BANCA D’ITALIA
ABRIDGED VERSION OF THE
REPORT
FOR THE YEAR 1979
PRESENTED BY THE GOVERNOR TO THE
ORDINARY GENERAL MEETING OF SHAREHOLDERS
HELD IN ROME ON 31 MAY, 1980
ROME PRINTING OFFICE OF THE BANCA D’ITALIA 1980
ABRIDGED VERSION OF THE REPORT
FOR THE YEAR 1979
PRESENTED BY THE GOVERNOR TO THE
ORDINARY GENERALMEETING OF SHAREHOLDERS
HELD IN ROME ON 31st MAY, 1980
ROME
PRINTING OFFICE OF THEBANCA D'ITALIA 1980
CONTENTS
Page
I. Tbe Intemational Economy 9
II. The ltaIian Economy . 25 FORMATION OF INCOME AND ECONOMICDEVELOPMENTS 25 Domestic demand 34 Domestic supply 38 Employment, wages, prices and the distribution of income 49 THE BALANCE OF PAYMENTS 62 PUBLIC FINANCE .•...• 73 MONEY AND FINANCIAL MARKETS 78 The centraI bank's operations and the regulation of the monetary base 82 Banking 91 The capitaI market 104 The activity of the special credit institutions 117 TotaI f'mancing and the fonnatian of f'mancial assets 131 THE SUPERVISION OF CREDIT INSTITUTIONS 137
m. Tbe Gavemor's Coocluding Remarks 149 Tbe new oi! crisis 153 Intemational liquidity 155 The European Monetary System and the exchange rate 158 The domestic economy 160 The roots of inflation 164 Monetary and credit developments 168 Financial intermediatian, business f'mance and the State 173
IV. Tbe Bank's Capitai and Reserves 181
V. BaIance Sheet and Profit and Lass Account 183 List of abbreviations . 189 LIST Of TABLES
Page L Economie indicators in the EEC and in other industrial countries ...... lO 2. Consumption, disposable income and average propensity to consume of households 35 3. Gross fixed investment in EEC countries ...... ,...... 36 4. Public and private gross f1Xed domestic investment by branch of economie activity 37 5. Investment and saving .•...... " .... 38 6. Marketable production and value added in agriculture 39 7. Value added at market prices in industry 41 8. Index of industrial production ...•.... 45 9. Value added at market prices of marketable services 46 lO. Sources and uses of energy 48 11. Employment in Italy .•... 50 12. Gross minimum contractual wages 55 13. Wholesale prices ..... 57 14. Retail prices and cost of living 59 15. The distribution of income 60 16. Indices ·of the inequality of individual incomes from employment 61 11. Balance ofpayments on a transacHons basis 63 18. Italy's external f'mancial position ...... •. 64 19. Capital movements ..•.•..•...•.... 68 20. External position of the Banca d'Italia, the Italian Foreign Exchange Office (VlC) and banks ...•...... 70 21. Italy's foreign debt and official reserves ...... 71 22. Trade-weighted effective exchange rate of the lira vis-à-vis quotations on 9th February 1973 ....•...... 72 23. Public sector: cash operations ...... 74 24. The State sector borrowing requirement and its f'mancing 77 25. Monetary and credit aggregates and interest rates 84 26. Monetary base ..•...... 85 27. The activity of the banks: iridicators 93 28. Banks' assets and liabilities 96 29. Banks: securities portfolio 101 30. Market shares of banks 102 31. Profit and loss accounts of the banks: formation of profit 103 32. Net issues of bonds and government securities 105 33. Short, medium and long-term securities 106 34. Net purchases of bonds by class of investor 108 35. Average maturity yield on f'1xed-interest bonds 112 36. Share capital by class of investor ..•.. 115 37. Assets and liabilities of the special credit institutions 119 38. Fvnd-raising sources of the special credit institutions 122 39. Domestic lending by the special credit institutions by sector 123 40. Domestic lending by the special credit institutions by class of borrower 124 41. Financing of investment in housing •.. 127 42. Lending by the agricultural credit system 129 43. Export credits .•...... 130 44. The f'mancial assets of the Economy and total f'mancing 132 45. Financing of domestic f'mal-user sectors ...... 133 46. Total domestic credit .•.•..•...... 134 47. Components of the banks' and the special credit institutions' capital base 144 LIST OF CHARTS
Page 1. Capacity utilization in industry (excluding construction) 44 2. Value added, employment and hourly productivity in industry excluding construction ...•.•...... •. 52 3. Currency holdings and interest rate on bank deposits 90 4. lnterest rates and bank credit ...... 111m i••11 5. Bank loans and industriai production 99 6. Bond Yields and net issues by class of investor 109 7. Net public investment and disinvestment in f'1xed-interest securities and the expected yield ...... •••..... 110 8. Tfme]yield curves ...... 113 9. Prices, yields and other share market indicators 116 lO. Outlays of the special credit institutions •.• 111m i••11 11. Credit, money and fmancial assets of households and fmns 136
I - THE INTERNATIONAL ECONOMY
Production, the structure of demand, employment and prices
In 1979 the growth in productive activity and employment in the OECD area was not significantly different from that recorded in the two previous years. The 3.4 per cent increase in real GNP (compared with 3.9 per cent in 1978 and 3.5 per cent in 1977) was in line with the downward trend of growth rates during the 'seventies and was only just large enough to offset the rise in the labour force, so that the average rate of unemployment remained virtually unchanged (5.1 per cent). On the other hand, the new oil crisis caused a sharp rise in inflation and a worsening of balance-of-payments positions as well as of the general economic prospects for 1980. Last year saw an average increase in OECD prices (as measured by the private consumption deflator) of 8.5 per cent, as against 7.2 per cent the year before. This was coupled with a current account deficit of 34 billion dollars, whereas at the beginning of the year a further reduction in inflation and balance-of-payments equilibrium had been expected. The resurgence of inflation led policy makers to give priority to the objective of monetary stability and, therefore, to maintain or accentuate the restrictive stance of economic policy. The GNP growth rates of the major western countries varied widely. That of the United States, which had provided the main support to economic activity in the OECD area in the three previous years, fell by a half. Faster growth in Western Germany, Italy and the smaller countries, together with unchanged rates of growth in Japan and France, offset the slowdown in the United States and the United Kingdom (Table 1). Real private consumption provided the basis for growth in all the OECD countries. In the United States, France, Italy and Japan households' propensity to save declined. In particular, in the United States — where the expectations of a recession in the second part of the year were upset by the rise in private consumption — the proportion of disposable income that households saved fell in 1979 to the lowest ever average value of 4.5 per cent, as against more than 7 per cent in the early 'seventies. Table 1 ECONOMIC INDICATORS IN THE EEC AND IN OTHER INDUSTRIAL COUNTRIES (percentage changes)
10 The higher level of company profits and the improvement in the financial position of enterprises permitted a small increase in private non- residential investment. This was mainly in machinery and equipment rather than plant and buildings, in line with the post-1973 tendency to rationalize existing productive structures instead of expanding capacity. However, this strengthening of investment demand only offset a part of the fall in the accumulation rate recorded by the industrial countries as a whole after 1973. This slower rate of accumulation is one of the factors underlying the slowdown in the rate of increase in labour productivity in the last few years. Public expenditure played a negligible role in 1979 — in contrast with what happened in most of the 'seventies. This reflected the aim — common to most of the OECD countries — of reducing public sector deficits in order to fight inflation and, in some cases, the fact that their expansion was anyway considered to be excessive. The change in the level of inventories and the balance of the current account in real terms contributed virtually nothing to the growth in demand in 1979 as a whole. The limited growth in GNP did not permit a significant recovery in employment in the OECD area. Only in Western Germany and Canada was there a marked improvement in labour market conditions (Table 1). The acceleration in the rate of increase in prices, to which the rise in the price of oil made a decisive contribution, was common to all the industrial countries and particularly sharp in the United Kingdom, Italy and the United States. The dollar price of the OECD's oil imports rose by 36 per cent in 1979 (compared with 2 per cent in 1978), while that of the area's exports of manufactures rose by 14 per cent (compared with 15 per cent in 1978). There was thus a considerable deterioration in the industrial countries' terms of trade. The increase in the price of oil was coupled with an upturn in those of raw materials, the decline in which (2 per cent) had made a major contribution to the slowdown in the rate of inflation in 1978. In 1979 the dollar prices of the OECD's imports of non-oil raw materials rose by 16 per cent. The rises in domestic costs were less marked. The moderate growth in productivity, coupled with a still relatively limited increase in wages, resulted in industrial unit labour costs rising in most of the OECD countries at rates close to those recorded in 1978 (Table 1). Japan,
11 Western Germany and France were exceptions in that they achieved large gains in productivity.
Domestic economic policies
In the main industrial countries taken together the effect of fiscal policy on income, as measured by the ratio of the change in the public sector's net borrowing to the GNP of the previous year, was neutral in 1979 after showing a half percentage point positive value in 1978. In Western Germany the measures taken in 1978 to support demand continued to produce their effects in 1979. Japan, albeit to a much lesser extent, showed a similar pattern. In both these countries, however, there was a reversal of fiscal policy during the year, and this is likely to have a deflationary impact in 1980. In the United States fiscal policy produced a mildly restrictive effect in 1979, in line with the tendency of recent years. Finally, in the United Kingdom, Canada and France fiscal policy was moderately expansionary in 1978 and in the first few months of 1979, but restrictive for the latter year as a whole. Monetary policy in the main industrial countries also took on a restrictive stance during 1979, a phenomenon that became more marked towards the end of the year and in the first few months of 1980. This restrictiveness was justified by the need to curb inflation and, in a number of countries, to forestall or limit the depreciation of national currencies against the dollar after the restrictive measures taken by the US authorities. The generalized downward revision of the targets for the growth of monetary aggregates that took place during the year was accompanied by repeated increases in official discount rates. In view of the limited and delayed effect of discount rate policy on nominal income, monetary authorities also had recourse to direct control of monetary aggregates at a time when, in the second half of the year, economic activity was running at a higher level than expected and inflation was accelerating. Such measures, which had already been in force for some years in a number of countries (ceilings on credit expansion in Japan and France and on deposits in the United Kingdom), were recently implemented in the United States through changes in bank reserve regulations and the introduction of selective credit controls. The restrictive stance of monetary policy was reflected in the second half of the year in a gradual decline in the ratios of money to income and
12 in a sharp rise in short-term interest rates, which, in most countries, were higher than the yields on long-term securities.
Coordination within the EEC and Community policies
The expansionary phase that was initiated by the monetary and fiscal measures to stimulate demand agreed at the July 1978 Bremen meeting of the European Council continued for the whole of 1979 and led to a rate of growth in GDP in the EEC as a whole (3.3 per cent) that was broadly in line with expectations. The improvement in income growth rates was not accompanied by a general reduction in unemployment, which, despite the falls in Western Germany, the United Kingdom, Denmark and Ireland, averaged 5.6 per cent for the whole Community (5.5 per cent in 1978). Both the balances on current account, especially for Western Germany and the United Kingdom, and the rates of increase in prices were considerably worse in 1979 than had been expected. Furthermore, the gap between the inflation rates of the member countries widened and they tended to be concentrated at the extremes of the range, which went from 4.1 to 14.9 per cent in terms of the year-on-year change in the deflator of private consumption. Western Germany and the Benelux countries were at the lower end, between 4 and 5 per cent, while the other member countries had rates close to 10 per cent or higher. In view of this situation, and also in consideration of the risks it involved for exchange rate stability in the context of the EMS, the meetings of the European Council in December 1979 and March 1980 confirmed as priority objectives of Community economic strategy in 1980, and as necessary conditions of stable economic growth, the slowing down of inflation rates and the reduction in their divergence, the curbing of the energy deficit and the improvement of the productive structures of a number of countries. Pursual of the first objective should be based on the control of the monetary aggregates, especially through the lowering of the money supply growth rate below that of nominal GDP, and through the reduction of public deficits. In addition, it is necessary to prevent the development of secondary inflationary pressures deriving from the initial impact of higher oil prices, above all by imposing temporary restrictions on the working of wage indexation mechanisms. In order to achieve the second objective, the member countries, besides strengthening energy-saving measures, should allow the increases in
13 energy prices to be passed on in full to final consumers and provide incentives for the investment programmes designed to develop alternative sources of energy and reduce oil consumption. Finally, with regard to sectoral policies, after the limited progress made in 1979, the Community should provide greater support for both the coordination of national sectoral policies and for the raising of the necessary finance. One of the financial instruments for the support of structural policies
•in general and particularly of those aimed at encouraging the convergence of the economies of the "less prosperous" countries on high growth rates is the Community budget. Since 1978 it has been at the centre of debate within the Community in view of the difficulty encountered in overcoming the differences of opinion between the member countries with regard to the effects of the financial flows of the budget on their economic situations and the extent of the consequent restructuring of budget expenditure and of the methods of intervention connected with sectoral policies. In this context the disproportion between the net financial contri- bution of the United Kingdom and its capacity to pay has taken on particular importance and, unless corrective measures are adopted, this imbalance seems likely to continue in the next few years. One of the main obstacles to the solution of the budget problem is that the possibility of increasing expenditure for structural purposes and implementing new sectoral policies in support of the less developed economies of the Community depends, on the one hand, on agricultural markét expenditure being curbed and, on the other, on the growth in revenues, the expansion in which is mainly linked to the growth in VAT resources. At present, however, the increase in the Community's share of VAT revenues is limited by the small scope for expansion within the 1 per cent ceiling set on the standardized tax base; and this limit was reaffirmed at the Dublin meeting of the European Council in November 1979. Furthermore, the possibility of achieving economies in the expenditure for the support of agricultural markets appears to depend on acceptance of a rigorous common price policy that would discourage the formation of structural surpluses.
International trade and current account balances
According to GATT statistics the volume of world trade expanded by 7 per cent in 1979, compared with 6 per cent in 1978. The analysis of trade by major groups of countries shows that there was a further increase in the volume of exports of the industrial countries
14 (65 per cent compared with 6 per cent in 1978) and a sharp rise in their imports (8 per cent compared with 5 per cent), despite the slowdown in their rate of growth. The propensity to import of the industrial countries rose in 1979 mainly as a result of the large increase in their purchases of raw materials, which in the first part of the year served to build up stocks, and because of the sharp rise in the imports of manufactures by the major European countries and Japan. The large increase in the volume of the industrial countries' trade was due to internal growth: intra-group exports rose by 8.5 per cent and, as a result of the fall in exports to the OPEC countries, those to the rest of the world by only 2.5 per cent. The large increase in the volume of EEC exports (7 per cent) was also due to the rise in intra-Community trade. Indeed, it is estimated that this rose three times as fast as that with third countries. The countries that sent the highest proportions of their exports to their EEC partners were the United Kingdom, Western Germany and Belgium. The increase in the total volume of the EEC countries' imports (8.8 per cent) was also large and exceeded the average increase for all the industrial countries taken together. The exports of the oil-exporting countries only rose slightly (1.5 per cent), while their imports, which had tripled between 1974 and 1978 in volume terms, fell by 12 per cent in 1979. This was mainly due to the sharp contraction in Iranian imports and, in fact, if this country is excluded, the imports of the oil-exporting countries remained at the same level as the year before. In 1979 the increase in the dollar prices of internationally traded goods amounted to 18.5 per cent, which was a great deal higher than the year before (10 per cent). This acceleration was mainly due to the sharp rise in oil prices and, to a lesser extent, to the increase in the prices of other raw materials. On the other hand, the increase in the prices of manufactures was the same as in 1978 (14.5 per cent). The rise in oil prices was reflected in the very large increase in the export prices of the OPEC countries (around 45 per cent). The increase in the export prices of the industrial countries was slightly higher than in 1978 (15 per cent as against 13 per cent) as a result of the particularly fast rise in the prices of the non-manufactured goods that they exported. The increase in the export prices of the non-oil developing countries was about four times larger than in 1978, mainly as a result of the rise in non- oil commodity prices, which, according to the IMF, rose by 16 per cent after declining by 5 per cent in 1978 (according to the Economist index they rose by respectively 22 and 5 per cent in the two years). The increase
15 during the year was even larger: 25 per cent between the first quarter of 1979 and the first quarter of 1980. Import prices rose more than export prices in the industrial countries (18.9 per cent) and in the non-oil developing countries. This led to a deterioration in their terms of trade, which, in the case of the former, completely offset the improvement of the previous year and, in that of the latter, came on top of the sizeable deterioration recorded in 1978. The current account imbalances between the major areas of the world, which had gradually declined between 1974 and 1978, increased substantially again in 1979. This was primarily due to the aforementioned worsening in the terms of trade. The further increases made in the price of oil since last December will intensify this phenomenon in 1980. The current account balances of the OECD countries worsened by 44 billion dollars, with a swing from a surplus of 10 billion to a deficit of 34 billion. The surplus of the OPEC countries, which had nearly disappeared in 1978 (5 billion), rose to 68 billion. T-he deficit of the non-oil developing countries increased from 25 to 35 billion, while that of the other countries (mainly those with planned economies) improved by 1 billion. Japan and Western Germany played a fundamental role in limiting the depressive effects on the OECD countries of the heavier oil burden. In fact, while the US current account (above all as a result of the increase in investment income from abroad) was almost in balance after two years of large deficits, those of Japan and Western Germany together showed a deficit of 13.5 billion dollars (respectively 8.6 and 4.9 billion), which was of the same order of magnitude as the total deficit of the seven major industrial countries. The changes in the current account balances of the major economic areas in 1979 reflected those in their trade balances. In the case of the OECD countries the trade balance deteriorated by 47 billion dollars. According to the estimates of the OECD the worsening of the terms of trade with the oil-exporting countries accounted for an amount of the same order of magnitude. Compared with the aftereffects of the 1973 crisis the trade deficit of the industrial countries was much more evenly distributed. More specifically, in 1974 the industrial countries' trade deficit was concen- trated in the smaller countries and in the two weakest of the seven leading countries (Italy and the United Kingdom). In 1979 and 1980 the smaller countries should bear a much smaller proportion of the total burden, while the United Kingdom and especially Italy appear to be in a much better position.
16 In the same way as for the current account balance, a large part of the deterioration in the trade balance of the industrial countries was accounted for by Western Germany and Japan.
International financial flows
In 1979, even though the aggregate deficit of the OECD area increased, the gradual reabsorption of current account disequilibria by major industrial countries resulted in a more balanced structure of capital transactions than in previous years as net capital outflows from the United States declined, the nature of capital flows in Germany and the United Kingdom changed and the situation remained stationary in the case of Japan. The increase in revenues from oil exports led the OPEC countries to expand rapidly their financial investments abroad (71 billion dollars, compared with 23 billion in the previous year). Owing to this development the countries in question, which were net borrowers from the xenobanks in 1978, completely reversed this position and ended the first nine months of 1979 as net lenders for over 18 billion dollars. Notwithstanding the further increase in their current deficit, patterns of financing to developing countries showed little change from those of previous years. Long-term private capital continued to play a predominant role, although it declined slightly compared with financial flows that do not add to the debt burden (in particular development aid). In this regard, especially important were the foreign aid and credit granted by the OPEC countries, which amounted to 8 billion dollars, an increase of 1 billion over the previous year. As has happened every year since 1976, the inflow of funds to the developing countries exceeded their current deficit, thus causing an increase in official reserves. This phenomenon has been encouraged by the relatively abundant supply of liquid assets with the xenobanks. Indeed, in the first nine months of the year these banks granted the developing countries net credit for 15 billion dollars, which is about twice the amount provided in the previous year. Looking ahead, the fact that the disequilibria created by the oil situation will be more difficult to adjust than those which followed the 1973 crisis makes it seem likely that in the medium term private capital markets will have to handle a large demand for international finance. Although in the past these markets have shown a great ability to adapt to new requirements, there is the danger that the world savings-investment circuit may undergo changes when new elements of uncertainty emerge. In
17 fact, a considerable share of the demand for funds comes from countries, including many emergent nations, with structural deficits and a high level of external borrowing. This increases the riskiness of providing finance to them and could make the banking system less willing to meet their demand, considering also that the main industrial countries are meanwhile absorbing more funds. On the supply side, the disequilibrium which has existed since 1978 has been due to the fact that private operators and some official ones have been seeking new combinations for their foreign currency portfolios. However, in 1979, with the dollar relatively stable, there was less propensity to continue to diversify financial assets. There are, nonetheless, still certain factors which point to a continuation in the medium-term of the tendency towards a reduced role for the dollar as a reserve currency, a process which has a destabilizing potential for the monetary and the exchange rate system.
Capital flows in the main countries
Although capital ouflows from the United States for direct investment increased, the country's deficit on capital transactions declined (from 29 billion dollars in 1978 to 14 billion) owing to the complete reversal of the trend of bank funds, from a net outflow of 16 billion dollars to a net inflow of 6.6 billion. The large inflow of bank funds during the year, which was only in part offset by the outflow that took place in the second half following changed expectations regarding the dollar exchange rate, should be put down principally to a positive interest rate differential for the dollar, as well as to certain measures aimed at encouraging external borrowing by US banks. In Western Germany the transition from a current account surplus to a deficit was accompanied by a change in the structure of and balance on both long and short-term capital transactions. Indeed, whereas in the period 1975-78 the inflows of short-term funds were offset each year either wholly or partly by outflows of long-term funds, in 1979 there was an outward transfer of short-term capital (2.1 billion dollars), mainly accounted for by non-bank credit to non-residents, and an inflow of long- terms funds (6.3 billion dollars), for the most part due to external borrowing by the banks. Capital flows in Japan retained a similar structure to that which had taken shape in 1978, confirming the role that the country has assumed in
18 intermediating funds. Indeed, to offset the inflows of short-term capital (4.3 billion dollars), which were to some extent encouraged by the dismantling of the controls that had been introduced in the first quarter of 1978, there was a large outflow of long-term funds (12 billion dollars). Finally, as regards the United Kingdom, the deterioration in the balance on current account was accompanied by a turnaround in the balance on capital transactions, which showed a large inflow (7.5 billion dollars, compared with a 6.1 billion dollar outflow in 1978). This surplus on capital transactions was due to the inflow of short- term funds which expectations of a strengthening of the pound sterling had encouraged and which occurred inspite of the liberalization of capital transfers abroad in the second half of the year. There were, in addition, inflows of funds from the monetary authorities of other countries, which increased official sterling balances by an estimated 1.5 billion dollars.
International financial markets
During the year international financial markets continued to expand at a rapid pace, especially following the increase in intermediation by the xenobanks (22 per cent), whereas the rate of growth of issues of interna- tional bonds was 17 per cent. The high level of liquidity, which kept competition between banks lively, made conditions on the market favourable to borrowers. Only towards the end of the year and in the early months of 1980, mainly owing to considerations of risk, did the spreads over LIBOR begin to widen again and the maturity of credits to shorten in the case of some of the less creditworthy borrowers. Among the explanations of the extremely high level of liquidity of the international banking system (in September deposits had increased by around 30 per cent compared with the same month of the previous year) is the growth of the deposits of official monetary institutions (23 billion dollars) and of the OPEC countries with xenobanks, as well as the behaviour of the US banks. These factors account for more than one third of the 179 billion dollar increase recorded in the first nine months of 1979 in the external liabilities of the banks of the Group of Ten countries plus Austria, Denmark, Ireland and Switzerland and the branches of US banks in off-shore centres. Medium-term credit and bond issues, which amounted to 104.5 billion dollars in 1978, totalled 123.3 billion in 1979. Specifically, medium-term credit granted by banking syndicates amounted to 83 billion dollars, compared with 70 billion in the previous year: of this figure the
19 share granted to the developing countries rose from 38 to 43 per cent, while that of the industrial countries declined from 41 to 32 per cent. Among the former countries Brazil and Mexico absorbed the most credit, for a total of 14.5 billion dollars, and among the latter the largest borrowers were Spain, Italy and France, for a total of 11 billion. Also important, although smaller than that of medium-term credit, was the role played by the international bond market, with issues amounting to 41 billion dollars compared with 34 billion in the previous year. This market continues to be a prerogative of the industrial countries, whose share was 79 per cent (the United States, Japan and Canada together issued 40 per cent of international bonds). Issues of dollar- denominated bonds represented the largest share, although those denominated in Swiss francs also increased by a considerable amount. At the threshold of the 'eighties serious concern has been expressed in many quarters about the ease of access to international credit and the high level of borrowing of some developing countries, which has been aggravated by the shortening of the term structure of their debt. The problem of financing current account deficits, therefore, is gradually being compounded by that of how to finance debts accumulated since 1974. The fact that the international banking system's exposure is concen- trated among a small number of countries has created anxieties about the future functioning of the market. In view of these considerations, the Governors of the central banks of the Group of Ten countries and Switzerland have decided to institute a regular and systematic monitoring of international banking developments and to strengthen the supervision of banks' international business by using parameters such as capital adequacy, liquidity, concentration of risks and maturity transformation and by encouraging the adoption of consolidated balance sheets for the transactions of parent banks and their branches abroad. Furthermore, the Governors, having noted that the disparities in the treatment of domestic and international banking have stimulated the growth of the latter and pose problems for the conduct of domestic monetary policy, have undertaken to make efforts to reduce the differences in competitive conditions between the two sectors of banking.
