005), which resulted in lower issuance costs due to the elimination of the currency risk and a widening of the investor base. The recent efforts by the Italian Stock Exchange to adopt best industry standards such as streamlining bond listing procedures and unifying trading platforms for stocks and bonds also helped (Borsa Italiana, 2005), with the first asset-backed securities being issued in 2004.

Figure 1.
Figure 1.

Size of the Financial Sector 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 065; 10.5089/9781451820003.002.A004

Source: World Bank, Financial Structure Database (January 2006 update).1/ Total loans to private sector and securities market capitalization.
Figure 2.
Figure 2.

Stock and Corporate Bond Market Capitalization

Citation: IMF Staff Country Reports 2007, 065; 10.5089/9781451820003.002.A004

Source: World Bank, Financial Structure Database (January 2006 update).
Figure 3.
Figure 3.

The Relative Importance of Loans and Securities

(Average 2000–04)

Citation: IMF Staff Country Reports 2007, 065; 10.5089/9781451820003.002.A004

Source: World Bank, Financial Structure Database (January 2006 update).

8. Italy’s currently low innovative potential also indicates benefits from developing alternative sources of financing. The link between innovation and growth is well-established (OECD, 2003), and Italian scores are low (and declining) in a number of indicators in this area (Figure 4). While the Italian industrial structure, with specialization in mature, medium and low-tech products and with a prevalence of small firms, is an obstacle to the diffusion of new technologies, in particular information communications technology (ICT) (Fabiani et al, 2005), its bank-dominated financial structure may not be optimal for innovation as well. Italian banks tend to support only lower-risk, better collateralized innovative activities, which may not be those generating the most growth (Guiso et al., 2004 a, b). In addition, venture capital—an important source of innovation financing in other countries—is underdeveloped, and is catering more to larger, more established firms with high levels of bank debt rather than to smaller, typically more dynamic, start-ups (Figure 5)33

Figure 4.
Figure 4.

Italy’s Innovation Performance is Poor

Citation: IMF Staff Country Reports 2007, 065; 10.5089/9781451820003.002.A004

Source: OECD, Main Science and Technology Indicators Database.1/ 2002 for Australia, Austria and Portugal; 2001 for Greece.
Figure 5.
Figure 5.

Italy’s Venture Capital is Underdeveloped

Citation: IMF Staff Country Reports 2007, 065; 10.5089/9781451820003.002.A004

Source: OECD, Venture capital database, 2003.

9. Econometric analysis of Italian micro data supports the idea that alternative sources of financing are associated with higher productivity and growth.34 In particular, it shows that:

  • Debt financing has a positive marginal effect on firm’s future investment, revenues, and productivity, while the effect of total leverage on productivity is negative (consistent with Schiantarelli and Sembenelli, 1997). The positive effect of bond leverage is consistent with the theory that financial pressure forces managers to make choices that improve firm’s performance (Jensen and Meckling, 1986).

  • Bond leverage is especially important in high-growth and tech-heavy sectors and for smaller firms. This suggests that bond markets more eagerly provide financing for knowledge-heavy and fast-growing companies that usually have high financing needs, are riskier and have less tangible collateral than mature firms specializing in traditional products.

  • Bond debt mitigates somewhat the (generally negative) effect of concentrated ownership.35 In particular, its effect on productivity is stronger for firms that belong to an industrial group. In addition, higher bond leverage increases firm’s chances to leave the group, although the causality here is not entirely clear due to the lack of data. It could be that bond financing allows firms to split off by providing alternative funding beyond the group’s internal financing, or that firms that are ready to restructure and leave the group are more likely to tap the bond market.

  • Diversification of bank lenders has positive effects on firm’s future growth. Firms that borrow from multiple banks have higher productivity and growth rates. This result is consistent with the previous result about the positive effect of bond debt. In this situation, relationship lending approaches arm’s length lending, especially as the number of banks increases (see Ueda, 2004, and Bris and Welch, 2005)

  • For listed firms, equity and debt financing are strongly correlated with higher productivity and growth. This finding is consistent with survey evidence (Paleari et al, 2005) and suggests that Italian firms list to gain access to new funding—which eases financial constraints and hence enhances performance36—rather than for balance sheet rebalancing purposes. Moreover, listed firms are more likely to operate in high growth sectors, with high capital requirements and leverage.

These results support the hypothesis that deepening corporate and stock markets and strengthening competition in the banking sector could boost Italy’s growth performance by making it more competitive, support industry structure changes, and help diversify away from traditional, low-growth sectors.

C. Policy Implications

10. Accordingly, policies that create the conditions for market-driven development of alternative financing venues should be pursued. These, according to country studies and business surveys, could include the following measures:

  • Removing impediments to stock market development37, in particular, reducing costs of listing—estimated in 2002 at 3.5 to 7 percent of total capital raised, compared to about 0.5 percent cost of listing on NASDAQ38. In this regard, considerable progress has been made by Borsa Italiana, including by differentiating listing and disclosure requirements by firm’s size (Box 1). Additional measures include further enhancing investor protection, including through underwriter regulations and more evaluation disclosure in prospectuses; improving transparency of takeovers and disciplining insider dealing. Temporary tax breaks for firms going public are also shown to spur stock market development without a negative impact on the budget due to higher taxation base (Guidici and Paleari, 2003).

Segmentation of Listed Companies on Borsa Italiana

Borsa Italiana allows companies to list three different segments, according to their size and ambitions for raising capital. Listing requirements, and hence costs of listing vary across segments:

Mercato Expandi, for small firms, with less than €100 million in revenues. Created in December 2003, Mercato Expandi has offered small-sized companies the opportunity of listing, using a €1million market capital minimum for entry level. This segment is characterized by less costly listing requirements, with regards to disclosure, initial float, and third party requirements.

Standard, for medium-sized companies, with revenues between €100 million and €1 billion. This segment also includes so called STARS segment—a market for small and medium enterprises, which voluntary subject themselves to more stringent listing requirements, applied to all large companies (see below).

Blue Chip, for large companies, with more than €1 billion in turnover. Theses companies are subject to all standard transparency, disclosure, governance, and liquidity requirements, in line with international standards.

  • Boosting the development of the corporate bond market. Italy’s legal, regulatory and institutional framework is, overall, adequate.39 However, progress on a number of fronts would be beneficial: simplifying legal frameworks; boosting investor protection and regulatory frameworks that promote self-regulation (i.e. stock exchanges); promoting efficient and transparent primary and secondary markets;40 broadening the investor base, including through the promotion of private pension funds; encouraging market mechanisms for credit risk transfer; and increasing pre-trade and post-trade transparency.41 In this respect, the recent initiatives taken the Italian stock exchange, Borsa Italiana, to transfer bond trading to the same platform used for equities, provision of information, and differentiating listing requirements with respect to firm’s size are all designed to boost listing activity and are in accordance with international practices.

  • Enhancing the effectiveness of corporate governance, accounting, and disclosure requirements, especially for groups. In some areas, Italy has one of the most advanced regulations, including requirements on financial reporting and disclosure, rotation of the external auditors, and the composition of company boards.42 In addition, the 2005 Savings Law, drafted party as a response to the Parmalat and Cirio corporate governance scandals, significantly enhanced investor protection.43 Nevertheless, there is scope to improve the effectiveness of existing regulations, especially since the prevalence of pyramidal groups, high concentration of ownership, and low foreign penetration in the Italian corporate landscape is found to lessen the protection potential built into the legal and regulatory frameworks. 44 This corporate structure has developed largely in response to Italy’s many legal, fiscal, disclosure, and investor protection loopholes, and is exploited for the purposes of limiting liability of a controlling entity; avoiding disclosure; and, by fragmenting capital, for evading taxes and obtaining financial incentives pertaining to small companies. They also put the interests of minority shareholders at risk.45

  • Improving the business environment is paramount to spurring growth and competition. Italy fares poorly on a number of indicators in this area (Figure 6). Particular measures include: level the playing field for companies, in particular in terms of ownership opportunities; reduce the overall administrative burden of doing business; and boost creditor protection, including through the bankruptcy code. Class action legislation currently considered is also a welcome step.

Figure 6.
Figure 6.