Movements in official reserves and the growth of international liquidity
Official international liquidity — defined as the total of special drawing rights (SDRs), reserve positions in the IMF, convertible currencies and gold (valued at 35 SDRs per ounce) — amounted at the end of 1979 to 301.7 billion SDRs, representing an increase of 22.3 billion over 1978,
20 or 8 per cent. The increase in official reserves was concentrated in the first quarter of the year and can be put down to the issue of SDRs by the IMF and, more especially, to the change in the method of valuation of the gold holdings and convertible currencies of the countries adhering to the European Monetary System (EMS). Excluding the effect of the creation of ECUs, at the end of December 1979 holdings of gold amounted to 35.3 billion SDRs, convertible currencies to 225.4 billion and the total of international reserves to 285 billion (with an increase of only 2 per cent compared with 1978). The trend of the other reserve instruments did not affect the growth in official liquidity, since the small increase, net of the "ECU effect", in convertible currencies was offset by a decline of 3 billion SDRs in the "reserve position in the IMF" as member countries repaid loans granted in the period 1974-77. For the second year running, in fact, these repayments exceeded the amount of new credit granted by the Fund during the year. The modest increase in official reserves in 1979 was partly the result of the trend of official intervention vis-à-vis the dollar by the main industrial countries, which made, in the first five months of the year, net sales for around 23 billion dollars and, in the rest of the year, net purchases of dollars for a much smaller amount. This development led to a decline in the United States' liabilities vis-à-vis official organizations (14.4 billion dollars). The phenomenon, which was caused, among other things, by the fact that some countries increasingly preferred to keep their dollar assets on the Euro-currency market rather than in the United States, led, for the first time since 1969, to a destruction of international liquidity through the channel of US official liabilities. As regards the distribution of international reserves, there was a strengthening of the tendency, which had already been taking shape over the previous three years, for the developing countries' percentage share to rise inspite of the deterioration of their current deficit. On the other hand, the share of the industrial countries dropped by over 2 per cent compared with the end of 1978, while that of the oil-exporting countries increased.
Exchange rates
The pattern which emerged during 1979 from the movement of the various currencies differed in several respects from that of 1978. The effective exchange rate of the dollar strengthened in the first half of the year after the marked decline in 1978; there was a halt in this trend in
21
July, however, with a depreciation of 2 per cent compared with the previous month, but subsequently the US currency continued to rise over the rest of the year, particularly owing to the growing weakness of the yen. Indeed, between December 1978 and December 1979 the dollar appreciated by 3.7 per cent, while on average it remained in 1979 close to the level of the previous year. The German mark and the pound sterling appreciated during 1979 by 5.2 and 8.4 per cent respectively (4.6 and 6 per cent on average compared with 1978), the French and Swiss francs remained basically stable, while the yen declined sharply (21.3 per cent during the year and 7.7 per cent on average compared with 1978), continuing the downward trend which had emerged after the sudden turnaround in August 1978. The trend of nominal exchange rates, interacting with the evolution of inflation in the various countries, led to changes, sometimes of considerable magnitude, in real exchange rates, which give a measure of the countries' competitive positions. In the period running from the fourth quarter of 1978 to the fourth quarter of 1979 Switzerland and, more particularly, Japan improved their competitive positions by 6.3 and 22.3 per cent respectively (1979 on 197 8 average rises of 3.6 and 11.5 per cent). In the case of Japan the gain in competitiveness was due almost entirely to the depreciation of the yen, while in the case of Switzerland the growth of domestic prices, which was particularly moderate compared with its main competitors, was the major factor. Losses in competitiveness were suffered by the United States, France and the United Kingdom: in these countries the real exchange rate appreciated, in order, by 8.6, by 4 and by 12.8 per cent (2.5, 5.2 and 9.7 per cent on the basis of year-on-year averages). The competitive position of Germany remained on the whole stable, while that of Italy deteriorated by 6.3 per cent (1.2 per cent on average compared with 1978). Further progress in the area of international monetary cooperation was made during 1979 with positive effects on the exchange markets. Inspite of the increase in oil prices and the rate of inflation, the variability of exchange rates was reduced during 1979. Specifically, the exchange mechanism operating within the European Monetary System that was launched on 13th March only suffered pressures of some magnitude in September; these were overcome by a realignment of central rates on 24th September, which consisted in the revaluation of the German mark by 5 per cent vis-à-vis the Danish crown and by 2 per cent vis-a-vis the other currencies. The central rates of the currencies participating in the exchange agreements were then realigned again on 30th November
22 following the depreciation of the Danish crown by 4.76 per cent against all the other currencies. The agreements among the EEC members which created the European Monetary System provided for the definition of a "divergence indicator" based on the ECU. From the date of creation of the EMS until the end of the first quarter of 1980 the upper divergence threshold (which indicates an excessive average appreciation of any one currency vis-à-vis the set of the other currencies participating in the system) had been reached only by the Danish crown, for just one day, immediately after the realignment of 24th September. The lower threshold, on the other hand, was reached and overshot several times: by the Belgian franc on various occasions throughout the period and by the Danish crown in mid-1979, thus prompting the respective economic policy authorities to adopt monetary and budgetary measures.
In the period under consideration the operation of the divergence indicator presented two anomalies, inherent in its very definition, which had already been pointed out at a technical level before the creation of the EMS and the importance of which has been confirmed by events. Firstly, a currency does not always overshoot the divergence threshold before touching some of the bilateral fluctuation margins (in fact, in the case of the Belgian franc the first ECU alarm went off at the beginning of May, by which time the currency had been at the outer margin of the bilateral fluctuation band, in opposition to the Danish crown, for over a month). Secondly, the method of "correction" of the indicator, which was adopted to take account of the wider margin applying to the lira and of the non-participation of the pound sterling in the exchange agreement, cancels out the effects of movements of these two currencies outside the narrow fluctuation band and therefore artificially raises the absolute value of the indicator for the other currencies (this failing was present for a long time because the lira and sterling remained above the 2.25 per cent band for a considerable while).
The agreements provide that within two years from the start of the EMS the credit mechanisms and the existing procedures will be consolidated into a definitive system, with the creation of a European Monetary Fund. In this connection, the debate currently under way in the various Community bodies has developed around three basic alternatives: the first solution, which can be defined as "minimalist", consists in attributing to the nascent EMF functions of a predominantly accounting nature, similar to those of the EMCF; the second provides for the creation of an organization resembling the International Monetary Fund; the third implies that the EMF will be a true "embryo" European central bank. In the case of the third approach, however, emphasis has been placed on the need to envisage it as an evolving process in which nothing exists to compromise the possibility of adopting more advanced solutions in the
23 medium term but initially the objectives will be limited and compatible with existing constraints of a legal and political nature. More generally, it has been stated that the process of monetary integration which will begin with the creation of the EMF must move in parallel with more effective coordination of domestic economic policies and more decisive pursual, through Community policies, of convergent growth rates in the various economies.
24 II. - THE ITALIAN ECONOMY
FORMATION OF INCOME AND ECONOMIC DEVELOPMENTS
Overall results
After the progress achieved in 1978 in the stabilization process, in 1979 the growth of income in Italy was one of the highest recorded in the entire OECD area. Gross national product increased by 5 per cent in real terms and total employment by 200,000 units. The current account of the balance of payments closed with a surplus of 4,300 billion lire; however, the aggregate surplus was smaller (about 1,800 billion), principally because of outflows for short-term trade credits. These successful results were countered by a strong upturn in inflation. Consumer prices rose by 15 per cent, with a sharp upward trend during the year: in fact, in December the price index was about 20 per cent above the level of the corresponding period of 1978. For industrial products there was an even larger increase, caused initially by the rise in raw material costs and in the price of foreign manufactures; from July on, the renewal of labour contracts in industry, which were settled with similar features among different sectors, increased pressures on production costs. Finally, in the last part of the year, the upturn in demand and expectations of growing inflation made it easier to transfer costs onto prices. In last year's Report it had already been maintained that the crisis in Iran, the increase in quotations of metals on world markets and the rise in prices in all the industrial countries had jeopardized the objective of the Three Year Programme to bring the rate of inflation down to about 10 per cent at the end of 1979. The forecasts contained in that document were based on increases in the dollar prices of oil, raw materials and internationally tradable goods of 10, 6 and 9 per cent respectively; the actual increases were instead of 34, 17 and 15 per cent. Terms of trade deteriorated by just 1 per cent, the largest rises in crude oil prices having only begun to affect unit import values in summer, while, on the exports side, the slackening of the constraint of international competition as expectations of inflation spread in the main countries enabled the exporting firms to raise their list prices at the beginning of the year, prior to the growth of domestic costs. A further favourable effect on the terms of trade came from the depreciation of the dollar, which made it
25 possible to keep down the lira cost of acquiring supplies of energy and industrial raw materials. The contribution provided by the foreign component of demand was greater than expected. Indeed, since growth continued in the OECD countries inspite of the uncertain prospects of the beginning of the year created by the contractionary effect on world demand of the rise in oil prices and by the supposed turning point in the United States, exports of goods and services rose by 8.9 per cent. Once again the small and medium- sized firms, encouraged by competitive conditions that were still largely favourable on average during the year, played a major role in increasing the Italian share of international trade. As far as domestic demand is concerned, private consumption, after five years of moderate increases, picked up considerably (4.8 per cent in real terms). In fact, the renewal of the most important labour contracts in industry, the increase in capital and entrepreneurial incomes and the growth of employment brought about a rise of 4.4 per cent in real terms in the disposable income of households. At the same time the joint effect on consumption of the increase in income and in financial assets during the previous year and of the expectations of inflation which developed in 1979 caused expenditure on durables to increase more than that on other goods and services. The support to demand provided by investment in plant and means of transport was considerable, with an increase of 7.6 per cent in real terms due to improved profit formation, a higher degree of capacity utilization and a moderate interest rate level compared with inflation expectations. A large share of external financing of corporate investment was obtained in the form of short-term credit. Firms were encouraged to carry out investment programmes promptly not only by the continual dwindling of available capacity but also by the gradual spread of inflation expectations, which led them to anticipate their purchases of machinery. Moreover, given that the main laws on financial incentives are not yet effective and that the procedures for obtaining funds from the special credit institutions are extremely lengthy, there was no incentive to borrow on a medium or long-term basis. In the building sector, the early dissolution of Parliament at the beginning of the year prevented important additional programmes for investment in public works and subsidized housing from being put into effect and the projects subsequently approved, because of lengthy procedures, produced no effects in 1979. Meanwhile, private investment in
26 housing, which is heavily conditioned by present laws, remained basically stationary inspite of a small upturn in households' demand for houses. Another factor which contributed to the growth of domestic demand was stock-building, which was encouraged by the need for firms to adjust their stocks to increased production and, particularly towards the end of the year, by precautionary motives, and in some cases by speculative operations connected with expectations of a depreciation of the exchange rate and of increases in the prices of raw materials on world markets. The events of the last months of 1979 seem to have been mainly responsible for the large increase in imports (14 per cent). In the first half of the year, in fact, notwithstanding domestic supply shortages caused by strikes over the renewal of labour contracts, low real interest rates and the high level of liquidity of firms, the elasticity of imports to GNP was only slightly above the medium-term value. Oil imports increased by only 2.5 per cent. In fact, a greater awareness of energy problems meant that the economizing on oil was larger than changes in domestic relative prices had led the authorities to expect. On the supply side there was a considerable expansion in the agricultural sector for the second year running, with a rate of increase of output of 4.8 per cent in real terms, which was only lower in the last decade than the rate of 1973. There was also a large growth in the services sector (4.4 per cent) caused by the rise in consumption, but the increase registered in industry excluding construction was even greater (6.8 per cent) owing to the fact that demand was directed more towards manufactures in general. The number of employees in the private services sector increased by 180,000 while employment in industry excluding construction remained stationary with a particularly large increase in productivity. Moreover, the trend of economic activity contributed to an increase in the supply of labour that was even greater than the growth in the number of persons of working age; the unemployment rate therefore rose from 7.2 per cent in 1978 to 7.7 in 1979, principally in connection with a greater female participation. Recourse to the Wage Supplementation Fund, on the other hand, declined by 9 per cent but was still high even though the year saw a substantial recovery of production. The fiscal and budget policy pursued during the year was affected by the measures adopted under the financial law passed at the end of 1978. The measures aimed at containing expenditure flows and increasing their productivity and the efforts to reduce tax evasion led to a decline in
27 the general government debt of about 4,500 billion lire compared with its trend. Hence, with respect to the previous year there was a slight decline in the ratio of the current deficit to GNP, which was partly due also to the increase in taxation produced by the growth of inflation. The total borrowing requirement of the enlarged public sector dropped in absolute terms compared with 1978 (33,000 billion lire against 34,800 billion the previous year), among other things because some major expenditure commitments were postponed to the present year. The expansion of total domestic credit (53,300 billion lire) was practically identical to the values established in the Three Year Programme. Monetary and financial conditions in the first three quarters of the year were reflected in the levels of interest rates, which remained practically stationary until September with a yield structure that was intended to encourage the funding of public debt securities. Subsequently the appearance of tensions on the lira exchange rate and the acceleration of inflation prompted the monetary authorities to raise the discount rate in October and then again in December. The ratio of liquid assets (M2) to GNP, which had risen considerably between 1977 and 1978, remained stationary in 1979. This result should be ascribed to the spread between the yields on money market instruments and those on bank deposits, which brought about a large shift in the public's preferences from deposits to short-term and floating-rate securities.
Economic developments during the year
The impetus of the favourable economic developments of the last quarter of 1978 carried over into the first quarter of 1979. There was a further increase in both exports and private consumption while investment maintained the improvement that had taken place at the end of the previous year. On the supply side the start of the strikes connected with the renewal of labour contracts blocked industrial output at the high levels of the fourth quarter of the previous year while imports continued to rise. Stocks of finished products declined in relative terms since enterprises used them to fill orders. Industrial employment remained unchanged while productivity rose considerably and wages increased almost exclusively through the working of the indexation mechanism. The moderate rise in unit labour costs did not prevent the reversal of the slightly downward trend of the rate of inflation which had developed
28 during 1978. Consumer prices increased by 3.8 per cent compared with the previous quarter and those of industrial manufactures by 3.6 per cent. Whereas the increase in the former appears to have been due in part to the simultaneous increases in regulated prices and tariffs and in part to the high level of domestic demand (which enabled wholesalers and retailers to widen their margins), the increase in the prices of manufactures was accompanied by a generalized upward trend of international prices. The increases in OPEC oil prices that took effect in January and the rise in international metal prices that started in the autumn of 1978 triggered off a world-wide acceleration in the rate of increase in the prices of industrial products. The easing of the external constraint permitted Italian enterprises to raise their domestic and export prices without undermining their competitive position. The increase in price lists was in any case also in response to the rise in the cost of primary inputs. The second quarter was considerably affected by the strikes connected with labour contract negotiations. Between April and June twice as many hours were lost in industrial disputes as in the whole of 1978. Industrial production declined in May and June. The sectors involved in contract renewals with a high level of unionization and centralized production suffered very large falls. Domestic demand was not very strong in this quarter. The seasonally adjusted trade balance showed a surplus of 300 billion after recording a much larger surplus in the first quarter (1,120 billion). Despite the increase in the price of oil in April the terms of trade remained unchanged for the whole of the first part of the year and expectations of a devaluation of the dollar against the lira discouraged enterprises from building up speculative stocks of imported raw materials and semi-finished goods, even though real interest rates were falling. The easy conditions for loans in lire and foreign currencies, the latter made attractive by the interest rate differential between Italy and abroad, and the satisfactory level of profits resulted in an improvement in firms' liquidity. At the end of May outstanding lira-denominated bank lending was 2,000 billion below the maximum allowed amount. Agreement on the new labour contracts, with increases that were in line with the recommendations of the Three Year Programme, permitted a recovery in productive activity in the third quarter. The orders accumulated during the period of strikes and the satisfactory level of domestic demand enabled expansionary production schedules to be drawn up. Industrial production increased by 2.7 per cent, employment rose considerably and the number of hours paid by the Wage Supplementation Fund fell sharply.
29 Monetary policy continued to maintain conditions favourable to the growth of productive activity. With Italian interest rates undergoing little or no change, the increase in rates abroad led to a reduction in foreign currency lending and to an increase in that denominated in lire, the value of which drew close to the ceilings that had been set. At the beginning of the third quarter the problem of the cost and availability of oil became particularly pressing. The increase of more than 4 dollars per barrel in July caused renewed inflationary pressure at the international level, while the OPEC countries' more rigid approach to the control of production raised worrying questions with regard to the medium-term growth prospects of the industrialized countries in the absence of adequate energy policies. On foreign exchange markets the large increase in oil prices triggered off speculation against the dollar, which the main European central banks countered with interventions in support of the US currency. The German mark rose slightly against the dollar and the lira followed suit, albeit only partially. In September continued tension on foreign exchange markets led to a realignment of the central rates of the currencies participating in the EMS. With the increase in oil prices fully reflected in import unit values in the third quarter the trade balance deteriorated rapidly and recorded a seasonally adjusted deficit of 790 billion. The current account still showed a surplus, however, of 500 billion. The acceleration in the rate of increase in import prices quickly passed through on to domestic wholesale and consumer prices. Especially in the case of manufactures the final effect of the increase in costs was reinforced by doubts as to the possibility of reducing domestic inflation and by the pressure that demand was beginning to exert on productive capacity in a number of sectors. On the financial market the public's greater preference for liquid assets, which was linked to the acceleration in inflation, was countered by raising the yield on long-term securities, with a consequent increase in the positive differential compared with those on short-term securities. Nor could a change in short-term interest rates be put off any longer. At the beginning of the fourth quarter of 1979 the raising of the discount rate from 10.5 to 12 per cent, together with the renewal (until July 1980) of the ceilings on bank lending with only small percentage increases up to March, indicated that monetary policy was preparing to exercise a greater degree of control over productive activity.
30 The rise in interest rates followed those that had already taken place abroad and coincided with the additional and more severe measures adopted in the United States. The change in monetary and credit conditions did not influence the level of economic activity. Industrial production, pushed up by all the components of demand, rose more than had been expected (3.9 per cent compared with the third quarter). The ceiling on bank lending, which had been calculated with reference to a lower rate of growth in the value of production, was exceeded by more than 2,500 billion in November, even though the exemption threshold for individual loans had been raised from 100 to 130 million. There was a further improvement in employment: the survey of the labour force showed that the number of employed in October was about 400,000 higher than in the same month of 1978. Investment in equipment and means of transport was the fastest growing component of demand, but investment in construction also accelerated. Private consumption was strengthened by the implementation of the new labour contracts in the private sector, with the payment of increases backdated to January, and by the payment to public sector employees of a lump sum to compensate for the fact that the indexation of their wages had been on a six-monthly basis instead of a three-monthly basis in 1979. Furthermore, the upturn in inflation caused households to bring forward their purchases of durable and semi-durable goods. Exports also grew strongly, despite the fact that the increase in domestic industrial prices (which was larger than that of the main competitor countries) caused a reduction in competitiveness compared with the beginning of the year (- 6.3 per cent between the fourth quarter of 1978 and the fourth quarter of 1979). The increase in exports, however, was smaller than the extremely large rise in imports, so that the seasonally adjusted trade deficit grew to 1,480 billion. The balance of the current account also became negative, with a deficit of around 600 billion. The increase in imports, besides being caused by the growth in consumption and investment, was due to the level of interest rates, which was still too low even after the monetary measures adopted in October, and to expectations of a sharp rise in the lira prices of raw materials. At the beginning of December mounting pressures within the economy and on the foreign exchange market led the monetary authorities to raise the official discount rate by three points.
31 At the end of the year fears of shortfalls in the supply of oil became more acute. New criteria were established for fixing the prices of oil products, the ex-refinery prices of which had remained at the July level despite the repeated increases in costs in the intervening period. The OPEC meeting in Caracas in the second half of December, at which further large increases in oil prices were decided, strengthened inflationary pressure at the international level.
The prospects for 1980
On the trend of inflation will depend the continuance and the rate of the growth in income and employment in Italy and abroad in 1980. The international economic organizations predict that there will be a deterioration in the terms of trade of the industrial countries and a consequent decline in world demand. The current account of the balance of payments is expected to show a deficit in 1980 in all the main OECD countries. Meanwhile, in the first months of the present year the monetary authorities have reacted to the acceleration of inflation by intensifying their intervention on the availability and cost of credit; in the United States the authorities have added fiscal policy measures to monetary ones in order to control the economic cycle. In the first quarter of 1980 the United States' GNP, though at greatly decelerating rates, nonetheless increased compared with the previous quarter. In France, Japan and Western Germany, on the other hand, the growth rate of productive activity has not yet shown any clear signs of slowing down. The picture of the international situation which emerges from the foregoing is dominated by expectations of a recession, neither the start nor the strength of which can yet be predicted with any certainty. These uncertainties reflect on the Italian economy's prospects of growth, even if the rise in prices and average results for production in the year seem to be heavily conditioned by the measures adopted and the tendencies that emerged in the final months of the previous year. The acceleration of inflation during 1979 has left 1980 with a difficult heritage. Already in December the consumer price index was 8.6 per cent higher than the average value for the year; the increase in electricity and telephone charges (the latter having been stationary since 1977) and administered prices of oil products decided by the Government in the same month accounted for about one third of the January rise in consumer prices (3.3 per cent compared with December). Moreover, the
32 increases in industrial prices in the second half of 1979 have not yet been wholly passed onto consumer prices, and nor have the end of the year rises in oil prices. In the first months of 1980 international prices of raw materials and manufactures have undergone further large increases on world markets, aggravated in March, in terms of import prices, by the considerable appreciation of the dollar. The result is a series of inflation pressures that are especially strong in an economic system such as Italy's, which has the characteristic of being highly open and containing abundant and extensive indexation mechanisms. The satisfactory trend recorded at the end of 1979 and the level of unfilled orders enabled firms to expand productive activity in the early months of 1980. However, since the growth in world trade has slackened, the level of domestic demand is still high and Italian goods have lost competitiveness it seems unlikely that Italian exports will be able to increase their share of world trade any further than the present level. On the domestic demand side, households' demand for durables and semi-durables appears still lively at the beginning of 1980. However, over the year as a whole the rise in private consumption is expected to be smaller than in 1979. The disposable income of households, which will be affected by the high elasticity of direct taxation to the increase in money values, will probably show only a modest percentage change in real terms even taking account of the considerable rise in general government transfers. The increase in interest rates and the acceleration of inflation, because they affect the real value of personal wealth, represent further contributory factors in the slowdown of the growth rate of consumption. As yet there are no clear signs of a reversal of the cycle in the case of investment in equipment and means of transport. The reasons underlying the acceleration of investment activity in the second half of 1979 have already been mentioned in the foregoing pages; it need only be added that the implementation of the law on industrial restructuring has encouraged a tentative upturn in projects enjoying subsidized interest rates. Moreover, ENEL (National Electricity Agency) plans to increase its investments to a substantial extent in 1980. The situation would therefore seem to be favourable for a large expansion in investment were it not adversely affected by expectations of a decline in the level of capacity utilization, by reduced profit formation and by a worsening of prospects of continued economic growth. In addition there
33 may be a negative effect exerted by the level of interest rates, the spread that has appeared between short and medium to long-term rates (which makes it difficult for the special credit institutions to raise funds at fixed interest rates) and by the containment of credit expansion through the existing ceilings. Finally, in view of the gradual decline in the last three years in the real value of funds allocated for public works, the conditions hampering the expansion of private residential housing, and the difficulty of implementing legislative provisions on residential building by the public sector issued in the second half of 1979 and the beginning of 1980, it is likely that investment activity in the building sector will be generally moderate. On the whole, considering the tendencies outlined above the Italian economy will probably register a growth of around 4 per cent in 1980, with a downward trend during the year. The rise in consumer prices could be close on 20 per cent and the balance of payments is expected to show a deficit. The economic policy strategy for the short term, the aims of which were to contain inflation without aggravating the expected recession and which was based on a reduction of the public sector deficit, on balance-of- payments equilibrium and on the limitation of production costs, has suffered a setback. Specifically, the measures to limit the rise in production costs have been postponed for the time being; the consequences of this will be seen in the competitiveness of Italy's exports and the rate of inflation. However, insofar as international events and the trend of domestic costs permit, the stability of the exchange rate may help to weaken inflationary pressures.
Domestic demand
Consumption
Households' consumption increased by 4.8 per cent in real terms. This was the largest increase in the last ten years. At current prices consumption rose by 20.6 per cent compared with a rise of just over 20 per cent in households' disposable income. There was thus a slight increase in the average propensity to consume after the falls recorded in the two previous years (Table 2). In conformity with the pattern of similar cyclical phases, marked by a large increase in income and a progressive acceleration in the rate of inflation, the bringing forward of purchases of durable and semi-durable
34 goods more than offset the lag with which expenditure on the other items of consumption follows changes in disposable income. The latter rose by 4.4 per cent at constant prices, despite the lower degree of cover provided by the wage indexation system.
Table 2
CONSUMPTION, DISPOSABLE INCOME AND AVERAGE PROPENSITY TO CONSUME OF HOUSEHOLDS
Consumption showed a rising trend over the year with the exception of the second quarter, when the fall in disposable income caused by strikes probably had a depressive effect. In particular, the renewal of labour contracts and the payment of backdated wage increases contributed to the growth in consumption, while the increase in the rate of inflation resulted in strong demand for durable goods and especially means of transport.
Investment
After stagnating at low levels for four years, fixed investment rose by 4.5 per cent in real terms. At current prices the increase was equal to 21.2 per cent since, after slowing down last year, there was a new upsurge in implicit prices (up 16.0 per cent after rising respectively 18.9 and 11.6 per cent in 1977 and 1978). The downward trend of the ratio of fixed inves.tment to GDP, which in 1978 had fallen to its lowest value in twenty-five years, was thus
35 -
halted. In fact, at constant prices the value of the ratio remained unchanged at 18.9 per cent (Table 3). This is the lowest value of all the EEC countries with the exception of the United Kingdom. Lower rates of capital accumulation were a generalized phenomenon in Europe in the years following the 1973 oil crisis; however the largest fall in the volume of resources allocated to investment in plant and machinery between 1974 and 1979 occurred in Italy, precisely the country in which the restruc- turing of production appears to be especially urgent and necessary.
Table 3
GROSS FIXED INVESTMENT IN EEC COUNTRIES (as a percentage of GDP at 1975 prices)
The recovery in fixed investment in 1979 was entirely due to the private sector, which showed a rise of 6.7 per cent in real terms. Despite a higher level of social investment and a substantial increase in that for energy prospecting, the capital accumulation of the public sector declined for the third year running (— 3.1 per cent; Table 4). The financial difficulties of IRI (Institute for Industrial Reconstruction) and the failure to make a start on new projects resulted in a lower level of investment in marketable services and industry. On the other hand, there was a small increase in investment by general government. There was also a substantial rise in stocks, the value of which increased by 7,945 billion at current prices and by 1,591 billion at 1970 prices. Excluding this change, the volume of total investment increased by 10.8 per cent and the value by 30.7 per cent. Despite the large volume of fixed investment, the formation of saving in the private sector was sufficient to cover both this expenditure and the general government deficit on current account. Thus, for the third year
36 Table 4 PUBLIC AND PRIVATE GROSS FIXED DOMESTIC INVESTMENT BY BRANCH OF ECONOMIC ACTIVITY
37 running, the balance on foreign transactions was positive, amounting to 1.6 per cent of GDP (Table 5).
Table 5 INVESTMENT AND SAVING (as a percentage of GDP at current prices)
Domestic supply
Agriculture
At the close of a decade of fairly moderate expansion compared with the other EEC countries and especially given the trend of consumption the Italian agricultural sector succeeded in 1979 in consolidating the recovery that had begun in 1978. Gross marketable production again registered a substantial increase (4.8 per cent compared with 4.4 in the previous year; Table 6). The value added at factor cost increased in real terms by the same percentage owing to the support of current transfers, which continued to rise (by 3.9 per cent, after 15.1 per cent the year before), and this helped to offset the growth in intermediate consumption (4.5 per cent). Employment continued to decline but at a faster rate than in the previous year (79,000 units compared with 31,000 in 1978) and, as in earlier years, once again the outflow of self-employed workers was greater than that of employees (- 3.4 and - 1.6 per cent as against - 0.3 and - 2.3 per cent in 1978). For the second year running, therefore, agriculture retained its share of total productive activity, breaking off the tendency to decline in importance that had been present since the end of the last war. These results were achieved inspite of some setbacks caused by the climate (frosts
38 at the very beginning of the year and drought in summer) and by delays in supplies of fuel and fertilizer. Considering the separate branches of activity, the improvement in production in field and fodder crops was not as large as in the previous year (3.3 per cent compared with 12.5) but tree crops showed a considerable recovery (up by 9.5 per cent compared with a decrease of 3.9). Livestock production, on the other hand, continued to follow an expansionary trend (increasing by 3.6 per cent in 1979 compared with 3.7 in 1978 and 4.4 in 1977), but was nevertheless not large enough to reduce to any great extent the wide gap between levels of production and domestic consumption (which grew by 10.6 per cent in the three years).
Table 6
MARKETABLE PRODUCTION AND VALUE ADDED IN AGRICULTURE (billions of lire)
In a year of increasing and particularly strong inflationary tensions, the trend of prices in the agricultural sector was on the whole relatively less sustained than in the other major productive sectors and was almost the same as in 1978 (11.5 per cent against 11.4 per cent, measured in terms of the index of the implicit prices of gross marketable production). The containment of agricultural prices was mainly due to the high level of available stocks and the magnitude of production flows at both the domestic and EEC level. In the branches where increases in output were largest there was a slowdown in the growth of prices, whereas the opposite occurred in the less expansionary branches.
39 Instead of aggravating the rise in agricultural prices, the repeated devaluations of the "green" lira (for a total depreciation of 14.5 per cent during the year), the last of which (5 per cent) only took place in December, made it possible to reduce substantially the monetary compen- satory amounts (from 18 to 2.3 per cent) and bring the agricultural exchange rate closer to the central EMS rate. In May 1980 the process of alignment was completed with a further devaluation of 3.5 per cent. In this way not only were the dampening effects of Italy's deficit products mitigated but a general improvement in agricultural incomes was also obtained. Notwithstanding the fact that the year was satisfactory for agriculture, in 1979 the share of Italy's food and agricultural requirements met with internal production again declined. The aggregate deficit at current prices deteriorated at an even faster pace than in the previous year (18.3 per cent compared with 14.7), second only to the exceptionally high rate of growth of the oil deficit (33.9 per cent), so much so that it continues to be of a similar order of magnitude to the latter (7,765 billion and 9,881 billion lire respectively). Particularly noteworthy was the large increase in the import volumes of all those products that Italy traditionally acquires abroad, which was not merely due to factors linked to the terms of trade. Among the principal items the largest was livestock and dairy products (accounting for about two thirds of the entire deficit), followed, apart from coffee, by forestry products, vegetable oils and fats and fish. Exports also increased in both value and volume and at fairly high rates. The increase, however, only concerned those few branches which are traditionally in surplus, there having been no major changes in production lines. There remains, therefore, the problem of carrying out a combined conversion of the existing production and consumption patterns that will make it possible to contain the external deficit, which is the most evident sign of the structural weakness of Italy's food and agricultural system. This is the main strategic objective, the attainment of which seems quite remote, of the series of measures known as the "food and agricultural plan" which is still only at the stage of preliminary and partial implemen- tation. At the moment this plan mainly consists of the provisions for the implementation of the "four-leaved clover" law (Decree Law No. 984/77). The relative national agricultural programme (covering a four- year period for hillside and mountain areas, livestock, fruit and vegetable, wine and grape production and Mediterranean products, and a nine-year period for irrigation and forestation) should already begin to produce expenditure effects in the present year.
40 According to the programme the funds allocated under Decree Law No. 984 (6,030 billion lire, 81.4 per cent of which to be administered by the regional authorities) and all other funds available under past legislation on agriculture are to be invested on a sectoral basis, both at the national and regional level. The total allocation will therefore amount to 14,623 billion lire, 87.3 per cent of which will go to the sectors covered in the four-year plan and the rest to those in the nine-year plan. There remains the important problem of ensuring the careful and prompt management of these funds by central government bodies, on the one hand, and by local authorities, on the other. Moreover, the law on industrial conversion and reorganization (Decree Law No. 675/77), under which funds are allocated for all industries connected with agriculture, is only now about to become operative in the sector in question as in all the others. Finally, some of the fundamental laws provided for three years ago in the "indications for a food and agricultural plan" prepared by the Minister for Agriculture are still at the stage of bills.
Industry
The continuation and strengthening during the year of the cyclical upturn that had begun in 1978 led to an increase in value added at constant prices in industry of 6 per cent, which is three times greater than the increase recorded in the previous year (Table 7).
Table 7 VALUE ADDED AT MARKET PRICES IN INDUSTRY
41 In the construction sector the rise in value added, though larger than in 1978, was again very moderate (2 per cent) and therefore caused a further decline in the relative importance of building in total industrial output. This sector, which accounted for 26.4 per cent of the value added at constant prices in industry in 1960 and 19.5 per cent in 1970, represented only 14.4 per cent in 1979. In industry excluding construction, on the other hand, the satisfactory trend of all demand components led to an increase in production levels of close on 7 per cent. In 1979 exports again provided the major contribution to the growth in output and in particular, given the composition of Italian sales abroad, that of consumer goods. During the year this sector was also sustained by a more regular course of domestic consumption than the other components of aggregate demand: hence the increase in output was uninterrupted and, on average for the year, results were better in this sector than in investment and intermediate goods (9 per cent compared with 6.7 and 4.6 per cent respectively). In the investment goods sector, in fact, the average increase was the outcome of a decline in the fourth quarter of 1978 and second quarter of 1979 caused by heavy strikes in the metal and engineering industries and of a very rapid growth in the second half of the year which pushed up the general index of industrial production. Finally, the level of production came under upward pressure from the large growth in stocks. This increase was based principally on the need to adjust the level of stocks to the expected volume of sales, which had been increasing at a steady pace up to the middle of the year, but was also encouraged by prospects of future capital gains that would not be offset by a parallel rise in the money cost of external finance: in fact, in view of the considerable strengthening of short-term inflation expectations the real expected interest rate continued to decline until the third quarter of 1979.
Throughout 1979 the volume of sales and the flow of orders to firms registered rates of increase close to those of 1978. Moreover, orders rose at a faster pace than turnover, leading to a further increase in outstanding orders as has occurred in previous phases of cyclical expansion. The growth of firms' backlog of orders, which had been particularly marked between the end of 1974 and the end of 1976, has again become a feature of the present cycle since the third quarter of 1977 following the decline during the earlier part of that year. The increase, however, has been at a uniformly lower rate than in the previous expansionary phase.
42 Notwithstanding the satisfactory performance of demand, the trend of production in 1979 diverged from that of orders and sales owing to the difficulties created by heavy strikes: in the first and second quarters of 1979, in fact, the number of hours lost in strikes in industry excluding construction was double that registered in the period immediately preceding. As a consequence production declined by 3.9 per cent between February and June and in the first half of the year remained on average stationary at the levels reached in the fourth quarter of 1978. In the first quarter the increase in output was particularly small after the very large one recorded in the previous period: this slowdown can be ascribed primarily to the metal and engineering industry where there was a general decline. In the second quarter increasing labour disputes led to a larger decline in output in the metal-working and means of transport sector and brought to a halt the expansion of the textile, clothing and leather and hide industries, where the hours lost in strikes were triple the figure for the first quarter. The general level of production, however, declined by only 0.3 per cent, the downturn having been curbed by increases in the industries producing non-durable consumer goods, precision engineering for investment and intermediate goods for building. After the peak in the fourth quarter of 1978 capacity utilization declined for two consecutive quarters and in the second quarter of 1979 was about 8points below the peak of the first half of 1974 and almost 5 points below the value recorded at the end of the preceding cyclical upswing (Chart 1). Following a period of about six months during which sales (up by 2.6 per cent between the fourth quarter of 1978 and the second quarter of 1979) and production (stationary in the same period) diverged, the recovery of output in the second half of the year took place at the same rate as the increase in turnover and in the flow of orders to firms. As a result the backlog of orders ceased to rise. Only in the fourth quarter, however, did capacity utilization reach levels close to the previous peaks in almost all sectors; the exception was the sector of means of transport for investment where, however, this indicator recorded the largest increase. A further stimulus to the increase in output was the combined need to restore stocks to normal levels and to reduce the backlog of orders; but it was principally an unexpectedly lively demand (businessmen's expectations in fact were declining during the middle of the year) that determined the strength of the expansion.
43 Chart 1
Capacity utilization in industry (excluding construction) N.B. The data were obtained by applying the graphical method of the Wharton School to the quarterly averages of 31 corrected and seasonally adjusted series, which cover 89.94 per cent of the general index of industrial output.
Thus, notwithstanding the large increase in production, stocks of finished products continued to be below normal, having settled at the level attained in the second quarter; slight signs of an upturn appeared only in the fourth quarter as a consequence of behavioural patterns that mainly concerned the consumer goods sector. In the first quarter of 1980, with the backlog of orders and hence the level of guaranteed production of firms still high, the general index of
44 Table g INDEX OF INDUSTRIAL PRODUCTION (1) (1970=100)
industrial production recorded an increase of about 3 per cent, principally owing to the results obtained in the final consumer goods branch, where the level of stocks returned to normal (Table 8).
Services
The difficulties which have impeded the expansion of economic activities throughout the decade that has just come to a close do not appear to have had important repercussions on marketable services. Taken as a whole, in fact, these represented the sector with the most sustained and least irregular growth in the volume of gross product (the average annual increase was over three and half percentage points). Above all it
45 was also the only sector of the three traditionally comprising market- oriented economic activities in which employment increased. It is within the context of this trend that the results attained in 1979, with the contribution of a satisfactory performance of consumption, should be viewed. During the year the value added of services excluding lettings increased by 4.9 per cent at constant prices (compared with 3.7 per cent in the previous year; Table 9) while that of the sector as a whole rose by 4.4 per cent (compared with 3.4), a figure which in the entire decade was only exceeded in 1973 (5.4 per cent). From the point of view of employment, nearly 183,000 new positions were created, the largest number of the whole of the 'seventies (equivalent to a percentage increase of 2.8 compared with 2.2 in 1978 and an average in the decade of about 1.5).
Table 9
VALUE ADDED AT MARKET PRICES OF MARKETABLE SERVICES (billions of lire)
The trend of productivity during the year was less satisfactory, therefore, considering also that the great majority of newly employed persons (89.4 per cent) was absorbed by the distributive trades and miscel- laneous services, sectors where there are still large areas of fairly low and sluggish productivity. The rise in prices was faster compared with both the previous year (16.2 against 13.6 per cent) and the other sectors (15.0 per cent in industry and 12.0 per cent in agriculture, measured in terms of the indices of the implicit prices of value added). This was the result of a
46 particularly sharp upturn in the prices of transport and communications (20.5 compared with 14.6 per cent in 1978) owing to the raising of charges, in the prices of lettings (19.7 per cent compared with 15.9) following the complete implementation of Decree Law No. 392/78 (the "fair rent" act), and in those of the distributive trades, hotels, catering and entertainment (16.4 as against 11.1 per cent). As a result both total income and income per employed person increased to a greater extent than in the previous year (22.3 per cent compared with 16.8 and 18.9 per cent compared with 14.3 respectively) although not as fast as in industry (23.0 for total income and 22.8 for income per employed person). Final demand for services generated by households' consumption presented a lively trend, as it had frequently done throughout the decade, with peaks for hotels and catering (7.6 per cent), recreation, entertainment, education and cultural services (6.5 per cent) and health services (6.4 per cent). Consequently the rate of increase of aggregate investment was higher than in the previous year (2.9 compared with 1.6 per cent), although there was a decline in the branch with the greatest average capacity for technical progress of the entire services sector: transport and communications (- 1.8 per cent).
Energy
In 1979 domestic demand for primary sources of energy increased by 2.6 per cent, a figure similar to that for 1978, which caused net imports of all the various components to rise (by 5.1 per cent). Domestic production, on the other hand, which had already declined by 2.3 per cent in 1978, again dropped slightly, by 0.8 per cent (Table 10). The largest increase in uses of final sources of energy was recorded in the transport sector (6.9 per cent, a figure very much higher than that for 1978) owing to the greater demand for petrol and, in particular, for diesel oil. The trend of consumption in industry and in the other sectors (households, agriculture and services) was the reverse of the preceding year: in industry there was an increase of 3.8 per cent (- 2.8 per cent in 1978), while in the other sectors there was a decline of 2.4 per cent (+ 8.2 per cent in the previous year). The consumption of electricity increased in all sectors (5.2 per cent on average compared with 3.2 in 1978). Production of electricity rose by 3.2 per cent compared with 5.1 per cent in 1978. The increase in the use of coal, nearly double that of the previous year, made it possible to curb the rise in consumption of fuel oil,
47 the share of which in fact declined slightly inspite of the growth of demand and a smaller production of hydro-electric and nuclear energy. The increase in net imports of oil and oil derivates (3.4 per cent) and in particular the large rise in crude oil prices (35 per cent on average in the year) worsened the oil account, which closed with a deficit of 9,881 billion lire (compared with 7,378 billion in 1978). However, since the raising of the price of crude oil took place mostly in the second half of 1979 it will only fully produce its effects in 1980. Indeed, the rises already decided will cause an estimated average annual increase in the price of oil of about 70 per cent, which, assuming the same volume of oil
Table 10 SOURCES AND USES OF ENERGY (millions of TOE)
48 imports as in 1979, will make the burden of foreign currency outlays heavier by about 6,000 billion lire. The new oil crisis, involving large increases in the price of crude oil and the risk of interruptions in supplies, has again confirmed the need to put into prompt effect the measures proposed on several occasions to reduce the Italian economy's dependence on oil by containing energy consumption and developing other sources. Six years after the eruption of the oil crisis the progress made in these two directions has not been in proportion to the gravity of the problem for Italy. On the other hand, although the achievement of more rational consumption patterns and the development of supplementary and renewable sources of energy are, with reason, primary objectives of the country's energy policy, they cannot be an alternative to the implemen- tation of the plan for coal and nuclear power stations, unless a different socio-economic model, based on a lower standard of living and the rationing of energy consumption, is adopted. At any rate, since the programmes implemented by ENEL (National Electricity Agency) and the other measures taken to economize on energy and develop renewable sources will only begin to produce substantial effects after several years the Italian economy will continue to depend on oil for a long time to come. Therefore it is still equally necessary to formulate a policy of domestic prices and international agreemekts aimed at increasing the stability and the certainty of oil supplies.
Employment, wages, prices and the distribution of income
Employment
In 1979 employment rose by 198,000 units (1 per cent): this was the largest increase since 1967 in both absolute and percentage terms (Table 11). The rise in the number of employees was even larger (1.6 per cent), while the number of self-employed fell (0.5 per cent). As a result the proportion of total employment accounted for by employees rose to 72 per cent. The growth in employment took place almost entirely in the services sector, where the number of workers grew by 265,000 units (2.7 per cent) in line with the uninterrupted rising trend of the 'seventies. This has led to nearly half of all employment now being in this sector, compared with 35 per cent in 1960 and 42 per cent in 1970. The rate of growth in
49 employment in services rose during the first three quarters, reaching 0.9 per cent in the third, after which it declined. Within the sector, employment in marketable services rose slightly faster than that in non- marketable services (2.8 per cent, as against 2.5 per cent). The growth in the former was due to rises of more than 3 per cent in the finance, distri- bution and miscellaneous services sectors, while the increase in the transport sector was only 0.6 per cent.
Table 11 EMPLOYMENT IN ITALY (percentage changes on previous year)
After slowing down in 1978, the decline in agricultural employment accelerated again (2.7 per cent, compared with 1.1 per cent), with the result that agriculture's share of total employment declined further to below 14 per cent. In industry the combination of surplus labour and a substantial rise in production resulted in employment remaining virtually unchanged, with an increase of only 12,000 units compared with 1978. This further confirmed the stability of industrial employment, which emerged during the 'seventies as a fundamental feature of this sector. Nonetheless, there was a marked recovery during the course of the year, and especially in the third quarter, when the number of employed rose by 1.3 per cent compared with the
50 previous quarter. There was thus a reversal of the downward trend that had started in the second half of 1977. For the year as a whole the positive effects of the growth in demand appeared, therefore, in the form of a large reduction in the number of hours paid by the Wage Supplementation Fund. These fell by 22 per cent for industry excluding construction and by 9 per cent for all industry. Employment in construction remained unchanged, despite a slight increase in output. However, there was a substantial increase in the number of hours paid by the Wage Supplementation Fund (26.8 per cent compared with 1978), and its intervention has come to be a permanent feature of this crisis-ridden sector. Finally, Istat surveys showed that the number of persons with second jobs declined by 37,000 compared with 1978, and as a proportion of total employment from 2.4 to 2.2 per cent. The greater part of those with second jobs (40.8 per cent) were in the services sector, though the proportion in agriculture was also high (20.9 per cent). Per capita productivity in industry excluding construction rose by 6.5 per cent, more than twice as fast as in 1978 (3.1 per cent). This confirms the direct link between productivity and production, which is mainly due to the rigidity of employment (Chart 2). Institutional factors, such as limits on the freedom of firms to reduce employment in line with their ptoduction requirements, and increases in production that were relatively small on average but marked by large variations were the main causes of this rigidity. In addition to these factors, there was the role played by the Wage Supple- mentation Fund. This acts as an employment stabilizer by smoothing the effects of cyclical fluctuations, with the curbing of unemployment in a recessionary phase resulting in a smaller increase in employment in the subsequent recovery. In order to show the importance of the Wage Supplementation Fund for the stability of employment, the number of full-time workers corresponding to the hours paid by the Fund has been estimated. Subtracting this number from that of total employment gives the number of employees who actually worked. This indicator shows much larger fluctuations than total employment, so that the corresponding cyclical variations in per capita productivity are smaller. In 1979 the increase in the number of workers actually engaged in production is estimated to have been 1 per cent, as against 0.3 per cent for total employment. The rigidities that influenced per capita productivity also affected hourly productivity. The increase in the latter was particularly large in 1979 (7.9 per cent) and exceeded that in value added (6.8 per cent), while average hours worked declined both in large industry and in firms with
51 Chart 2
Value added, employment and hourly productivity in industry excluding construction Sources: Based on seasonally adjusted Istat and Ministry of Labour and Social Security data
more than 50 employees. A large contribution to this reduction in the first six months of the year came from the strikes connected with labour contract renewals. However, the decline in production in this period was propor- tional to the hours lost, so that hourly productivity was not affected.
The labour force grew by 1.6 per cent compared with 1978 to over 22 million, and showed an increase of 1.6 million or 8 per cent compared with 1970. The activity rate rose from 38.9 per cent in 1978 to 39.4 per cent. The large rise in the supply of labour, due in part to the increase in the population aged between 14 and 70 (353,000 or 0.9 per cent compared with 1978), was coupled with a rise in the number of persons seeking employment (8.1 per cent). This caused the unemployment rate to rise from 7.2 per cent in 1978 to 7.7 per cent, the highest value recorded since the end of the 'fifties. The high sensitivity of the supply of labour, and
52 especially of female labour, to changes in demand means that an increase in employment does not necessarily lead to a reduction in unemployment in the short term. In 1979 the number of persons without employment rose by 127,000 compared with 1978 to a total of 1.7 million. A large part of this rise is attributable to the increase in the number of persons seeking their first job (9.3 per cent, compared with increases of 6.6 per cent for the unemployed and 6.7 per cent for other persons seeking employment). The distribution of employment by geographical area shows a situation of full employment in the northern regions, with a rate of male unemployment of 3.2 per cent, compared with 5.1 per cent in the central regions and 7.3 per cent in the southern regions; female unemployment rates were much higher, however, with a minimum of 10 per cent in the northern regions and a maximum of nearly 20 per cent in the South and Islands. The average duration of unemployment continued to increase and amounted to about one year. The time spent looking for work was considerably longer for those seeking their first job (15 months) than for the unemployed (10 months). On the other hand, there does not seem to have been a significant difference between the time taken by men and women to find work except for the category of other persons seeking employment. The seriousness of the problem of the unemployment of young people is even more clearly revealed when job seekers aged between 14 and 24 are considered. In 1979 their number rose above 1 million (with an increase of 7.3 per cent compared with 1978) and they represented 61 per cent of all those seeking employment. This high level of unemployment, besides reflecting the low rate of growth in demand and limited labour turnover, was also considerably affected by demographic factors: between 1974 and 1979 the number of persons in the 14-24 age group increased by 713,000 and from 15.4 to 16.3 per cent of the total population. On the other hand, the related activity rates declined or remained stationary. The influence of these demographic factors will diminish, however, in view of the reduction in the size of the less than 14 age group, both as a proportion of the total population (from 22.6 per cent in 1974 to 21.2 per cent in 1979) and in absolute terms (- 464,000 over the same period).
Wages
A feature of 1979 was the renewal of numerous labour contracts, above all in industry. The negotiations regarding the most important contracts, which had started at the end of 1978, were only concluded in the summer. The number of hours lost during the year through strikes
53 connected with labour disputes amounted to 159 million. Most of these losses were in the second quarter and about two thirds were in industry. On previous occasions of large-scale contract renewals the hours lost amounted to: 132 million in 1976 (preceded, however, by 181 million in 1975 when the wage indexation mechanism was renegotiated), 164 million in 1973 and 303 million in 1969. The labour contract renewals covered the greater part of industry, the whole of agriculture and some services (credit and transport). The wage increases for 1979 were generally the same for all categories of employees but the contracts foresee a widening of wage differentials in 1981. Moreover, they modify the amounts of seniority bonuses and introduce reductions in working hours as well as changes in the organi- zation of labour. In the second part of the year trade union activity was mainly concentrated in the public sector, where employees, besides demanding the implementation of the 1976-1978 contract and preparing to negotiate that for 1979-1981, sought and, towards the end of the year, obtained payment of their "special supplementary allowance" on a three-monthly instead of a six-monthly basis. This completed the process of standardizing the wage indexation systems of the public and private sectors, which had been started with the unification of the value of the cost-of-living index point in July 1978. Contractual wage rates in almost every sector grew faster than the year before (Table 12). This was mainly due to the larger cost-of-living increases (28 points, as against 20 in 1978) and the renewal of national labour contracts. The rise in wages was larger in the second part of the year, when the new contracts came into force. In fact, in every sector except credit and insurance the increases between December 1978 and December 1979 were larger than those on a year-on-year basis. The estimates of per capita employee earnings based on national accounts data also showed larger increases for the private sector as a whole than those recorded in 1978. More specifically, per capita earnings in industry excluding construction grew by 17 per cent, compared with 15.6 per cent in 1978 (respectively 1.1 and 2.8 per cent in real terms). In the last two years real hourly earnings in industry excluding construction increased less (2.4 per cent per year) than in both 1974-1977 (5.5 per cent) and 1970-1973 (12.2 per cent). The gradual decline in the rate of increase in real earnings coincided, on the one hand, with the acceleration of inflation and, on the other, with the greater weight of
54 sliding wage scale increases compared with those deriving from labour contract renewals. In fact, in 1976 and 1979 these provided much smaller rises than in 1970 and 1973.