Market regulation indices, 2005 1/

Citation: IMF Staff Country Reports 2007, 065; 10.5089/9781451820003.002.A004

Source: OECD and World Bank’s bank regulation and supervision database.1/ The scale of the indicator is 0-1 from least to most demanding. A higher value indicates regulation that is more conducive to financial development.2/ Covers contract enforcement, access to credit, investor protection, and bankruptcy procedures.
  • Further boosting efficiency of the banking system, including by increasing contestability. There has been appreciable progress on this front in the last year, boosted by an encouraging attitude on the part of the Bank of Italy. In fact, more mergers took place last year than in previous five.

11. Moreover, it is important to act on a broad range of issues, exploiting spillovers between measures and markets. Examples include (but are not limited to): positive effects on the stock market development from strengthening the governance and accounting rules for groups (Dalle Vedove et al, 2005); a higher likelihood of firms to go public if they have venture capitalists, private equity investors or banks among their shareholders (Franzosi and Pellizzoni, 2003); and the boost to banking competition stemming from the corporate bond market development. Developing the private pension pillar and further public divestment could also be helpful, in particular by boosting investor the base for equities and corporate bonds.

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25

Prepared by Iryna Ivaschenko (EUR), iivaschenko@imf.org. The author is grateful to the Bank of Italy, in particular, Andrea Generale for assistance with obtaining the data, and seminar participants at the Bank of Italy for helpful comments.

26

For a recent review of literature see, for example, Levine (2004) and Levine (2005).

27

Although the literature finds no optimal growth-enhancing structure of financial intermediation, these results should be interpreted with caution (Demirguc-Kunt and Levine, 2001). Macro studies rely on a wide range of countries at different stages of development, which may obscure the finer structural points that become salient for developed economies. In addition, aggregate indicators of financial structure may not be sufficiently country-specific to accurately gauge national realities.

28

It is important to recognize that the distinction between more or less arm’s-length-based financial systems is slightly different from the more conventional distinction drawn in the literature between bank-based and market-based financial systems. The arm’s-length definition would take into account the degree of arm’s length content within the banking system, such as the degree of competition between banks and the availability of public information.

29

For example, (Benfratello et al, 2006) show that although bank lending in Italy is associated with more investment in innovation, banks tend to favor one type of innovation, shying away from more risky, less collateralized types of innovation activities, typically performed by newer firms.

30

Firms with access to bond financing still rely on bank loans because of other services.

31

This happens usually in good times, when investor appetite for risk is high. However, in bad times, lower-rated firms tend to be priced out of the bond market (Chan-Lau and Ivaschenko, 2003) and need to rely on bank financing.

32

Italian households are also less reliant on capital markets for financing, having smaller holdings of quoted shares than their euro-area counterparts.

33

See Del Colle et al (2006).

34

Panel data estimation using Italian firm balance sheet data from Centrali dei Bilanci and base model by (Campello, 2006). See forthcoming Working Paper for details on methodology, estimation, and results.

35

In Italy, most firms belong to pyramidal groups, with high ownership concentration (see Bianco et. al, 1994, 1996).

36

See (Fazzari, Hubbard, and Petersen, 1987) and many follow-ups for an empirical investigation of investment and financing constraints.

37

(Klapper, Laeven and Rajan, 2004) show that regulation aimed at a better development of financial markets has a beneficial effect on entry of new firms, especially in industries with high R&D intensity or industries with greater capital needs.

39

See Italy—IMF Country Report No. 06/112, March 2006.

40

Examples include the initiative by the U.S. Securities and Exchange Commission with Trade Reporting and Compliance Engine.

41

Examples include GOVPX, the 24-hour source of real time U.S. treasury market prices and data. Pre-trade transparency relates to information about prices and volume opportunities in the markets, such as bid and offer prices and quantities and effective consolidation mechanisms of this information across various dealers. Post-trade transparency relates to the price and volume of all individual transaction that have already taken place.

42

See Italy—IMF Country Report No. 05/44, February 2005.

43

In particular, the Law included new rules on minority shareholder rights and corporate governance rules of listed companies, and on marketing and issuance of corporate bonds and procedures aimed at reducing potential conflict of interests within the financial industry. It also boosted powers of the securities regulator, Consob. See Italy: Selected Issues—IMF Country Report No 05/41, for details.

44

See (Bianco et. al, 1994, 1996) and Italy: Selected Issues—IMF Country Report No 05/41.

45

(Stulz, 2005) also finds that countries with worse corporate governance are characterized with smaller fraction of widely-held firms.

Italy: Selected Issues
Author: International Monetary Fund