Table 12 GROSS MINIMUM CONTRACTUAL WAGES (1) (percentage changes)
The average extent to which employee earnings in industry excluding construction will be protected by the sliding wage scale in 1980 can be estimated at around 76 per cent. Even though contractual increases tend to reduce the degree of indexation, this is slightly higher than the year before owing to the assumption of a gradual slowing down of inflation during the year. Unit labour costs in the private sector rose at very nearly the same rate as in 1978 (12.8 per cent, as against 12.7 per cent), since the faster
55 rise in the cost of labour per employee (18.1 per cent, compared with 15.3 per cent) was offset by an increase in productivity that was almost double that recorded in 1978 (4.7 per cent, compared with 2.3 per cent). In agriculture and industry the cost of labour per employee rose more than in the private sector as a whole. Nonetheless, substantial rises in productivity kept the rises in unit labour costs down to respectively 10.8 and 11.7 per cent, or below the value for the private sector as a whole and less than those recorded in 1978. The opposite is true of the services sector, where the more moderate increase in the cost of labour per employee was accompanied by a smaller growth in per capita output.
Prices
The year-on-year rate of increase in wholesale prices in 1979 amounted to 15.5 per cent or almost double that of 1978 (8.4 per cent). The increase during the course of the year was even larger and reached 21.1 per cent in December (9.3 per cent in December 1978; Table 13). Inflationary pressures were present throughout the year and intensified in the second half. The resurgence of inflation in conjunction with the large rises in oil and raw material prices on international markets shows the essentially cost- push nature of the increase in wholesale prices in 1979. The highest rates of inflation were in fact shown by industrial raw materials, most of which are imported. Their prices on wholesale markets rose by 19.0 per cent in the first half of the year and by 11.9 per cent in the second (Table 13). The high levels of productivity that were achieved resulted in the increase in unit labour costs being lower than in 1978 despite the renewal of numerous labour contracts (10.7 per cent year on year in industry excluding construction, compared with 11.0 per cent the year before). The rise in costs was clearly reflected in the prices of industrial products, which rose by 14.4 per cent year on year and by 20.4 per cent during the year (8.1 and 9.3 per cent in 1978). The pass through of cost increases on to prices appears to have accelerated in the second half of the year, when the prices of manufactures rose by 11.5 per cent, compared with 8.0 per cent in the first half (Table 13). The prices of agricultural products and foodstuffs rose respectively by 12.3 and 10.5 per cent year on year (16.1 and 13.7 per cent during the year; Table 13). These rises, which were the smallest of all the various product groupings, were caused mainly in the first part of the year by the increases in the prices of crop products (17.8 per cent on an annual basis) and in the second by those of livestock products (31.9 per cent). The
56 pattern of the increases during the year owed a great deal to the reductions in monetary compensatory amounts subsequent to Community decisions to devalue the green lira (5 per cent in March, 4.2 per cent in April, 1.1 per cent in September and 5 per cent in December).
Table 13 WHOLESALE PRICES (percentage changes in indices, 1976 =100)
The 4.4 per cent average depreciation of the effective exchange rate of the lira (calculated on the basis of the geographical distribution of Italy's trade in manufactures among its nine main competitors) did not completely offset the higher rate of increase in the relative prices of Italian manufactures (5.8 per cent on average). There was thus a loss of competitiveness, which, though it was still small in year-on-year terms
57 (1.2 per cent), was much larger during the course of the year (75 per cent) owing to the faster increase in Italian prices compared with those of its competitors. The substantial increase in oil prices decided by the OPEC countries at the end of December and the rapid adjustment of the prices of all oil products by the Interministerial Price Committee, the re-emergence of speculative prices on international markets for some raw materials, the persistence of a high level of productive activity and the growth of inflation expectations, linked in part to the performance of the exchange rate of the lira against the dollar, kept wholesale prices rising at a very fast rate in the first quarter of 1980. In March the general index was 6.2 per cent higher than at the end of 1979 (24.8 per cent on an annual basis). The prices of industrial raw materials and industrial products were again those that rose fastest (respectively 38 and 27.6 per cent on an annual basis; Table 13). The general index of consumer prices rose at rates that were only slightly lower than those of wholesale prices: 14.8 per cent year on year and 18.8 per cent during the year (Table 14). Only in the second part of the year were the average monthly rates of increase in consumer prices and the cost of living (respectively 1.8 and 1.7 per cent) nearly equal to that of wholesale prices (1.9 per cent). The rate of increase in the sliding wage scale index was lower (1.3 per cent), since the basket of goods and services upon which it is based was less sensitive to the direct effects both of the generalized increases in oil product prices and of the policy for public utility charges pursued by the government in the latter part of the year. The indirect effects make themselves felt with a lag of about twelve months, in all probability mainly as a result of higher transport and energy costs passing through to the prices of many of the food and industrial products in the sliding wage scale basket. Consumer prices, besides being influenced by the course of producer prices, were affected by the policy pursued with regard to regulated prices. The increases in the prices of services (16.6 per cent compared with 1978) were larger than those in the other sectors and in the main were spread evenly over the twelve months. In the first year of the "fair rent" law there was a striking rise in house rents. In fact, despite the difficult interpretation of the law, which held up its application and gave rise to a great many disputes between owners and tenants, rent expenditure rose 33.9 per cent in 1979 (28.6 per cent year on year; Table 14). Transport and communications tariffs rose by 15.4 per cent compared with 1978 and 24.5 per cent during the year (Table 14). The cost-of-living index rose by 15.7 per cent compared with the year before, or by about one percentage point more than consumer prices in
58 Table 14 RETAIL PRICES AND COST OF LIVING (percentage changes in indices, 1976=100)
general (14.8 per cent). All the items of expenditure contributed, albeit to a varying extent, to this rise, with increases ranging from 25.4 per cent for housing to 13.7 per cent for food, the cost of the former rising even faster than that of electricity and fuel (19.7 per cent) owing to the end of the rent freeze (Table 14). In the first quarter of 1980 the cost-of-living and consumer price indices continued to rise at very high rates, mainly as a result of the
59
increases in regulated prices and public utility charges decided by the Interministerial Price Committee at the end of 1979 and the beginning of this year. Both these indicators had risen at an annual rate of close to 24 per cent at the end of March.
The distribution of income
In 1979 the large increase in prices and the good performance of production, which made it possible to curb the rise in unit costs, resulted in a shift in the distribution.of income in favour of profits (Table 15). Labour's share of value added at factor cost, corrected for changes in the structure of employment, fell by 2.2 percentage points in the private sector (from 84.2 to 82 per cent), by 3.4 points in industry excluding construction (construction, 0.5 points), by 1.2 points in the services sector and by 1.1 point in agriculture.
With the sole exception of the construction sector the shift in favour of profits stemmed mainly from a growth in unit labour costs that was smaller than that in the implicit prices of the private sector, since the changes in relative prices were small.
60 Labour's share of income in each sector can in fact be expressed as the ratio of unit labour costs, deflated by an aggregate price index, to the index of the sector's relative prices. It is therefore worth examining the shifts in the distribution of income in the light of the changes in these elements. Favoured by large cyclical gains in productivity, industry excluding construction showed the largest reduction in real unit labour costs (4.7 per cent, compared with an average of 2.6 per cent). In view of the limited decline in the sector's relative prices, this led to an approximately equal shift in its distribution of income. In the construction sector, on the other hand, the increase in real unit labour costs was more than offset by the increase in prices, which rose 1.8 per cent more than the average. In agriculture the substantial reduction in costs — mainly due to the increase in productivity, since the rise in the cost of labour per employee was one of the largest — did not bring about a similar shift in the distribution of income because of the 3 per cent fall in relative prices. Finally, in the services sector the increase in relative prices and the decline in real unit labour costs both helped to raise the share of profits.
61 The sample survey of the income and saving of Italian households conducted annually by the Banca d'Italia showed that the average household income net of taxes was a little below 10 million lire in 1979. The distribution by income shows that in the highest income bracket 16 per cent of households had incomes of more than 15 million lire and accounted for 37 per cent of total income, while in the lowest bracket 17 per cent of households had incomes of less than 4 million lire and received only 5 per cent of the total. The inequality indices calculated for the income distributions of individual employee workers showed that over three quarters of the total inequality is accounted for by the differences within the various profes- sional categories (Table 16). Furthermore, the inequalities within the different sectors account for 93 per cent of the total. Compared with 1974, the total inequality showed a percentage reduction that was mainly due to the narrowing of the differences between the various professional categories.
THE BALANCE OF PAYMENTS
Oil price increases, international interest and exchange rate tensions and the high level of domestic economic activity all affected the balance of payments in 1979. The outcome was an overall surplus of 1,824 billion, compared with 6,997 billion the previous year. The current account surplus fell from 5,260 to 4,249 billion and capital movements swung from an inflow of 1,319 billion to an outflow of 2,468 billion (Table 17). Since the banks' net borrowing abroad increased by 1,004 billion, the position of the Banca d'Italia and the Italian Foreign Exchange Office improved by 2,828 billion, net of exchange rate adjustments and the revaluation of gold. These results, coupled with the persistent weakness of the dollar vis- a-vis the other major currencies, contributed to the fundamentally stable course of the lira's effective exchange rate. For the year as a whole the trade balance (on a f.o.b. basis) showed a deficit of 850 billion lire, compared with a surplus of 2,460 billion in 1978. There was a 14.6 per cent rise in the volume of imports, as against 8.8 per cent for exports. The latter increase was larger than that in world demand, since the growth in Italy's export markets was also relatively larger. The loss in competitiveness, which was moderate for the year as a whole, did not have any significant effect on trade volumes.
62 Services and transfer payments showed a surplus of 5,100 billion (2,299 billion more than in 1978). This was attributable primarily to the increase in tourism and to the contraction in contributions to interna- tional organizations.
Table 17 BALANCE OF PAYMENTS ON A TRANSACTIONS BASIS (1) (billions of lire)
As for capital movements, those with medium and long-term maturities recorded a deficit of 866 billion as a result of a 3,047 billion inflow of private and public loans, a 2,064 billion outflow for the repayment of compensatory loans and a 1,849 billion negative balance on the other long-term items, which were mainly related to the financing of trade.
63 In the short-term sector, trade credits gave rise to a net outflow of 1,602 billion, concentrated to a large extent in the second half of the year. Bank funds showed a surplus of 2,265 billion in the first six months and a deficit of 1,261 billion in the second. Total short-term capital movements were influenced by the differential rise in interest rates abroad compared with those in Italy, which remained virtually unchanged in the first three quarters, and the exchange rate crisis at the end of the year. Compensatory and official borrowing fell by more than 3,400 billion, while private and public borrowing rose by about 2,500 billion. At the end of 1979 Italy's long-term financial and trade liabilities amounted to 16,521 billion, compared with assets of 19,147 billion. The maturity structure of these assets and liabilities shows that receipts will exceed outlays mainly in 1980 and 1981 (Table 18).
Table 18 ITALY'S EXTERNAL FINANCIAL POSITION (1) (billions of lire)
The value of outstanding short-term trade credits at the end of the year was estimated to be 7,600 billion and that of trade and bank debts in foreign currencies around 13,500 billion. Over the last three years these amounts have more than doubled, principally as a result of the growth in the volume of trade to be financed.
64 Whereas it is possible to pursue structural equilibrium between maturing credits and debts in the long-term sector, the fluctuations in the amounts of short-term credits and debts — stemming from interest and exchange rate variations and related expectations — have grown to an actual and potential size that requires an adequate level of reserves. At the end of the year the net official reserves amounted to 30,640 billion, or nearly three times the maximum potential outflow of short-term capital. When only the immediately available liquid reserves are considered, this ratio falls by a half to a value close to that recorded at the end of 1977, when the process of rebuilding the reserves could be considered to have reached a satisfactory result.
Goods
The trade deficit in 1979, calculated on the basis of national accounts data, was equal to 5,557 billion lire, compared with 1,075 billion the year before. Imports rose faster than exports (respectively 34.8 and 26.1 per cent), with very different increases in volume (14.6 and 8.8 per cent) and less divergent changes in average unit values (17.6 and 15.9 per cent).
The trade deficit tended to increase during the year as a result of the pattern shown by volumes and prices. The seasonally adjusted volume of exports remained virtually unchanged, whereas that of imports rose sharply in the second half of the year. The deterioration that took place in the terms of trade, though limited for the year as a whole, appears considerable during the course of the year. The growth in the volume of exports (8.8 per cent year on year) was larger than that in world demand, so that Italy's share of the exports of all the industrial countries increased further, from 6.9 to 7.2 per cent at current prices and from 7.5 to 7.7 per cent at constant prices.
The export performance benefited from the high level of imports of Western Germany, France and the United Kingdom, which together absorb more than 40 per cent of Italy's total exports. The increase in Italy's market share also reflected the high level of exports reached in the last quarter of 1978 (7.1 per cent higher than the annual average).
The year-on-year rise in the volume of imports (14.6 per cent) was almost three times as large as that in GDP (5 per cent); the resulting elasticity was above the medium-run average value.
65 Imports of goods other than finished goods rose more (16.3 per cent) than total imports and industrial production. The rates of increase in imports of raw materials and intermediate goods were particularly high (respectively 12 and 22 per cent) as a result both of the expansionary phase of the cycle and of the building up of stocks that occurred in the second half of the year. The rise in imports in the last part of 1979 was also influenced by the change in relative prices: the average unit values of imported manufactures and the domestic wholesale prices of industrial products, which rose respectively by 12.8 and 14.4 per cent year on year, diverged to a greater extent in the last quarter owing to the sharp rise in the latter. The year-on-year deterioration in the terms of trade amounted to 1.4 per cent, with both export and import average unit values rising rapidly. The deterioration was more marked during the course of the year since it took place exclusively in the second half. This is attributable to the fact that the increase in oil prices, which rose more than 60 per cent between December 1978 and December 1979, made itself felt gradually in terms of import prices. The dollar prices of Italy's exports of manufactures rose only slightly faster than world prices in the first half of the year, but the gap widened in the second half, with a consequent reduction in competitiveness. At the end of 1979 there still existed, however, a part of the favourable relative price differential that had been inherited from previous years.
Services
The transport deficit amounted to 1,073 billion lire in 1979, an increase of 311 billion compared with the previous year. Only air transport showed an improvement, while the shipping and land transport deficits rose sharply. The surplus generated by tourist flows increased from 4,310 billion in 1978 to 5,564 billion. Foreign currency receipts grew by 28 per cent, rising from 5,334 to 6,816 billion, while expenditures abroad grew more slowly (22 per cent). The particularly marked growth in foreign tourism in Italy over the last two years, besides reflecting the continued expansion in world tourism, was due to Italy's consumer prices expressed in dollars rising less than those of its main competitors in the tourist market.
66 The number of foreign visitors and the prices of tourist services rose respectively by 16.5 and 15.3 per cent. The relatively modest increase in foreign currency receipts compared with these figures seems to be attributable both to a reduction in per capita expenditure and to an increase in the proportion of tourism financed in lire, in line with an increase in the volume of Italian banknotes exported for touristic purposes. The net contribution of worker earnings and emigrants' remittances rose by nearly 22 per cent to 2,330 billion. The investment income deficit fell from 935 billion in 1978 to 672 billion. The volume of payments abroad benefited from the reimbursement of large amounts of official and compensatory debt, which more than offset the new borrowing of the banks. Nonetheless, the principal factor affecting outflows was the sharp rise in foreign interest rates. The larger volume of receipts mainly reflected the higher level of Italy's foreign currency reserves and the increase in the yields earned on them.
Capital movements
Capital movements gave rise to a deficit of 2,468 billion in 1979, compared with a surplus of 1,319 billion the year before. This was the result both of a smaller inflow of foreign capital (down from 3,399 to 2,784 billion) and of a larger outflow of Italian capital (up from 2,080 to 5,252 billion) (Table 19). There was a further reduction (2,064 billion) in the volume of compensatory debt that had been contracted prior to June 1974 (more than 6,000 billion). About two thirds of the reimbursements were made in advance of maturity within the framework of a policy designed to reduce the related interest burden and to improve the country's medium and long- term debt position. The inflows attributable to the foreign loans raised by the public sector amounted to 1,575 billion and those of the private sector to 2,798 billion, while their reimbursements amounted respectively to 272 and 1,054 billion. The outcome was a surplus of 3,047 billion, compared with one of 2,184 billion in 1978. The gross volume of import finance granted abroad in the form of loans and trade credits rose from 217 to 400 billion for the former and fell from 365 to 305 billion for the latter.
67 On the export side, the financial and trade credits disbursed amounted respectively to 822 and 3,512 billion (510 and 2,919 billion in 1978). Reimbursements of financial credits rose from 269 to 385 billion, while those of trade credits fell from 2,272 to 2,190 billion. The net interventions of the Italian Foreign Exchange Office declined further from 257 to 87 billion, since it has not undertaken new commitments in the last
Table 19 CAPITAL MOVEMENTS (billions of lire)
68 few years. Overall, the medium and long-term financing of exports gave rise to a net capital outflow of 1,846 billion, compared with one of 1,145 billion in 1978. Short-term trade credits produced a net outflow of 3,101 billion for exports and an inflow of 1,499 billion for imports. In 1978 the figures were respectively an outflow of 1,032 billion and an inflow of 1,440 billion. Direct inward investment remained virtually unchanged (559 billion, as against 597 billion), while the volume of disinvestment rose from 164 to 259 billion. The outcome was a net outflow of 300 billion, 133 billion less than in the previous year. Italian direct investment abroad, net of disinvestment, rose from 143 to 452 billion. Foreign portfolio investment in Italy showed almost equal purchases and sales (respectively 968 and 917 billion), so that the balance was negligibile. The inflow of commercial bank funds during 1979 amounted to 1,004 billion lire, so that the banks' net foreign debt increased from 5,884 billion at end-1978 to 6,888 billion at end-1979. Net short-term foreign currency borrowing was concentrated almost exclusively in the first five months of 1979, exceeding 8,000 billion at the end of May, after which it declined. Only at the end of the year was the interest rate differential that had obtained in the first part of the year re-established, thus recreating the conditions for new inflows of bank funds, which came in the first few months of 1980. More specifically, in March 1980 the effect of the new regulations regarding the ceilings on lending in lire contributed to the very large inflow of bank funds (1,850 billion), which brought the total for the first quarter to 2,900 billion.
The external position of the Banca d'Italia and the Italian Foreign Exchange Office
The net official reserves of the Banca d'Italia and the Italian Foreign Exchange Office rose from 20,960 to 30,640 billion in 1979. This was the result of increases in gold holdings, SDRs and European Currency Units (ECUs) and a decrease in convertible currency reserves (Table 20). The net medium and long-term debt position of the Banca d'Italia and the Italian Foreign Exchange Office improved by 1,207 billion in 1979, so that there was a negative balance of only 100 billion at the end of the year. Reimbursements made in March, July and September
69 Table 20 EXTERNAL POSITION OF THE BANCA D'ITALIA, THE ITALIAN FOREIGN EXCHANGE OFFICE (UIC) AND BANKS (end-of-period amounts in billions of lire)
70 extinguished Italy's IMF oil facility debt in advance of the September 1982 maturity. At the beginning of the year this debt had amounted to 951 billion, of which 183 billion were due for repayment during the year. Finally, in November Italy repaid the first instalment (314 billion) of the EEC loan granted in 1976 to finance oil deficits. As a consequence of the increase in the net official reserves and the improvement in the medium and long-term position, the nominal change in the external position of the Banca d'Italia and the Italian Foreign Exchange Office amounted to 10,887 billion lire. Net of exchange rate adjustments (- 202 billion) and the 8,261 billion revaluation of the gotd reserves, including those held with the EMCF, the change falls to 2,828 billion, which corresponds to the overall balance of payments and the inflow of bank capital. The reimbursement of official loans (1.5 billion dollars) and compen- satory loans (approximately 2.5 billion dollars, of which about one third actually matured during the year) considerably reduced that part of Italy's foreign debt that had been contracted during the years of balance-of- payments crises. The improvement in the overall foreign debt position was
Table 21 ITALY'S FOREIGN DEBT AND OFFICIAL RESERVES (millions of dollars)
71 less pronounced because of the increase in the commercial banks' net foreign debt (Table 21). The year-on-year average depreciation of the lira, weighted in accordance with the geographical distribution of Italian trade, amounted to 2.8 per cent. Between the beginning and the end of 1979, instead, the lira showed an albeit small appreciation (0.3 per cent). The changes in the bilateral exchange rates of the lira vis-à-vis the other Community currencies were influenced by the inception of the EMS in March and by the exchange rate policy pursued in the preceding months, and especially at the end of 1978, when the lira was allowed to fall slightly against the other EEC currencies. The repeated periods of weakness of the dollar against European currencies made it possible for the lira to appreciate against the US currency while simultaneously depreciating against the others. The effective exchange rate, on the other hand, fluctuated during the course of the year: essentially stable up to the end of June, it appreciated slightly throughout the summer and then returned to the levels of the early part of the year in the autumn (Table 22). The purchases made by
Table 22 TRADE-WEIGHTED EFFECTIVE EXCHANGE RATE OF THE LIRA (1) VIS-A-VIS QUOTATIONS ON 9th FEBRUARY 1973 (monthly averages of the daily rate)
72 the monetary authorities from January to August were intended to limit the appreciation of the lira in order to reconcile the aim of curbing inflation with the defence of Italy's competitiveness and respect of interna- tional commitments. In conjunction with the generalized recovery in the dollar in March 1980, the exchange rate of the lira against the US currency fell sharply and, towards the end of the month, reached values close to those recorded in May 1976. On the other hand, the lira remained essentially stable vis-à- vis the other EEC currencies. As a result, the effective exchange rate was considerably affected by the change in the dollar rate and depreciated by 3.4 per cent between the beginning and the end of the month.
PUBLIC FINANCE
The total borrowing requirement of the public sector (central government, social security institutions, local authorities and autonomous government agencies) declined from 33,650 billion lire in 1978 to 31,830 billion in 1979, respectively equal to 15.1 and 11.8 per cent of GDP. The decrease was due, however, to the trend of the balance on the financial items, which was affected by the slowdown in the rate of growth of the sector's bank deposits and, to a lesser extent, by the reduction in transfers to public enterprises. The aggregate deficit on current and capital account rose from 23,500 billion to 27,420 billion, but as a percentage of GDP declined from 10.6 to 10.2 as a result of a larger decrease in the ratio of the current balance to GDP (Table 23). The economic policy action implemented with the financial law and other provisions of minor importance temporarily interrupted the upward trend of the public sector borrowing requirement. The measures taken in fact reduced current expenditures and increased revenues from taxation and social security contributions for a total of about 4,500 billion lire and curbed the expansion in the bank deposits of public bodies. Certain factors of a special nature contributed to this slowdown, including the early dissolution of Parliament, and consequent postponement of the approval of important programmes for increasing the endowment funds of the autonomous agencies and ENEL (National Electricity Agency) and financing public enterprises; the acceleration of inflation and of productive activity, which had a favourable effect on revenues during the period under study without making any appreciable difference to expenditures; and, finally, the deferment to 1980 of some
73 transfer payments owing to end-of-year strikes in the commercial banks, which administer the collections and disbursements of public bodies. The course of action adopted also had the objective of restructuring public intervention; in fact, the measures introduced, although incomplete and limited, made it possible to improve some of the most evident aspects of the malfunction of the tax system and social security and health service
Table 23 PUBLIC SECTOR: CASH OPERATIONS (1) (general government and autonomous government agencies; calendar years; billions of lire)
74 and to begin the process of rationalizing the use of public bodies' financial resources. In particular, the following changes were introduced: a) changes in the method of linking INPS (National Social Security Institute) above- minimum pensions for employees and pensions to civil servants to real wages; b) acknowledgement of only one cost-of-living increase in the case of cumulated pensions or combined pensions and wages; c) increases in contributions to the Wage Supplementation Fund and to the special pension schemes for self-employed workers in order to bring them into line with the services provided; d) measures to reduce the evasion of taxes and social security contributions (a VAT receipt for goods in transit, the requirement to enter the individual tax code number in tax returns, the raising of the fines for inaccurate tax returns, etc.); e) payment by the beneficiary of part of the cost of medicines, as a means of containing the demand for this service; f) requirement for government financed public bodies to transfer gradually to the Treasury their assets with the banking system. Revenues from taxation and social security contributions rose from 72,560 billion to 86,450 billion lire, an increase of almost 20 per cent. The total fiscal burden, which rose from 32 to 33 per cent in 1978, remained practically stationary in the year under study, notwithstanding the progress in reducing the evasion of social security contributions and VAT (totalling over 1,500 billion lire). More specifically, direct taxa 'on increased rather moderately (17.8 per cent) as a ratio to the tax base, while as a percentage of GDP it declined from 10.1 to 9.8 per cent. This trend, however, can be ascribed to certain specific factors, such as the deduction from the base of personal income tax of payments of Ilor (local income tax) made in 1978 (which were very much larger than in the previous year), the introduction, also in 1978, of the system of advance payments for Ilor and withholding tax on payments of interest on bank deposits (which increased receipts in that year and correspondingly reduced those of 1979) and finally, to a much smaller extent, some delays in accounting. Indirect taxation increased by 14.2 per cent, which is large if account is taken of the upturn in refunds of VAT and the transfer of a share of the tax to the EEC. Consequently, as a percentage of GDP indirect taxes decreased considerably (from 10.1 to 9.5). Notwithstanding the extension of the reductions in social security contributions for medical care, total contributions increased by 24.2 per cent (a much larger growth than that of the wage bill) because the rates were raised and evasion was curbed. The revenue from public utility charges matched the rise in costs: the share of the current expenditures of the autonomous agencies and
75 municipal bodies that is covered by revenues from the sale of services in fact only declined by a small amount (from 49.6 to 49.3 per cent). The increase in spending (18.9 per cent) was smaller than that in GDP. This moderate growth can be put down principally to the trend of transfers to households, which did not rise much owing to the measures to contain expenditure on health care and pensions, the delays in the indexation of pensions and the unchanged amount of family allowances. Outlays for wages increased by 20.8 per cent owing to the signing of
the 1976 - 1978 contract and the granting of a lump sum to employees at the end of the year (to compensate for the disadvantage suffered by civil servants in 1979 because their cost-of-living increases were paid every six months instead of every three as in the private sector. The systems have been unified as of January 1980). In fact, the public sector's wage policy, which since 1970 had caused the unit wages of general government employees to decline compared with those of private sector employees, has for the last two years been directed at reducing the difference in the relative positions. Transfers to enterprises, including contributions to the endowment funds of public enterprises, remained practically stationary, the decline in such contributions having been offset by the particularly large increase in direct transfers and investment grants. The large public debt involved a particularly heavy burden for interest payments, which were nevertheless not sufficient to balance the loss in purchasing power which, as a whole, holders of public debt instruments suffered in 1979 owing to the resurgence of inflation. The interest charges of the sector amounted to 16,540 billion lire, which corresponds to an average burden (excluding differences between face value and bid price of medium and long-term securities) of about 10 per cent. The 27.3 per cent increase in this expenditure, although large, was nonetheless smaller than that recorded in 1978 (34 per cent). This was due not only to the reduced borrowing requirement but also to increased tapping of the Treasury current account and the favourable trend of Post Office deposits (both less costly forms of coverage), as well as to delays in entering in accounts the coupons on the securities issued which, because of the upturn in bond issues in the second half of 1977, had reduced interest charges for that year but increased those for 1978. If account is taken of operations carried out by ENEL and financial transactions, as well as of EEC transfers and other minor operations not included in these accounts, the borrowing requirement of the enlarged public sector appears to have declined from 34,760 billion to 33,130 billion.
76 The authorities continued to pursue the policy of centralizing the public debt with the State sector (Treasury, Central Post Office Savings Fund, autonomous government agencies and Southern Italy Development Fund). The total borrowing requirement of this sector amounted to 30,080 billion lire compared with 34,250 billion in 1978 and, net of debts paid with securities, totalled 30,020 billion and 32,410 billion respectively (including the payment of debts contracted by hospitals, health insurance institutions and local authorities for 3,380 billion in 1978 and 760 billion in 1979; Table 24).
Table 24
THE STATE SECTOR BORROWING REQUIREMENT AND ITS FINANCING (1) (calendar years; on a cash basis; billions of lire)
77 The fact that the borrowing requirement, net of repayments of debts, remained largely stationary was due to the decline in the surplus on minor Treasury operations, offset by the fall-off in loans by the Central Post Office Savings Fund and in the budget deficit (down from 30,480 billion to 30,060 billion). The growth of the public debt, following the tendency of the previous years, mainly concerned the securities on the market, the trend of which, however, differed greatly during the year between bonds and Treasury bills. In fact, net issues of medium and long-term securities were particularly large in the first half of the year but then declined as inflation expectations shifted, giving rise to net redemptions in the fourth quarter. Overall, market placements amounted to 12,110 billion lire compared with 14,370 billion in 1978; this decline is less marked however (12,050 billion, as against 12,530 billion in 1978) if securities issued to fund debts with commercial banks are excluded. In the case of Treasury bills, the increase in market placements (from 9,480 billion to 10,150 billion in 1979) occurred for the most part in the middle of the year. Recourse to Banca d'Italia financing amounted to barely 340 billion lire, compared with 5,020 billion in the previous year. The repayments made in the early months of the year owing to large sales of securities on the market, stimulated by the large amount of liquidity created by the Treasury towards the end of 1978, was offset in the last quarter by a substantial creation of monetary base. Post Office deposits, on the other hand, increased (from 4,850 billion in 1978 to 6,600 billion in 1979), principally because of the expansion of giro accounts. In the case of public bodies not included in the State sector, recourse to bank lending increased by 2,160 billion lire.
MONEY AND FINANCIAL MARKETS
In 1979, a year marked by an acceleration in domestic demand and a rapid resurgence of inflationary tensions connected with the rise in import prices, monetary policy combined with a reduction in the public sector borrowing requirement curbed the growth of the monetary and financial aggregates and, towards the end of the year, increased interest rates substantially. In the first half of the year, given a still very large surplus in the current account of the balance of payments and substantial inflows of capital through the banking system — which were encouraged by the large differential in yields with respect to foreign markets and the satisfactory
78 movement of the lira within the EMS — the aim of monetary policy was to ensure the financing of investment and production while at the same time preventing a reduction in the yields on short-term bonds, which were attracting a growing share of the public's funds. The gradual spread of expectations of an increase in inflation acted as a dampener on purchases of longer-term fixed-interest securities. In the summer months, while banks' borrowing abroad decreased rapidly in response to the increase in interest rates in other countries, the intervention of the Banca d'Italia brought about a modest rise in yields on these bonds, in anticipation of the adjustment of the entire structure. At the end of summer the balance of payments began to deteriorate under the pressure, among other things, of the increase in production; the rate of inflation again accelerated; interest rates on world markets registered additional large increases; the exchange rate of the lira weakened; there were substantial reductions in reserves. Monetary policy thus took a gradually more restrictive stance: the official discount rate was raised twice and the ceiling on bank lending was extended for a further period at fairly low permitted percentage rates of growth for the first months in order to bring the cost of credit rapidly into line with the new situation; the extremely large increases in interest rates on shorter-term securities produced a decreasing yield curve in December. The creation of monetary base, which had slowed down in the first half of the year, rose substantially in the last quarter notwithstanding the postponement of large disbursements by the public sector and the absorption of liquidity by the foreign sector owing to the difficulty of placing securities at a time of declining quotations. During the same period, moreover, the scope of monetary policy action was limited by the restrictions placed on issues of Treasury bills by the budget law. In the first months of the present year purchases by the public, principally of Treasury bills, have increased appreciably, mainly because of the larger yield differential with respect to deposits. The Treasury borrowing requirement has recorded a slowdown. As a result there has been a sharp decline in bank liquidity which refinancing by the Banca d'Italia has only partly mitigated: extensive use has also been made of repurchase agreements, which were adopted for the first time in December of the year under study. Total domestic credit expansion in 1979 was 53,350 billion lire, or 19.8 per cent of GNP. In 1978 the respective figures were 49,340 billion and 22.2 per cent. This expansion was the same as that estimated in February 1979, but with a larger rise in interest rates than forecast. As already mentioned in the chapter "Public Finance", however, the borrowing requirement of the
79 enlarged public sector was very much smaller than predicted: in fact, the decline in net transfers to the Economy (households and enterprises) was only offset in part by the trend of bank deposits of public bodies, which showed an increase instead of the expected decline. On the other hand, credit granted to the private sector exceeded the forecast amount. If funds provided by the government are included, however, the final figure is not very different from the original estimate; but it must be noted that there were larger increases than forecast in the monetary value of income and investment and, on the other hand, a bigger surplus in the current account of the balance of payments. Flows of finance to private economic agents in the forms of loans by the credit system and bond issues rose from 15,400 billion lire in 1978 to 22,250 billion, equal to 6.9 and 8.3 per cent of GNP respectively. There was an increase (from 61 to 79 per cent) in the share of credit to the private sector granted by the banking system; indeed, bank lending, stimulated by the containment of public transfers to the corporate sector and by the decline in the flow of finance from the special credit institutions, amounted to 17,500 billion lire (compared with 9,370 billion in the previous year). This enabled Italian firms to grant trade credits to foreign ones and to greatly expand their stocks of imported raw materials. The expansion of bank lending in lire, which remained below the permitted amount in the first half of the year, accelerated sharply in summer, partly because of the decline in foreign currency loans, the larger than expected increase in production, and the postponement of Treasury transfers to public enterprises. Consequently, in November the ceiling was overshot by an extremely large amount. The decline in lending by the special credit institutions was not due to the difficulty of placing bonds but to the slowdown in the demand for credit, which was affected by the crisis afflicting large public and private groups in basic industries and by the delay in implementing the new laws on subsidized credit. The increase in domestic financial assets was smaller than in 1978. After the considerable growth of the previous year the ratio of the average stock of domestic financial assets to GNP increased again, owing to the smaller expansion of total domestic credit and the decline in the balance- of-payments surplus. The shift in the public's preferences, which consisted in a massive move into Treasury bills and, in the first half of the year, into Treasury floating-rate credit certificates, was to some extent due to a change of attitude on the part of the banks. In fact, compared with the previous year a larger number of banks showed more concern for their balance-sheet
80 results than for the volume of deposits and therefore expanded their operations in securities on behalf of clients. The liquidity of firms, measured in terms of the ratio of their domestic liquid financial assets to GNP, gradually improved during the year, partly in connection with the satisfactory trend of their profit and loss accounts. In the last quarter, however, the liquidity position appeared tighter owing not only to the considerable growth in productive activity, but also to the increases in trade credit to foreign firms and in stocks.
The prospects for 1980
During the present year monetary policy continues to follow the course established at the end of 1979, aimed at tightening the liquidity of the economy and of firms in particular while at the same time ensuring that sufficient resources are available to meet the demand for funds to finance investment and the increase in production, with interest rates still high. As far as controlling inflation is concerned monetary restriction is less effective than other economic policy instruments because of its adverse effects on investment and productive activity. In the present situation therefore, monetary policy remains entrusted with the important but limited task of preventing inflationary pressures originating from depreciations of the exchange rate due to capital outflows, a reduced propensity to invest saving in financial assets and speculative increases in stocks of domestic products. Total domestic credit expansion has been estimated at 59,300 billion lire; the ratio of this flow to GNP (18 per cent) shows a further decline on top of that of the previous year. This estimate conforms with the forecasts for the national accounts described in the chapter "Formation of Income and Economic Developments" and, as regards the borrowing requirement of the enlarged public sector, with the estimate given in the quarterly report presented to Parliament by the Minister for the Treasury last April: 43,000 billion lire, compared with 33,000 billion in 1979. Of the former figure 40,500 billion should be covered with internal funds. In view of the substantial increase in public sector transfers to firms (from 7,400 billion in 1979 to 13,000 billion) the expected flow of credit to the private sector (19,500 billion lire or 6 per cent of GNP), although smaller than in the previous year, will be sufficient to finance investment and the expansion of productive activity. The accumulation of trade credits and stocks which occurred at the end of 1979 makes it seem likely that
81 firms' borrowing requirements will be modest. It follows therefore that a tighter control must be placed on the credit available to this sector. The forecast credit expansion assumes that there will be a slowdown in total bank loans (from 18,500 billion lire in 1979 to 11,000 billion) matched by an upturn (from 5,800 billion to 7,400 billion) in lending by the special credit institutions; the latter are expected to step up their recourse to floating-rate securities. The ceilings on the expansion of bank lending to be fixed for the last five months of the year will take account of the actual trend of disburse- ments by the special credit institutions, which mainly depend on the implementation of the laws on subsidized credit. Inspite of the decline in the flow of finance to the private sector compared with the previous year and the expected deterioration in the balance of payments, the growth in the financial assets of the Economy will continue to be large (19 per cent) owing to the increase in the public sector's borrowing requirement, although it will be smaller than that in GNP. The magnitude of the share of liquid and short-term assets in the sector's financial wealth makes it necessary to keep interest rate levels high, given expectations that the reduction of inflation will be a slow process.
The central bank's operations and the regulation of the monetary base
The monetary base and interest rate policy pursued during 1979 can be separated into two phases: in the first, which lasted until September, the satisfactory trend of the balance of payments and the desire not to hinder the recovery in production made the control of credit less imperative and so the action of the Banca d'Italia was principally directed at reducing the liquidity of the banking system and the economy. In pursual of these objectives interest rates were kept stable: had they risen, in line with the worsening of inflation expectations, the already large inflows of capital, both direct and through the banking system, would in fact have been aggravated. In the second phase, following a general increase in interest rates in other countries, the appearance of the first symptoms of a deterioration in Italy's external position and the likelihood of a further increase in the rate of inflation prompted the authorities to give monetary policy a restrictive turn. This decision was reinforced by a growing awareness as time passed that productive activity was accelerating, and at a faster rate than expected.
82 The change in the course of monetary policy became evident in the first days of October with the raising of the discount rate and of the yields at which the Banca d'Italia purchases Treasury bills and the renewal of the ceiling on bank lending, at fairly low permitted rates of growth. Another, larger increase in the above rates followed in December, partly in connection with contingent unrest on foreign exchange markets. In practice, the restrictive impact of the ceiling was to prove inadequate, so that it was mainly the intervention affecting the monetary base and interest rates that determined the increase in the cost of bank credit and, in the early months of 1980, the considerable slowdown in the growth of the money supply. The increased dependence on monetary base and interest rate policy was then explicitly confirmed when, in March 1980, a modification was made to the ceiling with the introduction of a non- interest-bearing deposit with the Banca d'Italia proportionate to the amount by which loans exceed the permitted increase. But, while on the one hand the supply of bank credit continues to be conditioned by a growth "regulation", which has in fact become more binding at the economic level, on the other banks have been given the possibility, within the limits imposed by the progressive rates of the non-interest deposit, of satisfying unexpected peaks in the demand for credit: it is on this margin of freedom that the availability and cost of monetary base reserves exert their influence. During 1979 the monetary base (excluding Post Office deposits) increased by about 7,000 billion lire and 13.9 per cent, which is markedly less than in the previous year (10,134 billion and 25.1 per cent). In particular, bank reserves rose by 4,291 billion (13.7 per cent), compared with 6,965 billion (28.7 per cent) in 1978 (Tables 25 and 26). This result was due not only to a weakening of the pressure of the Treasury borrowing requirement and the balance of payments compared with 1978, but also to the placement of a large volume of government securities with the public, especially in the first half of 1979, as savers became aware of the growing spread between the yield on securities and that on bank deposits. In the data for 1979, however, the effect of the change in monetary policy in the last quarter of the year is barely discernible: the raising of the discount rate and of the yields on Treasury bills at the beginning of October could not halt the gradual decline in security purchases that expectations of an increase in interest rates had triggered in the middle of the year. It was only after the second, even more decided increase in December that investment in Treasury bills picked up and conditions on the money market became extremely tight.
83 Table 25 MONETARY AND CREDIT AGGREGATES AND INTEREST RATES
Although during most of the year conditions on the money market were calm and interest rates stable, the central bank was obliged to carry out large and frequent intervention to stabilize the monetary base and mitigate the abrupt movements in bank reserves caused not only by the usual erraticism of Treasury receipts and disbursements, but also by the more unpredictable nature of placements of government securities as the public increased its participation in auctions of Treasury bills. The reaction of the banks to the variability of monetary base flows was not to increase their stocks of liquidity, which they instead continued to reduce compared with the volume of intermediation, but to step up their recourse to central bank refinancing. The Banca d'Italia met these requirements with new methods of intervention; the traditional types of last resort credit were supplemented first by purchases on the market of maturing Treasury bills and later on by repurchase agreements. The forward transactions in securities gave the central bank additional possibilities of regulating the banking system's inflow of reserves in the very short run as well and led to a change of emphasis in this regard from bilateral relationships with the individual banks to intervention in the market. Compared with fixed-term
84 Table 26 MONETARY BASE (changes in billions of lire
85 advances the new operations have proved to be more flexible as regards duration and interest rate and can be employed not only to create liquidity but also to absorb it by offering an investment for a few days only at an attractive rate of interest. At the end of 1978 the level of bank liquidity was particularly high (5,340 billion lire) owing to large transfers by the Treasury, which, among other things, enabled the banks to meet the usual holiday demand for notes and coin at the end of the year without resorting to credit from the Banca d'Italia, the repayment of which would have automatically drained their excess reserves. The payment of the coupons on public securities at the beginning of January led to a further increase in liquidity, which on 2nd January reached the figure of 5,718 billion lire. The lively demand for securities by the public (during the month placements, net of redemptions, amounted to 1,534 billion for Treasury bills and 1,692 billion for Treasury credit certificates; the banking system in the same period reduced its portfolio of these two instruments by about 250 billion) caused an absorption of liquidity, which, added to the effect of the compulsory reserve requirement, not only wiped out any previous surplus but obliged the banks to apply to the Banca d'Italia for fixed-term advances for about 2,900 billion. In the months that followed, as the high propensity of the public to invest in government stock and especially Treasury bills persisted, similar situations tended to recur, with a large absorption of monetary base through sales of securities and the periodical decline in bank liquidity. The need to prevent decreases in interest rates at times of rising inflation, the advisability, which had long been recognized, of encouraging a reduction of the excess of bank intermediation and the belief that this process would not curtail the supply of credit to the economy prompted the Banca d'Italia to keep security market yields stable, thus allowing the growth in the monetary base to contract considerably. At the same time, however, the central bank intervened with fixed-term advances and security purchases in order to prevent the level of bank liquidity from becoming too low. In the first nine months of 1979 bank reserves increased by 889 billion lire, which is equivalent to a seasonally adjusted annual rate of growth of 9.2 per cent. In the same period government instruments were placed on the market for a value of about 21,000 billion lire, net of redemptions. The average size of the banks' debt for fixed-term advances in that period was 505 billion, an exceptionally large figure when monetary policy is not restrictive and lower only than that recorded in the same months of 1970 and 1974. In October the discount rate was raised and, by the same amount, also the yield on Treasury bills; the yield on medium and long-term
86 securities, which had been rising since summer, recorded a further small increase; in November three-month Treasury bills were offered at auction for the first time since January and yields were again raised. Inspite of these measures, the growth of uncertainty and the expectation of a further rise in interest rates, to which the instability on world foreign exchange markets and the acceleration of the rise in prices greatly contributed, brought about a marked fall-off in the demand for securities. Net placements of government stock, which had already been declining from an average of 8,300 billion in the first two quarters to 4,428 billion in the third, dropped to 1,376 billion in the following two months. Bank reserves rose in those two months by 44 per cent on a seasonally adjusted annual basis; this rise was partly due to the increased need for liquidity for technical reasons connected with the strikes of bank employees during that period, but its significance is demonstrated by the simultaneous upturn in bank deposits (27.4 per cent on a yearly basis).
In December the discount rate was again raised, and by an even greater amount; at the same time yields on Treasury bills, especially those with the shortest maturity, were increased. The effect of this was to boost sales of government securities — which, in the month in question, counterbalanced the 5,000 billion lire worth of maturing Treasury bills — notwithstanding the fact that the combination of a particularly small Treasury borrowing requirement and an absorption of reserves owing to the seasonal demand for notes and coin made liquidity conditions extremely tight: in fact, in the days preceding the Christmas and New Year holidays the banking system resorted to refinancing facilities in the form of fixed-term advances and repurchase agreements (used for the first time on that occasion) for a record figure of about 3,400 billion lire. The size of the debt and its distribution among a large number of banks had the effect of rapidly passing onto money market rates, and hence indirectly onto other interest rates, the increase in the cost of central bank credit.
In January 1980, the public's demand for Treasury bills, stimulated by the high yields recorded at the December auction compared with the much smaller increase in interest rates on deposits decided by the Association of Italian Banks, exceeded the supply at the auction, causing a sharp decline in the interest rates. Certain contingent factors, such as the availability of funds to the public owing to the payment of interest on bank deposits and securities and the failure to issue Treasury bonds to replace those maturing at the beginning of January because of the difficulty of placing medium-term fixed-coupon securities at a time of
87 variable interest rates, help to explain why the demand for Treasury bills was particularly large in January. But random factors aside, since the beginning of 1980 it has been possible to detect a revived tendency among the public to increase the share of saving invested in short-term and floating-rate securities. In the first quarter of the present year total bank reserves increased by less than 400 billion lire, notwithstanding the fact that at the beginning of the year the level of liquidity was not high and that the crediting of interest on bank deposits in December led to a deposit of 2,945 billion lire in compulsory reserves in January. The latter in fact decreased by 1,136 billion in February and March, which is indicative of the extent to which the intermediation activity of the banking system is declining at present; net placements of government stock amounted overall to about 2,600 billion lire but the banking system's portfolio declined by around 9,000 billion. Once monetary base creation had been reduced to very low levels, the central bank redirected its intervention at reversing the tendency of the average maturity of the public debt to shorten. The yield curve, which had shown a very marked downward slope in December, gradually changed in the months that followed in response to the slight fall in interest rates on three-month bills and the increase in those on longer-term stock. This development, which had been brought about by the policy of security supply, reflects the conviction that has grown up in the past months that the reduction of the very high levels of inflation recorded at the beginning of 1980 will be a slower process than originally predicted, but it is also a manifestation of the aim of lengthening maturities. In April the first signs appeared of a reversal of the tendency for demand to shift towards the very short term. The changes which have occurred in the composition of the public's portfolio of financial assets have for the first time ever, at the beginning of 1980, caused the share of Treasury bills in circulation held by the banks to decline to less than half. From the point of view of monetary base management, this development is no less important than was the expansion of the Treasury bill market following the reform of the placement system in 1975. At that time the most prominent effect was to shift the main burden of intervention to regulate the monetary base onto open market operations; the availability of a large volume of maturing Treasury bills each month, however, enabled the banks to regulate their reserve position, thus mitigating the directly quantitative, if not the interest rate effects of a restrictive monetary base policy. Today, the sensitivity of the public's demand for Treasury bills to changes in yield has greatly curtailed this
88 possibility of defending a given level of intermediation; the banks can in fact resist the public's move towards investment in Treasury bills by raising the interest rate on deposits, but the use of this policy is limited by profit and loss account considerations.
The central bank's assets and creation of the monetary base
Monetary base creation by the foreign sector amounted to 2,818 billion lire, which is about half the corresponding value for 1978 (5,820 billion). Unlike that year, when an exceptionally high balance-of-payments surplus accompanied a decline in the banks' debtor position which had the opposite effect, a large part of the result for 1979 was due to the inflow of funds through the banking system: indeed, an autonomous balance-of-payments surplus of nearly 4,000 billion lire was coupled with an increase in the banks' external borrowing of 1,004 billion. Finally, the repayment of compensatory loans produced an outflow of foreign currency of 2,064 billion lire. The components of this sector did not follow a uniform trend during the year. In the first half the inflow of foreign currency through the balance of payments amounted to 2,378 billion lire (which is very close to the figure of 2,334 billion recorded in the first six months of 1978). The banks, once the interest rate differential (net of the expected movement in the exchange rate) was again favourable to external borrowing, raised funds for an almost equivalent net amount (2,264 billion against only 510 billion in the same period of the previous year). The large increase in interest rates abroad that began in the middle of the year, together with expectations of a decline in the exchange rate of the lira, completely reversed the situation in the third quarter. In fact, whereas the autonomous balance of payments was in surplus for 1,620 billion lire, the banks repaid almost 1,000 billion worth of foreign loans; taking into account repayments of compensatory loans, for the first time in over two years the quarterly balance for the foreign sector was negative. In the last three months of the year the inflow of liquidity through the current account and capital transactions was practically nil. However, the raising of domestic interest rates, coupled with the absorption of the unused margins of the ceiling on bank lending during the previous quarter, slowed the rate of outflows of funds through the banking system, which dropped to only 304 billion lire. Monetary base creation through the Treasury, net of Post Office deposits, amounted in 1979 to 466 billion lire (compared with 5,473
89 billion in 1978). It covered only 2 per cent of the Treasury's cash requirement and accounted for 6.7 per cent of total creation (in 1978 the respective percentages were 18.6 and 54.1). The channel of monetary base creation represented by refinancing of the banks, which had been practically unused in 1978, was not only supplemented with new types of intervention such as forward operations in government securities, but was also extremely active throughout 1979.
The central bank's liabilities and uses of the monetary base
During the year under study notes and coin increased by 2,633 billion lire, or 13.9 per cent. The increase was lower, in absolute value as well, than that recorded in 1978 (2,917 billion, corresponding to 18.1 per cent).
Since the accumulation of a large volume of notes by the public at the end of 197 8 did not recur because the Christmas and New Year holidays were distributed differently, the data for the end of the period cause the magnitude of the slowdown to be overestimated (the twelve-month rates of increase of currency were on average lower by only two points than in 1978).
Chart 3
90 The slowdown is in fact part of a long-run tendency for the demand for monetary base for transactions to decline in relation to the other uses, owing to the preference for alternative means of payment (Chart 3). In 1979, there being no significant changes in the interest rate on deposits, this tendency showed up clearly. The trend of notes and coin, in relation to that of income, was not constant throughout the year: the decline of 619 billion in the first six months corresponded to a seasonally adjusted annual rate of increase of 4.2 per cent, which, even taking into account the random movements at the end of the year described above, must be regarded as extremely small (in the corresponding period of 1978 there was an increase of 185 billion, or 13.7 per cent). In the last six months of the year the increase in transactions in connection with the recovery of production instead caused the demand for notes and coin to increase; in the third and fourth quarters circulation rose by 552 billion (27.4 per cent) and 2,700 billion (21.4 per cent) respectively. Post Office deposits increased by 6,618 billion lire and 27.7 per cent during the year, compared with 4,810 billion and 25.2 per cent in 1978. The public in fact retained a lively interest in this type of saving because the interest rates paid by the Post Office authorities were never altered after the increase decided in the third quarter of 1976, while those on bank deposits declined between that period and 1979 by about 2 percentage points. During 1979 the monetary base of the banks increased by 4,291 billion lire or 13.7 per cent. This increase is very much lower than that recorded in the previous year (6,965 billion and 28.7 per cent) but, as has already been mentioned, owing to random movements in liquidity at the end of 1978 the magnitude of the slowdown has been overestimated. Compulsory reserves increased by 5,508 billion lire and 21.3 per cent; the trend during the year closely reflected, with the usual one month lag, the increase in bank deposits. Specifically, after the large payment into these reserves in January based on the increase in deposits in December, in February, for the first time since 1976, there was a withdrawal (350 billion lire). Over the year as a whole, the effective reserve coefficient was 15.15 per cent and therefore fairly close to the maximum theoretical rate (15.75 per cent).
Banking
The volume of bank intermediation in 1979 was affected by a particularly large demand for credit from firms and by the appearance of a tendency among savers to shift their accumulation of wealth from deposits
91 to Treasury bills. This tendency diminished at the end of the year, so as to be barely discernible in the overall results, but then resumed, even stronger than before, at the beginning of 1980. In response to this behaviour the banks abandoned the costly task of maintaining the rates of growth of deposits attained in the preceding years and at the same time met the economy's demand for finance over and above the targets fixed by the monetary authorities. The size of this demand can be explained, on the one hand, by the decline in outlays by the special credit institutions and the failure of the public sector to make certain transfers to firms that had already been programmed and, on the other, by the expansion of productive activity, accompanied by a build-up of stocks of real assets and an increase in trade credit granted abroad. Bank interest rates, which remained practically stationary in the first nine months of the year, were raised after the increases in the discount rate, much more in the case of lending rates than in that of deposit rates. For the first time since 1973 the share of deposits in total domestic financial assets declined (Table 27). The slowdown occurred mostly in the first quarter and was of a similar order of magnitude to that recorded, under tighter credit conditions however, in 1974 and in the first half of 1976. Loans increased by 21.4 per cent; their share in total bank credit, having declined continuously since the end of the preceding cycle in 1976, rose back during 1979 from 50.2 to 51.4 per cent (Chart 4). The banking system's share of total financial intermediation in 1979 differs considerably depending on whether it is measured in terms of the volume of deposits or of loans to the private sector. The decline in the importance of bank deposits as a form of financial saving was reflected in a reduction in bank financing of the public sector (Table 27). This coincided with a more active role in the market for private sector financing; the share of bank loans in fact rose from 60.9 per cent of total credit granted to the sector in 1978 to 78.9 per cent in 1979. The phenomenon sprang, on the one hand, from the large cyclical rise in demand for short-term funds — to build-up stocks, prefinance investment and, more generally, cover the upturn in expenditure prompted by expectations of inflation — and, on the other, from the more active presence of the banks in the market for medium and long-term credit, where they were able to take advantage of their expertise in operations at floating rates and of a few years' duration, which have recently become very popular. Whereas loans granted by the special credit institutions slowed down (from a rate of increase of 13.6 per cent in 1978 to one of 10.7 per cent in 1979) owing to difficulties in subsidized financing in particular, there was a 31.1 per cent increase in medium and long-term bank loans, the highest for several years. This indicates that the traditional
92 Chart 4 INTEREST RATES AND BANK CREDIT INTEREST RATES
Table 27 THE ACTIVITY OF THE BANKS: INDICATORS
93 specialization of the financial intermediaries is tending to weaken, even though long-term bank loans are not necessarily linked to investment projects, unlike those granted by the special credit institutions. The relative decline in bank deposits as a form of financial saving is consistent with the policy pursued by the central bank in recent years to reduce financing of the Treasury and other public bodies by money- creating institutions and thus to establish a direct link with savers. The result obtained also reflects the choice made by the banks themselves to play an active role in trading securities with the public, thereby causing a downturn in the most costly component of fund-raising, and to increase the share of loans in total credit, thus enlarging the most profitable item of their assets. In order to prevent a decline in intermediation which the individual banks, especially those most vulnerable to competition from Treasury bills, initially perceived as a reduction in their market shares, in preceding years interest rates on deposits had been kept at levels that were competitive with those on Treasury bills. This strategy had reduced the difference between interest received and interest paid, as a percentage of funds handled, from 4.12 in 1975 to 3.20 in 1978 (Table 31). By the first quarter of 1979, owing to the heavy demand of the public for government securities, a larger number of banks than in the past abandoned attempts to preserve a competitive position as regards interest rates. This course of action was implicitly recognized by the Association of Italian Banks when it was decided, after the raising of the discount rate in December, to increase the interest rate on deposits by only a quarter of the increase in the prime rate, whereas previously the suggested ratio between the increase in the prime rate and that in the interest rate on deposits was 2 to 1. For the banking system as a whole the margin of interest received again declined on average from 3.20 to 3.05 per cent during the year. The different reaction of the banks to changes in interest rates in the last part of 1979 compared with the similar cyclical phase of early 1976 was also due to the changes in the composition of their assets that had taken place during those years. Specifically, the continuous application since the end of 1976 of ceilings on the growth of lending and the requirement, albeit at rates that have decreased with time, to purchase long-term securities have led to a reduction in the short-term component of credit, the interest rates on which can be more rapidly adjusted to changes in money market rates. In fixing the ceilings on the growth of bank lending the central bank's stance was decidedly more restrictive in the last quarter of 1979 than in the rest of the year. In January the exemption threshold was
94 raised from 50 to 100 million lire in order to encourage lending to small firms, whose demand for funds has been fairly lively throughout the present cyclical phase. The increase in the number of exemptions and the decision to fix the maximum permitted increase in bank loans between January and September 1979 at 14.8 per cent on an annual basis allowed the banks to finance expanding productive activity at constant nominal rates of interest. With the provision of 19th October 1979, issued only a few days after the first increase in the discount rate, it was intended to resist the decline in the banks' foreign borrowing that had begun since the middle of the year and to prevent speculative build-ups of stocks that might have accompanied the recovery in production following the settlement of the labour contract negotiations. In accordance with the targets for total domestic credit expansion already announced in the Government Forecasting and Planning Report, the maximum permitted rate of increase of bank loans was reduced to 10.6 per cent on an annual basis for the period from September 1979 to July 1980. In order to mitigate the restrictive impact on smaller firms the exemption threshold was further raised from 100 to 130 million lire. The lending policy which banks followed in the second half of the year proved inconsistent with the policy of limiting the volume of lending pursued by the Banca d'Italia. Specifically, the interest rates on bank loans were adjusted in response more to changes in the discount rate than to the effective tightening of credit market conditions caused by the ceiling. At current interest rates the demand for loans was higher than the maximum permitted amount and was fully satisfied by the banks, which thus made it possible to reduce loans in foreign currency, especially between May and September, and enabled firms to build up large stocks and accumulate trade credits abroad at the end of the year. On 14th March 1980 the Banca d'Italia altered the provisions on the ceiling by making it compulsory for all banks that overshoot the limit to deposit in a non-interest-bearing account reserves in increasing proportion to the size of the excess. It has therefore been made costly for banks to depart from the established growth path; this will probably affect the criteria by which banks regulate the supply of credit, encouraging a more prompt adjustment of interest rates to tight conditions on the credit market. Through the management of their securities portfolio the banks were able in 1979 to reconcile the conflicting needs created by an accelerating demand for loans and a decelerating demand for deposits. Specifically, their investments in Treasury bills declined substantially since the public
95 Table 28 BANKS' ASSETS AND LIABILITIES (*) (amounts and changes in billions of lire)
96 took over from the banks a large part of the role in the short-term financing of the Treasury. Net purchases of bonds, on the other hand, remained stationary in absolute value (Table 28). Investments in securities were affected by the administrative ceilings less than in 1978: the rate of the security investment requirement remained at 6.5 per cent throughout the year whereas in the first half of 1978 it was 30 per cent. Moreover, in August additions were made to the range of securities eligible to replace bonds purchased in compliance with previous requirements.
Domestic credit
Bank loans increased in 1979 by almost twice the amount of the previous year: 18,583 billion lire (21.4 per cent) compared with 9,510 billion (12 per cent). Of this figure 17,515 billion lire (21.8 per cent, compared with 13.2 per cent in 1978) can be ascribed to lending to the Economy (households and enterprises) and 1,068 billion (16.3 per cent compared with 1.7) to lending to the public sector. The banks responded to the pressures on the demand side by exploiting the exemptions allowed under the ceilings on lending: loans in foreign currency increased during the year by 1,614 billion lire and 28.2 per cent (against a reduction of 842 billion and 12.8 per cent in 1978), while lending in lire for amounts within the exemption threshold rose by 22.2 per cent between January and September 1979 and by 24.1 per cent in the following four months. However, the overall expansion in lending was affected mainly by the fact that many banks overshot the ceiling, by a total of about 3,000 billion lire by November 1979 and about 4,200 billion by January 1980. In the first half of the year, as in similar situations in the past, the abrupt halt of the expansion in industrial production connected with strikes over the renewal of labour contracts in industry did not cause a slowdown in the demand for bank credit. In fact, this demand was lively, partly owing to the decline in lending by the special credit institutions, which was particularly pronounced (1,622 billion lire compared with 2,688 billion in the first half of 1978). In the third quarter the growth of lending to the Economy, equal to 16 per cent, was almost the same as the average increase in the first half of the year, but the rise in interest rates abroad and expectations of a devaluation of the lira prompted banks' customers to step up their demand for loans in lire. As a consequence loans in foreign currency decreased by
97 925 billion lire and the ceiling on lending in lire was overshot by almost 800 billion net (that is, the total amount in excess less the unutilized part of credit lines). Conditions on the market for bank loans changed completely in the last quarter of the year when the Banca d'Italia's policy took a more restrictive turn. Although they did not fully meet the demand, the banks increased their loans in lire at a fairly rapid rate in the fourth quarter (32.5 per cent on an annual basis), and faster than the ceiling permitted. The raising of the prime rate by 1.5 points in October and 3 points in December, decided in both cases immediately after the equivalent increases in the discount rate, was offset in part by the growth of inflation expectations: the real cost of bank credit at the end of the year still appeared much lower than the average for the last five years (Chart 5). Another factor that contributed to the overshooting of the ceiling was the postponement of almost 3,000 billion lire worth of government transfers to State-controlled enterprises. In fact, because these funds were not forthcoming, in the fourth quarter the State-controlled enterprises increased their borrowing from the banks by 2,121 billion lire or 21.2 per cent (in the whole of 1978 the increase was 326 billion or 3.2 per cent). After the modifications made to. the ceiling in March 1980 the amounts by which it was overshot declined considerably and at the end of that month the total excess was below 3,000 billion lire. Lending to smaller-sized private firms continued to increase more than the average (28.6 per cent compared with 23.4 per cent in 1978; Chart 5). The difference in the trend of demand among the various categories of firms was reflected in the movement in the market shares of banks: the larger increase in lending by cooperative banks, savings banks and rural banks was due, among other things, to the predominance of very small firms among their customers. This specialization became less marked, however, between 1976 and 1979: in fact, the credit institutions incorporated under public law, the largest banks and the central institutions for classes of banks increased their loans to small and medium- sized firms more than the rest of the banking system and at the same time reduced the share allocated to the public sector, public enterprises and the major private firms. Following the provision issued by the Banca d'Italia on 8th February 1979 exempting the negotiation of bankers' acceptances from the
98 Chart 5
99 regulations on territorial coverage and the granting of loans, these instruments were very widely used during the year: purchases by the banking system rose from 284 billion lire in April, the first month for which statistics are available, to a peak of 631 billion in December. Bankers' acceptances in fact make it possible to manage the ceiling in a more flexible manner by allowing the banks that have reached the maximum permitted limit to provide their customers with credit from institutions that still possess unused margins. The banks' portfolio of securities, on a balance-sheet valuation, increased by 13,496 billion lire and 15.6 per cent, both figures which are very much lower than those for 1978 (18,871 billion and 28 per cent). The decline in purchases involved government securities in particular, which increased by 8,765 billion and 20.3 per cent compared with 13,619 billion and 46 per cent in 1978. Apart from the almost complete cessation of operations to fund loans granted to local authorities and health insurance institutions (these securities declined during the year by 903 billion lire owing to redemptions), the slowdown was also due to the sharp upturn in loans, which encouraged banks to reduce their purchases of government securities as these have increasingly become a "residual" variable in the balance sheet. The substantial reduction in investments in Treasury bills (1,581 billion, compared with 5,218 billion in 1978) was offset by large purchases of Treasury credit certificates (6,019 billion during the year, equivalent to about 45 per cent of total purchases) following a tendency that had already taken shape in the second half of the previous year. The shift occurred for the most part in the first quarter, when a yield curve that was still unfavourable to short-term stock was accompanied by a particularly lively interest among non-bank operators for Treasury bills. The security investment requirement was relaxed during 1979 both as regards the volume of required investment (6.5 per cent of the flow of deposits during the six months ending in the month prior to the reference month) and the types of security that are eligible (only bonds issued by real-estate, construction and agricultural credit institutions). The reduced requirement, however, only partly resulted in a slowdown in purchases of bonds issued by the special credit institutions owing to the relationships that exist between some of these intermediaries and banks (the volume of these securities increased in 1979 by 4,679 billion and 14.3 per cent, compared with 4,627 billion and 16.5 per cent in 1978); at the end of the
100 year the banks possessed 79.9 per cent of bonds issued by these institutions, compared with 78.4 per cent at the end of 1978 (Table 29).
Table 29 BANKS: SECURITIES PORTFOLIO
Customers' deposits
Bank deposits increased by 37,557 billion lire and 20.1 per cent, a lower rate than in the previous year (23.1 per cent; Table 27). This result was affected to a large degree by the trend of general government deposits, which grew by a much smaller amount than in 1978 (18.3 compared with 58.5 per cent). The deposits of the Economy rose by 20.2 per cent, an increase that is only slightly lower than that recorded in 1978 (20.6 per cent) owing to the sharp upturn at the end of the year. In fact, the slowdown in this aggregate becomes more evident (from 22.4 per cent to 19 per cent) if average annual values are considered. During 1979 households' deposits rose by 18.8 per cent (compared with 19.4 per cent in 1978), while a higher increase was recorded in the deposits of non-financial firms (25.9 per cent compared with 25.5 per cent in 1978). The trend of bank deposits, which reflected the public's propensity to purchase securities, accelerated progressively during the year. After a fairly moderate expansion in the first quarter (11.3 per cent on a seasonally
101 adjusted yearly basis) deposits continued to increase at higher rates in the central quarters of the year (21.7 and 21.3 per cent), with the fastest rate in the last quarter (26.4 per cent). In. 1979, as in the two previous years, the rate of growth of deposits with savings banks was higher than that of the commercial banks (21.7 compared with 19.4 per cent). Among the latter, the lowest rates of increase were registered for the "major" and "large" banks (16.7 and 17.6 per cent respectively), whose market shares of deposits have been declining appreciably over the last years (Table 30). This phenomenon has sprung from numerous factors, some of which are internal to the banking
Table 30 MARKET SHARES OF BANKS (percentage ratios of end-of-year amounts)
system and others exogenous. Among the former of particular importance is the territorial distribution of the banks in question, whose branches are mainly located in large cities and towns where there is stronger competition from other banks and a greater availability of financial assets that are alternative to deposits. The decline in 1979 in the market shares of "major" and "large" banks is also a result of their policy with respect to deposit rates: these banks, which had previously paid more 'for funds than the rest of the system, brought their interest rates closer into line with those of the other banks; indeed, in the case of large deposits these interest rates were even lower than those paid by other banks.
102 Profit and loss accounts
In 1979 the banks reacted to the continuation of the tendency towards a reduction in the margin of intermediation that has emerged in recent years by containing the increase in staff costs and in provisions. Specifically, the difference between the proceeds from all the asset items yielding interest and the cost of raising funds has declined, as a percentage of funds handled, from 3.2 to 3.05. Pre-tax profits, however, remained almost stationary owing to the smaller impact of personnel costs (down
Table 31 PROFIT AND LOSS ACCOUNTS OF THE BANKS: FORMATION OF PROFIT (1) (as a percentage of total intermediated funds)
103 from 2.37 to 2.3 per cent) and of the total of depreciation and allowances (down from 1.01 to 0.93 per cent; Table 31). The unsatisfactory performance of proceeds from financial management and probably the difficulty of curbing further the growth in costs explain the decision made in the last part of the year to increase the differential between interest rates on loans and those on deposits by a larger amount than in similar circumstances in the past. The reduction in the interest margin was largely due to the decline in the yield on loans in lire (from 18.49 to 17.5 per cent), which was greater than the decrease in the interest rate on deposits (from 9.34 to 9 per cent). The differential between bank lending and deposit rates varies cyclically in the same direction as the average level of these rates; the reduction in the differential during the decline in interest rates between 1977 and 1979 was aggravated, however, by the upward pressure on the interest on deposits exerted by competition from the Treasury in raising short-term funds. A favourable effect on bank profits, on the other hand, was exerted by the expansion of the spread between the yield on the security portfolio and the unit cost of fund-raising (from 1.54 to 2.04 per cent). The increase in the average yield on securities (from 10.88 to 11.04 per cent) was due to the shift in the composition of banks' portfolios towards medium and long-term securities, which for most of the year offered a higher yield than short-term stock. In this connection it is significant that the yield on securities came much closer to that on loans: the spread therefore declined to the lowest value of the past six years. This result was achieved partly owing to the fact that less pressure was exerted on the operating decisions of the banks by the ceiling on lending and the security investment requirement, thus causing an increase in the supply of loans and making the placement of securities more dependent on market yields. As in the two previous years, expenditure on staff, which represents over 80 per cent of total operating costs, increased, as a ratio of the number of employees, less than the value of intermediated funds (12.2 and 15.4 per cent respectively). Because of this, between 1976 and 1979 the banks have been able to offset by half a percentage point the decline in the spread between lending and deposit rates.
The capital market
Net issues of bonds, government securities (including variable coupon Treasury credit certificates) and shares fell sharply in 1979. The .total net investments of the banks and the public also fell, though to a lesser extent
104 (Table 32). The Banca d'Italia, which compensated for the small volume of issues by selling securities from its portfolio on the market, kept interest rates stable in the first part of the year and then allowed them to rise gradually in response to the deterioration in market sentiment and the increase in rates abroad. The average maturity of securities has shortened considerably in the last few years, while the proportion of Treasury credit certificates, the yields of which are tied to those of Treasury bills, has risen. When the definition of the capital market is broadened to include Treasury bills, it is still found to have shrunk, albeit to a lesser extent. This contraction was due to the faster growth in other forms of company financing, such as bank loans, as well as to the decline in the public sector borrowing requirement. Furthermore, the downward trend of the public's and the banks' combined investment in securities continued. Finally, in 1979 there was a massive switch to shorter maturities, with Treasury bills and credit certificates accounting for 82 per cent of total net issues and 73 per cent
Table 32 NET ISSUES OF BONDS AND GOVERNMENT SECURITIES (billions of lire)
105 of the total net investment of the public and the banks (in 1978 the corresponding figures were 49 and 53 per cent; Table 33).
Table 33
SHORT, MEDIUM AND LONG- TERM SECURITIES (billions of lire)
The supply of securities
The issues of bonds and government securities, net of redemptions and placement losses fell by 43 per cent (from 25,634 billion in 1978 to
106 14,517 billion in 1979; Table 32), and as a ratio to GDP by more than a half (from 11.6 to 5.4 per cent).
The fall in net issues mainly concerned the public sector (9,218 billion, as against 19,716 billion), which had less recourse to the primary market in view of the smaller borrowing requirement and the difficulty of placing medium-term securities. The latter influenced the choice of instruments employed: there was a slight increase in the issues of Treasury credit certificates (10,250 billion, as against 9,683 billion in 1978), while those of Treasury bonds fell substantially (1,535 billion, compared with 9,374 billion). On the other hand, there was a considerable increase in Treasury bill issues.
The net issues of the special credit institutions declined slightly (4,656 billion, as against 4,762 billion). The small increase (from 2,060 to 2,113 billion) in the issues of the real-estate and agricultural institutions, which continued to benefit from the security investment requirement imposed upon the banks, was accompanied by a reduction in those of both the public works institutions (from 1,171 to 1,100 billion) and the industrial credit institutions (from 1,531 to 1,442 billion), which were particularly affected by the limited growth in the demand for loans. The institutions' fund-raising, which consisted almost exclusively of issues of fixed-interest securities, was slowed down by a limited increase in maximum allowed issue rates that was justified by the desirability of keeping down the cost of long-term finance. Issues could certainly be increased by making more use of securities with new technical features of greater appeal to investors, such as redemption plans without drawings and indexation mechanisms.
The net issues of the other categories of borrowers, consisting almost entirely of public corporations, fell by almost a half (643 billion, compared with 1,156 billion) and they only just maintained their very small share of the primary market. More specifically, the increase in IRI's net issues did not offset the large drop in those of ENEL and private companies. The State-controlled corporations and ENEL benefited from increases in their endowment funds: 1,600 billion at the end of 1978 and 926 billion during 1979. Furthermore, they got round the difficulty of raising funds on the domestic market by expanding their foreign borrowing. The financial needs of private companies, in a year which saw a high level of self-financing, was Satisfied to a greater extent than in the past through the banks.
107 The demand for securities
The two main categories of investors behaved very differently in 1979: the banks considerably reduced their net purchases (especially of Treasury bills) while the public substantially increased theirs, though not enough to offset the reduction in those of the banks. The switch in the policy of the latter with regard to securities has contributed to the progressive growth in the participation of the public in the securities market (Table 34 and Chart 6).
Table 34 NET PURCHASES OF BONDS BY CLASS OF INVESTOR (percentage breakdown)
The pattern of the combined purchases of the banks and the public underwent a radical change during the year. In the first six months, despite the first signs of an increase in the rate of inflation, the favourable attitude of investors that had been a feature of 1978 continued. In fact, even though there was a greater preference for Treasury credit certificates, investment in securities (14,043 billion) was at a much higher level than in either the first or the second half of 1978 (10,386 and 9,467 billion respectively). Purchases in the second half of the year fell sharply owing to the general worsening of expectations and amounted to only 3,246 billion. The public (enterprises, households and foreign investors) reduced its net purchases of bonds and government securities from 5,618 billion in 1978 to 3,641 billion in 1979 as a result of growing expectations of an increase in interest rates. These expectations also influenced the composition of purchases, which consisted mainly of Treasury credit certificates (up from 2,531 to 3,703 billion).
108 Chart 6
The large reduction in the public's purchases of bonds and government securities was accompanied by a large increase in purchases of Treasury bills (up from 3,723 to 8,248 billion). Total investment in securities therefore rose from 9,342 to 11,888 billion, while the average maturity of the public's portfolio was considerably reduced (Table 33). In the first half of the year the public's demand grew strongly in parallel with a sharp slowdown in the expansion of bank deposits. The initial acceleration in inflation did not affect the volume of investment but its composition, with a shift towards short-term variable-rate securities. The large increase in the total demand for securities was probably also influenced by the change in the behaviour of the banks, which accepted the slowdown in the rate of growth in their deposits and encouraged the public to modify the structure of its portfolio in favour of securities. This tendency came to an end in the second half of the year, when there was a sharp fall in the purchases of securities, and especially of those of a medium-term fixed-interest nature, which recorded
109 net redemptions. Expectations of higher interest rates spread rapidly and kept the public out of the market not only for Treasury bonds (Chart 7) but also for Treasury credit certificates, in view of the slowness of the mechanism for adjusting their coupons to increases in Treasury bill yields. On the other hand, the public continued to buy large quantities of Treasury bills, thus accentuating the tendency for the average maturity of its portfolio to shorten.
Chart 7
For the year as a whole, total purchases of government securities also declined in relation to GDP (1.4 per cent in 1979, compared with 2.6 per cent in 1978 and 0.4 per cent in 1977). When purchases of Treasury bills are included, however, the GDP ratio was stable (4.4 per cent in 1979, compared with 4.4 per cent in 1978 and 2.3 per cent in 1977). The distribution of bonds and government securities among the various categories of holders shifted in favour of the public, the share of which rose from 18.5 to 19.6 per cent. When Treasury bills are included, the increase was even larger: from 20.2 to 24.0 per cent. The banks considerably slowed down the expansion of their bond and government securities portfolio, with net purchases of 11,953 billion in
110 1979, as against 13,511 billion in 1978. The proportion of their deposits invested in securities also declined, from 34.2 per cent at the end of 1978 to 33.8 per cent at the end of 1979. The slowdown in purchases was already apparent in the first quarter and, though they remained steady in the second, they continued to decline in the third and fourth. In the same way as the public, the banks reduced their purchases, of medium and long- term fixed-interest securities (from 8,993 to 5,933 billion) while increasing their investments in Treasury credit certificates (from 4,518 to 6,019 billion). However, unlike the public, they substantially reduced their purchases of Treasury bills (from 5,217 to 1,581 billion). This behaviour is attributable in part to expectations of future, though not imminent, increases in interest rates that made Treasury credit certificates preferable to both fixed-interest securities (greater risk) and Treasury bills (lower yields). More specifically, the banks reduced their purchases of Treasury bonds (1,975 billion, as against 2,478 billion in 1978), which they made mainly in the first few months of the year, preferring those with shorter maturities offered by the Banca d'Italia to new issues. As usual, the banks took up almost the whole amount of the special credit institutions' issues with purchases of 4,640 billion, compared with 4,737 billion in 1978. They also underwrote the full amount of IRI's issues and that part of the ENEL issues which was not placed with the public. The Banca d'Italia made net sales and redemptions of bonds and government securities amounting to 2,772 billion (compared with net purchases of respectively 5,781 and 7,658 billion in 1978 and 1977). This disinvestment mainly concerned medium and long-term fixed-interest securities (down 2,945 billion), with large net sales of Treasury bonds (1,841 billion, compared with net purchases of 3,405 billion in 1978) and net redemptions of other fixed-interest securities. The Bank's portfolio of Treasury credit certificates increased slightly (173 billion), while its holdings of Treasury bills declined by 330 billion (compared with disinvestment amounting to 3,601 billion in 1978). The net sales were made mainly in the first half of the year and included fixed-interest securities, Treasury credit certificates and Treasury bills. These portfolio operations, coordinated with issuing policy, made it possible to satisfy the demand for securities with the effect of stabilizing interest rates and countering the withdrawal of investors from the medium and long-term end of the market. In the second part of the year there was a change in the sign of the central bank's intervention: the third quarter saw net purchases of
111 Treasury bills and the fourth of Treasury credit certificates and medium and long-term securities. The sizeable reduction in demand and the desire to raise interest rates gradually, led the Bank to take up unwanted medium-term securities, which resulted in part from the limit on Treasury bill issues established in the financial law having been reached. There was also a switch in the Bank's open market operations. Its sales (174 billion) were made mainly in the first three quarters and exactly matched its purchases (176 billion), which were concentrated in the fourth.
Interest rates
The yields of government securities rose from 13.04 per cent in December 1978 to 14.00 per cent in December 1979, while their average value for the year remained virtually unchanged at 13.12 per cent, compared with 13.18 per cent in 1978. Bond yields rose from 13.54 to 14.46 per cent between December 1978 and December 1979, with their average value also rising slightly from 13.51 to 13.78 per cent. Despite the worsening of inflation expectations and the increase in rates abroad, bond yields remained stable until September. Those of government securities, on
Table 35 AVERAGE MATURITY YIELD ON FIXED-INTEREST BONDS
112 the other hand, started to rise in the summer months, when, in antici- pation of a rise in the whole structure of interest rates, it was decided to raise those of medium-term securities first, partly through open market operations, and to postpone temporarily the raising of short-term rates in order to create favourable conditions for the issue of Treasury bonds planned for October (Table 35). The increase in short-term rates subsequently accelerated the rise in long-term rates, which, by the end of March, amounted to two percentage points for government securities and to one and a half percentage points for bonds. Yields thus returned to the peak levels reached in April 1977 at the top of the previous upward phase. This latest rise in interest rates was very different from those of the
previous crises on the capital market. In 1969 - 1970, in 1974 and in 1976 the rises were larger and accompanied by severe tension in the market. In 1979 - 1980, instead, the rise was moderate because the initial level was relatively high. In fact, at the end of 1978 and in the first part of 1979 the Banca d'Italia had sold securities on the stock exchange in line with a prudential policy that reflected the prospect of a structurally high rate of inflation. During the first nine months of 1979 the yield curve was rising and the slope greater than in 1978. This reflected both the greater risk of medium and long-term securities and expectations of an increase in interest rates (Chart 8). The good balance-of-payments results and the stability of Chart 8
113 the exchange rate tended to keep short-term rates down and curbed the pressures deriving from the rate of inflation and the rise in interest rates abroad. In October the curve started to rise and become flatter; in December it became downward sloping as a result of the second increase in the official discount rate. The steep slope of the first part of the curve in December was caused by the temporary effect of the switch in monetary policy, which was immediately reflected in short-term rates. During the first few months of 1980 the yield curve rose to the level of April 1977 with a sharp reduction in its downward slope. This reflected not only expectations that interest rates would fall in the longer run but also the rationing of the supply of medium-term government securities.
Share issues
There was a small rise in gross issues (3,894 billion, as against 3,608 billion in 1978), while net issues fell slightly (from 2,985 to 2,732 billion) as a result of the large increase in share issues made to finance the purchase of shares issued by subsidiaries. The very substantial rise in the increases in share capital of the last two years, about four and a half times those of the preceding two years, was mainly due to listed companies, and especially to State-controlled corporations. The level of share prices was not, however, the main reason for this raising of share capital. Indeed, excluding from the total issues of listed companies the shares issued at a price above their market quotations, and therefore unattractive to ordinary investors, results in the issues of the State-controlled corporations falling from 1,548 to 14 billion, and those of private companies from 353 to 343 billion. Thus only a very small proportion of the increases in share capital was able to attract the public and the greater part was underwritten by firms which were connected with the issuing companies and which bore the cost of the premium. The persistence of large differences between the balance sheet and stock exchange valuations of companies is clear evidence of the inadequacy of the rules for the compilation of company accounts in periods of inflation and, on occasion, of the limited efficiency of the official stock exchange. Among the unlisted companies there was also a large increase in the issues of the State-controlled corporations. On the other hand, there was a sharp fall in the issues of small and medium-sized companies, despite the increased cost of borrowing and the approaching expiry (December 1980) of the period allowed by Law No. 904 of 16th December 1977 for companies to conform with minimum capital requirements.
114 The demand for shares and the activity of unit trusts
The annual survey of share ownership conducted on the basis of the balance sheets of companies and public agencies showed a change in the distribution of the share portfolio among the various categories of investors that was in line with the trend of previous years. In particular, the proportion of shares held by "companies" increased (from 63.1 to 68.9 per cent), while there was a large fall in that of "the public" (from 21.1 to 16.9 per cent), notwithstanding the rise in share prices. These results provide further confirmation of the fact that the substantial increases in share capital of the last few years did not correspond to greater interest on the part of savers but were mainly underwritten by companies connected with those making the issues (Table 36).
Table 36 SHARE CAPITAL BY CLASS OF INVESTOR (amounts at end-year; percentage breakdown; total in billions of lire)
The net assets of the unit trusts authorized to operate in Italy rose by 30 per cent from 391 billion at the end of 1978 to 509 billion at the end of 1979. All the different categories of assets increased in value: shares, from 261 to 304 billion; "other securities", from 76 to 116 billion and cash from 54 to 89 billion. As for the composition of the unit trusts' assets, there was a further decline in the proportion of shares (from 67 to 60 per cent), which was matched by increases in those of "other securities" (from 19 to 23 per cent) and cash (from 14 to 17 per cent).
115 Share prices
The upward trend of share prices that had developed during 1978 continued in the first nine months of 1979, when they rose by 21.8 per cent. Subsequently, they fell by 12.1 per cent and this considerably reduced the total rise for the year in the share price index (8.0 per cent, compared with 28.4 per cent in 1978; Chart 9).
Chart 9
The increases in quotations during the first three quarters, which was coupled with a large rise in trading, was mainly due to renewed confidence in company profitability. However, it also benefited from the large number of transactions undertaken by private financial groups, which considerably
116 modified the structure of their shareholdings in listed companies. These operations, both because they were partly carried out on the stock exchange with a consequent inflow of funds and because they enabled the market to acquire more accurate information regarding the real asset value of several companies, led prices on the secondary market to rise extremely rapidly. The speculative bull operations that accompanied these purchases led to excessive margin positions being built up, but these were easily attacked by large short sales, to which the fall in prices in the last quarter can be attributed. Since a number of companies decided not to pay dividends in view of their poor results, the dividend index fell by 31.0 per cent and this was reflected in the current yield, which fell to the extremely low level of 2.8 per cent (compared with 4.3 per cent in December 1978; Chart 9). It should be noted, however, that total dividends declined, even though those paid on a great many relatively less important shares actually increased. In the first few months of 1980 expectations of higher dividends, subsequently confirmed by the results reported in March and April, helped to push prices up again: in the first quarter they rose by 10.3 per cent, compared with a rise of 13.0 per cent in the same period of 1979. As for the over-the-counter market which is held weekly on the Milan bourse, the Banca d'Italia's ex-dividend price index (10th May 1978 = 100) showed an average rise of 63.7 per cent between December 1978 and December 1979. The numerous increases in the share capitals of the banks listed on this market nearly always exerted upward pressure on prices and, unlike those on the main market, they continued to rise in the fourth quarter. Subsequently, a further rise of 30.7 per cent took the index up to 291.0 at the end of the first quarter of 1980.
The activity of the special credit institutions
The recent tendency for the lending of the special credit institutions to show only limited growth continued in 1979, when the rate of increase was below that of investment. The decline in the relative importance of the lending of the special credit institutions in the last few years also occurred in sectors, such as housebuilding, in which fund-raising received the greatest support from the compulsory security investment requirement. Domestic outlays amounted to 12,879 billion, or slightly more than in 1978 (12,364 billion, net of a 690 billion funding operation). As a ratio to investment they fell from 24.9 per cent in 1978 to 21.3 per cent,
117 but the increase in investment last year was especially large. In fact, if the lag between real investment activity and its financing is assumed to be equal to one year and the disbursements are compared with investment in the previous year, the fall in the ratio was much less marked. Outlays of subsidized credit (4,191 billion, compared with 3,908 billion in 1978) only increased to any appreciable extent in the agricultural sector, where the greater part of lending is for short-term working credit, and in the services sector. The small growth in the lending of the special credit institutions, besides reflecting cyclical factors, appears to have been due to longer term causes. In the early 'seventies the investment finance provided by the special credit institutions rose to a high level, boosted by the large proportion of subsidized credit. Despite the selective measures designed to limit the effects of the change in monetary policy after the 1973 oil crisis, the importance of the special credit institutions as suppliers of investment finance appears to have declined in the second half of the decade (Chart 10). Two important factors contributing to this process were the change in the system of financial incentives in the industrial sector, in view of the long delays in implementing the new procedures, and the reduction in the demand for financing, mostly at subsidized rates, for large investment projects in basic industries as a result of the crises in these sectors and the difficulties of large industrial groups that had already borrowed heavily from the special credit institutions. A more general cause of the decline was the limited scope for adapting the forms of their medium and long- term lending to the requirements of borrowers in periods of considerable uncertainty regarding future rates of interest and inflation. When account is taken of reimbursements, outstanding domestic lending, including the financing of stockpiles, grew less than in 1978 (5,812 billion, as against 6,638 billion; Table 37), and the rate of increase was the lowest ever recorded (10.5 per cent, compared with 13.7 per cent the year before). Outstanding lending on behalf of the Treasury fell by 611 billion. As in recent years, the growth in lending was influenced by the increasing weight of reimbursements caused by the shortening of maturities. A sizeable proportion of the instalments that matured were not honoured: in 1979 the outstanding amount of overdue instalments increased by nearly 900 billion, compared with 600 billion in 1978. The pattern of lending during the year showed a moderate increase in the first nine months and a strong upturn in the fourth quarter, when the rise in short-term rates was not accompanied by an increase in the cost of longer term finance.
118 Chart 10 OUTLAYS OF THE SPECIAL CREDIT INSTITUTIONS
Table 37
ASSETS AND LIABILITIES OF THE SPECIAL CREDIT INSTITUTIONS (billions of lire)
The decline in financing activity was almost entirely attributable to the industrial credit institutions. These were affected not only by the continuance of a low level of demand for credit from the industrial sector but also by a slowdown in lending to the services sector, which in 1978 had partially offset the decline in the flow of credit to industry.
119 The real-estate and housebuilding institutions, the fund-raising of which is supported by the compulsory security investment requirement, increased their lending at almost the same rate as in 1978. However, the financing of investment in housing continued to stagnate, in view of the difficulty that even middle-income households encounter in paying the instalments in the early years of a mortgage with the present level of interest rates, while recourse to innovative mechanisms such as indexed mortgages and rising instalments was limited. Both the public works institutions, which increased their share of the financing provided to the services sector, and the agricultural institutions, which mainly expanded their activity at market rates, continued to increase their lending at a good pace.
Fund-raising was sufficient to satisfy the institutions' financial requirements in view of the modest rise in lending. In fact, despite the large reduction in their cash flow caused by the substantial increase in overdue instalments, they did not suffer from serious liquidity problems. The value of the bonds placed was the same as the year before (8,372 billion, compared with 8,313 billion in 1978), even though the compulsory security investment requirement had been relaxed. This was partly because the structure of yields favoured long-term securities until October. The institutions also continued to strengthen their capital base: the ratio of paid-up capital and reserves to domestic lending was 8.8 per cent at the end of 1979, as against 7.7 per cent at the end of 1978.
In the first few months of 1980 the leading industrial credit institutions took more determined steps than in the past to increase the competitiveness of their fund-raising instruments, even if the tax advantages enjoyed by government securities make this a difficult task. Securities were offered with shorter maturities and variable coupons (in April issues of the latter amounted to more than 200 billion). An innovation already implemented by the real-estate institutions on a limited scale in 1979 was the revaluation of loan capital, in some cases using an index of domestic prices and in others the exchange rate of the lira vis-a- vis the ECU.
Removal of the obstacles currently hindering enterprises from raising funds in the market, such as the differences in the tax treatment of interest payments according to the nature of the issuer, would enable larger firms to offer bonds directly to savers. This would leave the special credit system as the main source of long-term finance for households and small and medium-sized companies, the categories which suffer most from capital market imperfections.
120 Furthermore, abolition of the inequalities in the tax treatment of bond yields, together with the wider adoption of innovative mechanisms, would help to make the securities issued by the special credit institutions more attractive to the public. Double intermediation cannot be eliminated by such measures in view of the public's preference for liquid assets and the banks' fund-raising policies, but they would enable the special credit institutions to reduce their recent excessive dependence on investment by the banks and, at the same time, permit the latter to reduce the rigidity of their balance sheets.
Fund-raising
The funds raised by the special credit institutions, net of the operations carried out on behalf of the Treasury, fell sharply compared with the previous year (7,148 billion, as against 9,139 billion; Table 38). The decline was even larger if account is taken of the large (and mostly advance) reimbursements of foreign compensatory loans, the counterpart to which was a 1,911 billion reduction in tied foreign currency deposits with the Banca d'Italia (- 818 billion in 1978). Net of redemptions, bond issues dropped from 5,707 billion in 1978 to 5,258 billion. Virtually all these securities were taken up by the banks, which exceeded the compulsory investment requirement (6.5 per cent of the increase in their deposits) and thus confirmed their willingness to invest in securities issued by special credit institutions with which they have capital and operational ties, even when the yields on these securities are not competitive. However, the Central Post Office Savings Fund as well as insurance and social security institutions also made substantial investments. The public's increased preference for more liquid investments, due in part to expectations of a rise in yields, led to a very large decline compared with the previous year in the funds raised by the special credit institutions in the form of medium-term deposits (176 billion, as against 1,326 billion). It should be noted, however, that in the first half of 1978 the banks could still use these certificates to satisfy the security investment requirement. In particular, there was a net decrease in time deposits with maturities of over four years. With foreign interest rates rising from the beginning of the second half of the year, the special credit institutions' foreign currency borrowing net of compensatory loan repayments declined by 150 billion lire, compared with an increase of 490 billion in 1978.
121 The banks' share of the total funds raised by the special credit institutions (mainly through purchases of securities) rose slightly; that of private investors fell, while that of the public sector rose (Table 38).
Table 38
FUND - RAISING SOURCES OF THE SPECIAL CREDIT INSTITUTIONS (percentage breakdown of changes)
Lending
The smaller increase in domestic credit (5,808 billion, as against 6,530 billion in 1978) reflected lower growth in lending at both subsidized and market rates. The latter slowed most (rising by 4,250 billion, as against 4,912 billion in 1978) as a result of the fall in the flow
122 of finance to industry and services. Subsidized credit, on the other hand, reflected the smaller increase in lending to the export and housing sectors, which was only partially offset by the larger increase in lending to the services sector (Table 39).
Table 39
DOMESTIC LENDING BY THE SPECIAL CREDIT INSTITUTIONS BY SECTOR (billions of lire)
Reimbursements in 1979 amounted to 7,100 billion, compared with 5,800 billion in 1978. Their increase in relation to total outstanding lending at the beginning of the year (from 12.2 per cent in 1978 to 13.0 per cent) confirms the trend towards shorter maturities. With regard to the various categories of beneficiaries, both lending to public enterprises and agencies and that to households and private companies grew at a slower rate than the year before. The slowdown was sharper, however, in the public sector (from 18.1 to 10.3 per cent) and was due almost exclusively to the State-controlled corporations, which received much less credit than in the previous year, partly as a result of their having been granted large increases in their endowment funds at the end of 1978 and also because they borrowed more from the banks (Table 40).
123 Table 40 DOMESTIC LENDING BY THE SPECIAL CREDIT INSTITUTIONS BY CLASS OF BORROWER
In the private company sector, with a number of large firms in serious financial difficulties, the upward trend of the share of credit granted to smaller firms continued.
The cost of finance
The average market cost of medium and long-term credit was 14.60 per cent in 1979, 0.40 per cent less than in 1978. The average cost of the loans disbursed by the industrial institutions fell by slightly more, from 14.95 to 14.35 per cent. On the other hand, the average market rate for real-estate mortgages did not change appreciably, remaining close to 15 per cent. The differential between the cost of bank loans and that of the credit provided by the special credit institutions, which appears to be structurally larger in Southern Italy, narrowed to a minimum in the second quarter and then widened at the end of the year.
124 The average cost of subsidized credit fell compared with 1978 from 6.35 to 6.05 per cent. The cost of the subsidized credit disbursed by the industrial institutions showed a similar fall (from 7.35 to 7.10 per cent) and remained about 7 percentage points below the market rate (9 percentage points in the case of credit for investments in Southern Italy).
Credit to industry
The credit disbursed to industry was the same as in 197 8 (5,094 billion, as against 5,004 billion). Net of export credits, disbursements amounted to 4,242 billion (4,025 billion in 1978; Table 39). As in 1978 the ratio of disbursements to investment expenditure fell sharply (from 35.2 to 29.6 per cent), though the large increase in the latter will probably be reflected in the volume of credit disbursed in 1980. The flow of subsidized credit to this sector continued to be small (1,084 billion, as against 1,013 billion in 1978). Furthermore, it did not offset the flow of reimbursements so that, as in the previous year, the outstanding subsidized credit to industry declined (- 36 billion, as against - 58 billion in 1978). The small growth in investment in crisis-ridden industries and the delayed implementation of the new incentives for industrial restructuring contributed to the reduction in the demand for special credit of sectors which had previously made the greatest use of the special credit institutions (chemicals, oil products and basic metals). Nonetheless this composition effect seems to have been less important than the substitution effect that is revealed by the changed importance of the various components of company financing. In fact, in the same way as in 1978, the structure of investment financing was marked not only by a large volume of self-financing but also by recourse to foreign loans and a larger volume of funds available to public enterprises. The substantial increase in companies' medium and long-term borrowing from the banks confirms the hypothesis of a partial substitution of special credit, though it is not possible to determine how much of this borrowing represented a financial operation designed to lengthen maturities rather than the financing of new investments. The large volume of bank credit shows, however, that industrial companies found it easy and advantageous to have recourse to alternative medium-term financial instruments, most of which were at variable rates, a feature that the special credit institutions rarely offer.
125 Credit to services
Outlays to the services sector amounted, if housebuilding is excluded, to 3,668 billion, which was slightly less than in 1978 (3,767 billion, net of a 690 billion funding operation). There was thus a sharp fall in the ratio of disbursements to investment compared with 1978 (from 24.3 to 19.7 per cent). It should be noted, however, that the flow of financing was exceptionally large in 1978 and that investment expenditure recovered in 1979. The ratio was nonetheless higher in 1979 than in 1977. The decline in disbursements occurred mainly in the transport and communications sector, which received 1,708 billion, compared with 2,166 billion in 1978 (respectively 722 and 1,442 billion net of reimbursements). In particular, there was a large fall in the financing of telecommunications services, which in the previous year had received very large sums from the leading industrial credit institutions. With investment continuing at a high rate in 1979, the State-controlled corporations operating in the sector, which were already heavily indebted with the special credit institutions, had recourse to variable rate bank loans and to direct fund-raising on both the domestic and the international capital market. Lending to the other branches of the services sector, mainly by the public works institutions, increased. The flow of credit to local authorities, the most important beneficiaries, nonetheless remained virtually unchanged in view of the larger contribution of the Central Post Office Savings Fund towards the financing of public works.
Credit to housebuilding
The outlays of the special credit institutions for housebuilding were slightly larger than in the previous year (1,968 billion, as against 1,909 billion). Since there was a small increase in building activity and a further rise in costs, the ratio of disbursements to investment in housing fell substantially (from 17.1 to 14.6 per cent) compared with 1978, when the decline that had started in 1974 was halted. The flow of subsidized credit fell in 1979 (453 billion, as against 490 billion) after rising in 1978 both in absolute terms and in relation to investment. In 1979 there was an upturn (with a rise from 5.2 to 7.7 per cent) in the share of public investment financed with funds for subsidized housing disbursed by the special section of the Central Post Office Savings Fund, mostly in connection with programmes approved prior to the "ten-
126 year plan" (Law No. 457 of 1978). The proportion of private investment covered by self-financing appears to have declined, while among the external sources of finance the decline in the relative importance of the special credit institutions continued, to the advantage of the banks. The increase in the latter's lending was especially marked for loans beyond the short term, some of which were granted at preferential rates in the context of special schemes (Table 41). The increase in the outstanding loans of the special credit institutions to housebuilding amounted to 1,148 billion (1,259 billion in 1978). The contraction was mainly in the borrowing of enterprises, which, on the other hand, considerably increased their indebtedness with the banks.
Table 41 FINANCING OF INVESTMENT IN HOUSING (1) (billions of lire)
The compulsory security investment requirement imposed on the banks made it possible to place a large amount of real-estate and housebuilding bonds at less than equilibrium rates. However, this ample supply of funds did not solve the problem that mortgages are excessively
127 costly at current interest rates, since the instalment payments continue to represent too large a proportion of most households' incomes, despite the burden borne by the banks. The continuance of the security investment requirement also meant that the special credit institutions were not stimulated to develop innovative instruments that would enable them to raise funds without the support of administrative constraints. In fact, fund-raising through bonds that will be partially revalued with reference to a price index remained at the experimental stage in 1979 (60 billion at the end of the year). The banks have been allowed to purchase these indexed securities, which are exempt from capital gains tax, to satisfy the security investment requirement, even though this type of asset introduces an element of disequilibrium in the balance sheets of intermediaries which pay a return on their liabilities that tends to incorporate the expected rate of inflation. Similar measures should, however, be limited to the introductory phase, during which many users may not be aware of the indexed alternative to fixed-interest instruments. In fact, it is intended that indexed schemes should operate without any "protection", while allowing certain categories of borrowers to obtain mortgages on the one hand, and savers to be defended against monetary erosion on the other.
Credit to agriculture
Lending to agriculture continued to increase at a fast rate, albeit more slowly than the year before (23.5 per cent, as against 28.0 per cent). In absolute terms the increase amounted to 1,456 billion, compared with 1,351 billion in 1978 (Table 42). There was a particularly large increase in the lending of the other authorized institutions (mainly banks), which further increased their share of both working and improvement credit compared with the special credit institutions. Total outstanding working credit at the end of 1979 showed an increase of 986 billion compared with the end of 1978 and amounted to 4,279 billion. This was equal to 16.9 per cent of gross marketable production, compared with 15.2 per cent the year before. The increase is attributable to the continued rapid growth of operations at market rates, which now represent one third of the total value of outstanding loans.
128 Disbursements of improvement credit amounted to 643 billion, compared with 555 billion in 1978. As a ratio to investment in the agricultural sector they rose slightly from 16.5 to 16.7 per cent. A larger proportion was at market rates than in the past (37 per cent, compared with 34 per cent in 1978), and the flow of credit for rural building showed an especially large increase. Subsidized improvement credit in 1980 should benefit from the implementation of Law No. 984 of 1977.
Table 42 LENDING BY THE AGRICULTURAL CREDIT SYSTEM (changes in billions of lire)
The desirability of reforming the system of agricultural credit, still basically regulated by legislation passed in 1928, has been reflected in a number of bills recently submitted to Parliament. One proposal that needs to be carefully assessed is that a share of financial flows should be reserved for agriculture, since, if it were put into practice, it would risk making the distribution of credit even more rigid without achieving the aims of those who favour a segmentation of the market. Significant in this connection is the permanent gap between the issues of agricultural improvement credit securities and the share of the banks' security investment requirement to which they are entitled (respectively 390 and 730 billion in 1979).
Export credit
Disbursements of export credit were slightly larger than in 1978 (1,851 billion, as against 1,688 billion; Table 43). Since there was a large increase in exports, this led to a further reduction in the proportion
129 Table 43 EXPORT CREDITS (1) (billions of lire)
that benefited from this form of credit (3.1 per cent, as against 3.6 per cent). The ratio of export credit to the value of final investment goods sold abroad, usually with recourse to deferred payment, fell from 14.6 to 13.3 per cent, further widening the gap compared with the early 'seventies (Chart 10). The increase in the flow of credit was entirely due to the rise in buyer credits (from 709 to 999 billion), since supplier credits declined (from 979 to 852 billion). The rise in reimbursements, and especially in those of buyer credits, caused the increase in outstanding loans to be smaller than that of the previous year (513 billion, as against 575 billion). When the refinancing of the Italian Foreign Exchange Office and the compensation paid by SACE are included, the net resources transferred abroad in connection with medium-term export finance amounted to 690 billion, compared with 890 billion in 1978. Developing countries continued to receive the greater part of export credit (75 per cent of the increase in lending), with Algeria once again receiving a large share (29 per cent). The industrial countries received 18 per cent of the additional lending, while the share of the countries with planned economies, which used to receive the greater part of buyer credits, was only 7 per cent. In particular, the buyer credits granted to the Soviet Union continued to decline sharply (— 196 billion, as against — 73 billion in 1978).
130 There was a slowdown in both applications and approvals after the large rise of the previous year. The special credit institutions' commitments rose to 7,879 billion at the end of 1979, compared with 6,810 billion at the end of 1978; those for buyer credits amounted to 4,209 billion, of which about one third will presumably be disbursed in 1980.
Total financing and the formation of financial assets
In 1979 the recovery in investment and consumption was coupled with a more moderate increase in the financial deficit of the public sector and a reduction in the surplus of the current account of the balance of payments. The saving transferred by households to the other sectors, although it increased in absolute terms, declined in relation to GDP from 16.1 to 15.4 per cent, thus reflecting the reduction in the disequilibria between saving and investment in the corporate and public sectors and the smaller current account surplus. Even though the rate of increase in investment doubled and there was a build-up of stocks, firms' financial deficit fell in relation to GDP from 3.2 to 2.1 per cent as a result of the substantial rise in gross saving. The total financing requirement of the corporate sector, boosted by the acquisition of a large amount of domestic and foreign financial assets, was about 40 per cent higher than in 1978 and one third of the total was covered by external sources, which provided 28,740 billion, as against 22,600 billion in 1978. The public sector's financial deficit, equal to 27,980 billion (23,720 billion in 1978), declined slightly in relation to GDP from 10.7 to 10.4 per cent. In fact, the smaller increase in the deficit on current account was offset by a higher level of investment and capital transfers to the corporate sector. The public sector borrowing requirement nonetheless declined from 34,370 to 33,470 billion since its credits and other financial assets increased by a half compared with the previous year, as a result of the reduction in capital grants to the State-controlled corporations and the smaller increase in the bank deposits of government agencies and local authorities. The curbing of the public deficit made it possible to satisfy firms' demand for external funds with an increase in total financing of 58,350 billion, equal to a rate of increase of 17.6 per cent (47,320 billion and 16.6 per cent in 1978). In relation to GDP, total financing rose from 21.3 to 21.7 per cent, whereas in 1978 it had risen by 1.4 percentage points compared with 1977 (Table 44).
131 Table 44 THE FINANCIAL ASSETS OF THE ECONOMY AND TOTAL FINANCING (1) (rates of increase and percentages of GDP)
For the first time since 1976 the distribution between the public and the private sector of the flow of funds shifted in favour of the latter, which received 52 per cent of total financing, compared with 49.9 per cent in 1978. The private sector's share nonetheless remained below the average of the last five years (Table 45). Total domestic credit (which, compared with total financing, is gross of public agencies' bank deposits but does not include share issues or foreign direct financing) amounted to 53,350 billion, which represents a rate of increase in outstanding credit of 18.6 per cent, compared with 49,340 billion and 20.7 per cent in 1978. As a ratio to GDP, total domestic credit fell from 22.2 to 19.8 per cent (Table 46). Net of the increase in the bank deposits of public agencies (2,200 billion, compared with 7,100 billion in 1978), which only reflect a transfer of funds between the Treasury and the banks, the rate of growth in total domestic credit rises to 18.9 per cent, as against 18.5 per cent the year before. In the first few months of 1979 the small increase in the State sector's borrowing requirement and the slowdown in the private sector's demand for credit compared with the high level of the last quarter of 1978 caused a moderate rise in total domestic credit. In the second and
132 Table 45 FINANCING OF DOMESTIC FINAL-USER SECTORS
third quarters it rose faster as a consequence of the larger State borrowing requirement and, after the new labour contracts had been signed, of firms' demand for funds connected with the recovery in production. The rise in credit flows continued in the last quarter despite the large increase in interest rates caused by the greater stringency of monetary policy.
The composition of the flow of new credit shifted in favour of the banks, which, partly as a result of the Treasury's failure to finance the increases in the State-controlled corporations' endowment funds, exceeded the ceiling on domestic lending in the second half of the year. In the short term the substitutability of public funds by those of the credit institutions is extremely high and makes it possible to reduce the negative effects of the irregularity of government payments on productive activity.
In 1979 the funds that flowed directly to the private sector from the credit institutions and the bond market amounted to 22,210 billion (15,400 billion in 1978), while the enlarged public sector provided transfers and financing to firms amounting to 7,410 billion (6,680 billion in 1978). The proportion of the total flow of funds to firms contributed by the public sector thus fell from 30 to 25 per cent, but nonetheless remained at the high average level of the last five years, during which
133 Table 46 TOTAL DOMESTIC CREDIT (changes in billions of lire and percentage growth rates)
134 about one quarter of the funds employed by firms were disbursed by the public sector. The banking system and the capital market have thus come to provide a declining share of the financial resources needed for productive investment, and consequently the area over which the central bank has control has shrunk. The public financing of the corporate sector has led to the growth of a parallel system of intermediation, which, either directly or through the placing of public debt securities with the banks, channels households' saving to the productive sector, thereby partially compensating for the crowding out of companies on the capital market by the borrowing of the State sector. However, the achievement of a better allocation of resources would have required an overall plan for public intervention that fostered the structural changes needed to support a sound process of productive expansion. By channelling funds towards loss-making sectors and firms, the public financial circuit has reduced the efficiency of resource allocation within the economy, even if in some cases it may have replaced the traditional financial intermediaries in high risk ventures. The counterpart of the moderate expansion in total financing and of the reduced current account surplus was a formation of financial assets by households and firms that amounted to 66,230 billion (52,360 billion in 1978), with an increase of 20.1 per cent, compared with 19.7 per cent in 1978 and 16.8 per cent in 1977. The ratio of the average amount of total financial assets net of shares to GDP rose by 1.1 percentage points from 115.5 to 116.6 per cent, while in 1978 it had increased by 2.8 percentage points. In the last two years the more regular growth in credit and monetary aggregates resulted in this ratio not showing the large fluctuations of the preceding years (Chart 11). The rate of growth in domestic financial assets fell from 21 to 20 per cent. Net of shares, they rose from 110.6 to 111.8 per cent of GDP. If shares are included, the rise was larger as a result of the increase in their prices. The monetary component of the flow of new financial assets rose only to a very limited extent in the first part of the year since conditions were favourable to investment in short and medium-term securities. Subsequently, the rise in inflation expectations and the increase in foreign interest rates gave rise to expectations that nominal rates would rise, and consequently caused an increase in the demand for money. For the year as a whole liquid assets rose a little faster than total financial assets: the rate of increase in money (M2) was 20.6 per cent (20.4 per cent in 1978), which was slightly below that of GDP at current prices. The average ratio
135 of money to income in 1979 was virtually unchanged (88 per cent, as against 88.3 per cent in 1978). In the last quarter of the year, despite the change in the public's liquidity preference, the velocity of circulation of liquid balances rose as a result of the large increase in income.
Chart 11
Credit, money and financial assets of households and firms (ratios to GDP; the shaded areas indicate the periods of stagnation or recession in production)
(1) Seasonally adjusted average quarterly total amounts; financial assets are net of shares. — (2) Twelve-month flows, net of the changes in public agencies' bank deposits.
The liquidity of households and firms appears, instead, to have improved compared with the previous year if account is taken of the Treasury bills they held. Total liquid assets (M3) actually increased by 23.3 per cent (21.7 per cent in 1978), which was two percentage points more than GDP. Their average value as a ratio to GDP thus rose from 91.9 to 93.2 per cent.
136 THE SUPERVISION OF CREDIT INSTITUTIONS
During 1979 the main objective of the supervisory authorities in the performance of their function was to bring the structure of the financial system into line with the requirements of the economy. As part of this policy measures have been taken, prompted to some extent by the progressive harmonization of legislation on banking in the EEC countries, to stimulate competition among banks, increase the scope of their operations and improve their geographical distribution and the efficiency of their internal organization. These measures, however, have been adopted with due consideration for the need to protect depositors and ensure the stability of the banking system. They have been accompanied by a policy of authorizations and controls based on uniform criteria for the entire banking system, irrespective of the legal status of the individual institutions, and aimed at strengthening the capital base, limiting the concentration of risks and monitoring the financial situation and internal organization of credit institutions. This function, combined with the task of conducting inspections, has the purpose of preventing, as far as possible, the development of situations that make it necessary to adopt compulsory measures. It is performed in respect of the lending institution, since the assessment of the individual operations is the preserve of the governing boards of the credit institutions that decide whether to undertake the risk. In addition to the activities described, during the year the supervisory authorities also provided contributions of a technical nature in drafting legislation and administrative regulations relating to the banking sector.
Changes in the operating conditions of the banking system
The structure of the banking system. — During 1979 the number of banks decreased by 5 - from 1,071 at the end of 1978 to 1,066 at the end of 1979 — mainly because the completion of some mergers and take- overs was only in part offset by the opening of 4 branches of foreign banks, confirming their interest in establishing an office in Italy. As in the recent past, this development was matched by a tendency for the largest Italian banks to expand their business abroad, since three (two in 1979 and one at the beginning of 1980) were each authorized to open a branch outside the country. Within the framework of the harmonization of legislation on banking in the EEC countries a particularly important step has been made with the
137 application of the EEC directive of 12th December 1977 concerning the coordination of laws, regulations and administrative provisions relative to the taking up and pursuit of the business of credit institutions. The major implication of the directive for Italy is the change-over from a system of discretionary authorizations to one whereby authorizations are based on the fulfilment of given conditions. To prevent too sudden a change-over from causing undesirable shocks to the system, provision has been made for a transitional period, that Italy has had recourse to, during which the supervisory authorities can assess applications to set up new credit institutions according to the economic requirements of the various markets and can refuse to grant authorization in cases in which, although the conditions set down in the directive have been complied with, the establishment of new institutions is considered not to be in line with the objectives of the directive as regards produc- tivity, competition and range of services offered by the banking system.
Geographical structure. — During the year several new branches were opened on the basis of authorizations granted under the programme for 1978. At the end of the year, however, one third of the authorizations to set up new branches and half of those to transfer branches from one location to another had not yet been put to use. This was due not only to the difficulty of finding suitable premises but also to delays in obtaining the necessary building permits. The EEC directive mentioned earlier has not introduced any changes concerning the establishment of branch offices since it explicitly empowers member states to make the establishment of branches within their own territory subject to authorization in accordance with domestic legislation and procedures.
Operations beyond the short term. — During 1979 there was a further expansion of banks' medium-term operations. It was sought to increase the financial support of export activity on the basis of the changes
introduced by Law No. 227 of 1977 — under which finance granted by banks with funds raised abroad also became eligible for subsidies from the Mediocredito centrale (Central Medium-Term Credit Institution) — by amending the provisions of the resolution of the Interministerial Committee for Credit and Saving (CICR) of 4th June 1976, which required a close matching of maturities between fund-raising operations and the corresponding lending operations and thus de facto impeded the expansion of foreign currency business.
138 Specifically, the Decree issued by the Treasury Minister on 12th July 1979 empowers the supervisory authorities to fix a revolving ceiling on foreign currency fund-raising beyond the short term for lending operations on condition that a substantial degree of equilibrium exists in the overall business of the bank rather than among the single operations — the average time to maturity of finance operations may not exceed by more than 6 months the average time to maturity of the corresponding fund- raising operations — and that the interest rate on lending from funds borrowed at a variable rate must be subject to revision at least every six months. Moreover, provision is made for the establishment of operating ceilings on finance in foreign currency with a maturity of over 18 months that is not covered by funds of equivalent maturity. In this case the ceiling is kept low.
Policy regarding articles of incorporation and the internal organi- zation of banking institutions. - The adoption of a suitable policy regarding articles of incorporation has been a further aspect of the steps taken to improve the operating conditions of banking institutions along lines that conform with the need to ensure sufficient uniformity within the banking system. In this connection approval has been given for amendments to the articles of incorporation of the three banks of national interest concerning the business conducted by branches located abroad and medium-term operations in lire. In the case of the savings banks and rural and artisan banks, with a view to reformulating the standard provisions of their articles of incorporation the individual institutions have been encouraged to update their articles by extending the scope of their business and at the same time improving the structure of decision-making.
The governing boards of credit institutions. - A considerable commitment has been required of the supervisory authorities to complete the numerous preliminary formalities to the different procedures for appointments to the governing boards of public credit institutions. In connection with the procedure, at present under way, for filling vacant positions on the boards of savings banks, during the debate in Parliament, which concluded with the resolution of 19th December 1979 by the Finance and Treasury Committee of the Chamber of Deputees, emphasis was placed on the need to base the choice of nominees - on whom an opinion will be given, after their appointment, by the competent
Parliamentary committees in accordance with Law No. 14 of 1978 - on
139 their professional ability, moral standing and public prestige. The Banca d'Italia - in line with these criteria and with the principles laid down in
the above-mentioned law - has proposed candidates that respond to the guidelines set by Parliament.
The granting of authorizations
In order to protect depositors and ensure the stability of the banking system the provisions of the present legislation require that banks obtain authorization from the supervisory authorities to lend in excess of certain limits and to make investments that tie up capital assets. This task of the supervisory authorities is supplemented by the policy of authorizations aimed at ensuring the smooth functioning of the securities market. The authorizations are issued by the supervisory authorities on the basis of criteria that are selected to ensure homogeneity and perfected with experience and by the use of methods for assessing the soundness of the banking institutions.
Extensions of the ceiling on individual large loans. - In the matter of granting credit the present legislation allows the credit institutions adequate limits within which they are completely free to make their own decisions regarding lending. This is in full respect of the principles underlying banking legislation, whereby it is the privilege of the credit
institutions — which have a duty towards savers to reimburse the funds
gathered — to examine independently applications for loans and hence to assess the risks that they correspondingly assume. In order to ensure that risks are diversified the supervisory authorities monitor the activity of the banking institutions and exert their power of authorization on the basis of technical assessments of the financial situation. Special attention is paid to lending to associated companies to prevent banks from carrying out independently, through companies in which they have shareholdings, operations that would otherwise come under the control of the supervisory body. At all events the final objective is to prevent an excessive concentration of risks and so ensure the solvency and preserve the stability of the lending institution. It follows that applications for authorization are rejected or granted on the basis of considerations that relate to the lender, who is alone responsible for evaluating the borrower.
140 Participations and property investments. — The policy as regards participations in other banks has remained to prevent de facto mergers. The attitudes adopted with regard to affiliates have been in line with the principles agreed at international level, that the supervisory authorities of the country of origin should be able to obtain adequate information on the activities of the establishments that domestic banks have set up outside the country. It has therefore become necessary to formulate new criteria for authorization that take account of these requirements. A notice has also been issued prohibiting the acquisition, through affiliates abroad, of participations not permitted under domestic legislation.
With regard to non-bank participations, apart from the role that the credit institutions have been required to play as part of the measures to redress the financial situation of firms, they have also displayed a greater interest in improving their customer relations by expanding the services offered alongside their traditional business. This tendency has not been resisted insofar as the acquisition of such participations has actually permitted a real improvement in the efficiency and profitability of banking.
Funding operations under Law No. 787. — At 30th May total authorized funding operations amounted to 97.5 billion lire and related to the debts of twenty banks vis-à-vis two firms. The authorization of the CICR for the funding plan relating to the Società Italiana Resine (SIR) has not yet been granted.
In compliance with the resolution of the CICR of 29th December 1978 authorization for these operations was granted once it had been ascertained that the subjective and objective conditions had been fulfilled, that the beneficiary firms would be able to achieve economic and financial equilibrium by this means and that the funding operations would be legally admissable and, moreover, would not have destabilizing effects on the banking institutions in question.
From these points of view it should be noted that even if all the available information is taken into account the analysis nonetheless relates to factors and conditions that may undergo changes in the course of the operations owing to unpredictable events. In assessing the operations due account has been taken of the fact that their purpose is to permit a return to normality on the part of borrower firms and the rectification of anomalous positions that may already be having a detrimental effect on the profitability and/or capital base of the bank.
141 Bond and share issues. - The supervisory authorities are em- powered to issue a series of authorizations that are managed in such a way as to ensure the smooth functioning of the financial market, which is the foremost condition for the satisfactory operation of the special credit institutions. In 1979 authorizations for bond issues were again dosed in relation to market conditions and in consideration of the short-term financial requirements of the issuing bodies. In view of the fact that applications are being made for increasingly different types of issues in order to stimulate the interest of investors, authorization has been given for issues of securities indexed in real or financial terms. Care has been taken to make the parameters of indexation easy to understand so as not to confuse investors, and linking to money market rates alone has been avoided.
The task of monitoring banking business and controlling the financial conditions of the credit institutions
The supervisory authorities' task of monitoring the individual credit institutions demands an assiduous control over their capital, financial situation and profitability. This function is performed through analyses of prudential returns and on-the-spot inspections.
Analysis of prudential returns. — The main purpose of the analysis of the prudential returns of banking institutions is to identify those which 3how clear signs of irregularities and thus subject them to closer scrutiny or carry out intervention in their regard in order to prevent situations developing or taking hold that may disrupt their stability and efficiency. The authorities have in any case not failed to monitor the major banks which, because they possess a large share of the market, can affect the entire sector of credit intermediation through variations in their business. Special attention has been paid to the smaller-sized banks among which general inspections have brought to light irregularities in the granting of credit due to inadequate organizational structures, insufficient internal control and shortcomings on the part of the directors. These defects have often had poor effects on the quality of lending, causing the share of bad debts to increase and encouraging situations that are incompatible with the need to diversify risks.
142 The capital base of the credit institutions. - In 1979 the capital base of the banking system increased at a faster rate than intermediation. The own funds/risk assets ratio rose from 8.1 to 8.9 per cent and the own funds/liabilities ratio from 4.6 to 5.1 per cent. The largest increase was recorded in the case of the special credit institutions (the above ratios rose respectively to 9.1 and 8.4 per cent) as a result of operations carried out to strengthen the capital base of the industrial credit institutions. In the case of the commercial banks, on the other hand, the increase was principally due to the growth of provisions against loan losses, which rose by about 65 per cent and thus accounted for over half of the total expansion in capital base (Table 47). The enlargement of these provisions is proof of the concern that the management of banks have shown for the problem of bringing the size of their capital base more into line with the volume and changing features of credit. In the past the capital base has been used as a point of reference for numerous supervisory constraints, but its components have not always been uniformly classified, with the result that over the years legislation has been superimposed on legislation creating difficulties of interpretation that have been compounded by more recent changes in civil and fiscal laws to include or exclude certain provisions from the capital base. The need to standardize gradually the components of capital base in order to facilitate the perfomance of administrative supervision has led to the entire matter being reviewed from the point of view not only of the destination of reserve provisions but also of the method by which they are formed. The criterion makes it possible to draw a clear line between provisions that are without doubt part of the capital base and other provisions that may be classified as such only on condition that they do not represent adjustment of asset items.
The management of constraints on banking business. — The supervisory authorities are entrusted with the management of general legislative provisions that place constraints, some of which are of a temporary nature, on the assets and liabilities of banking institutions. No amendment has been made to the legislation regarding the compulsory reserve requirement. Indeed, during 1979 the volume of this reserve increased by 5,511 billion lire. At the end of the year it totalled 30,974 billion lire, which is equivalent to 14.5 per cent of bank deposits. In the case of the ceiling on individual large loans, during 1979 there was an increase in both the number of banks which overshot the
143 Table 47 COMPONENTS OF THE BANKS' CAPITAL BASE (excluding rural and artisan banks and central institutions) (millions of lire)
COMPONENTS OF THE SPECIAL CREDIT INSTITUTIONS' CAPITAL BASE (excluding the Mediocredito centrale and Artigiancassa) (millions of lire)
144 limit and the amount by which they did so. This increase was due to the inclusion of new categories of banks among those subject to the requirement as well as to factors that often made it difficult to respect fully the established ceilings. In order to ensure that on the whole credit flows are kept within the programmed volume and at the same time that the banks enjoy greater flexibility in the conduct of business, in March 1980 the regulations concerning the above ceiling were amended with the introduction of a requirement for the banks failing to comply with it to deposit for two months with the Banca d'Italia, in a non-interest-bearing account, a sum proportionate to the amount by which the ceiling is exceeded. For the period ending March 1980 the banks which lent in excess of the ceiling deposited, in compliance with this requirement, the sum of 235.6 billion lire. In fulfilment of the security investment requirement the banks increased their portfolio of bonds issued by the real-estate, agricultural and public works credit institutions by 3,237 billion lire or 8.8 per cent of the increase in deposits registered in the twelve months ending in November 1979, compared with a requirement of 6.5 per cent for both halves of the year. The total portfolio of securities eligible for compliance with the requirement increased by 3,516 billion lire or 9.6 per cent of the expansion in deposits. As a result of these investments at 31st December 1979 the value of eligible securities held by the banks was about 58,300 billion, compared with a minimum requirement of around 54,000 billion lire.
The performance of inspections. — The inspections policy continued to be shaped by the need to reconcile the performance of urgent and unexpected investigations with the conduct of periodical inspections, while continuing the programme of visits to banking institutions that have never been examined or inspected in recent years. In 1979 seven sectoral inspections were conducted and 155 general inspections (126 in 1978), 148 of which of commercial banks with total deposits of 17,669 billion lire, which is equal to 8.8 per cent of all funds raised, and 7 of special credit institutions, whose traditional form of fund- raising (bond issues) amounted to 2,866 billion lire, or 5.4 per cent of total funds raised by this sector of the credit system. As in the past, in 1979 too the general inspections were organized according to the geogra- phical distribution of the banking institutions.
145 Extraordinary administration and compulsory administrative winding up. - In cases in which the situation of banking institutions appears anomalous as regards its capital base and/or administration, plans for their rehabilitation and reorganization according to the situation have been proposed as alternatives to the adoption of compulsory measures. Specifically, replacements of top management and/or of members of the boards and internal inspectorates, mergers with other banking institutions, and recourse to support from central institutions including, whenever possible, use of guarantee funds are all solutions that are regarded with favour. On occasions when the situation has been considered so serious as to prevent the adoption of alternative measures, the supervisory authorities have proposed, according to the case, the dissolution of the governing boards or the compulsory winding up of the banking institutions.
The contribution of the supervisory authorities in the drafting of legislation and in international cooperation
During 1979 the supervisory authorities again, sometimes of their own initiative, provided the competent authorities with the technical advice necessary to ensure that the various legislative and administrative provisions would be consistent with the legislation on banking. At the same time they were present in the various international fora in which the central banks of numerous countries are intent on coordinating their activities.
Contribution in drafting legislation. — Within the framework of cooperation with the domestic authorities a review has been made of bills concerning the reorganization of the public banking sector, of cooperatives and of rural and artisan banks aimed at improving the legislation governing them. In the area of subsidized credit, emphasis has been placed on the need to define unequivocally the jurisdiction and sphere of responsibility of the banking institutions with respect to the general government bodies that administer the subsidies. In order to enable the Minister of the Treasury to issue the necessary decrees fixing the basic rates, the supervisory authorities contributed in calculating the average cost of fund- raising and the cost of intermediation paid by the special credit institutions, while at the same time continuing the task of harmonizing the various sectors of subsidized credit.
146 Finally, as regards the powers of the regional authorities, it has been the constant aim of the supervisory body to prevent the introduction of elements in regional legislation or by-laws that conflict with the general organization of the credit system.
International cooperation. — In the international fora where the problems posed for the supervisory authorities by the increasing interna- tionalization of banking business are discussed, 1979 marked a progress from the enunciation of general principles to the need for the individual member states to put those principles into practice. The demarcation of the respective areas of control of the supervisory authorities in the case of business conducted by banks in more than one country has been one of the major questions at issue. In this connection, it has been agreed that, in the case of affiliates abroad which exist as separate legal entities, although the control of their solvency and liquidity position is primarily the responsibility of the authorities of the host country, those of the country of origin cannot be relieved of a share of responsibility. In order to put this principle into practice the national authorities must be put in a position to call on sufficient information concerning the activities of domestic banks, wherever they conduct their business. The consolidation of the accounts of the parent bank with those of its affiliates has been judged an effective instrument for achieving this end. The banks concerned have shown a willingness to help reach a constructive form of cooperation that will make it possible, in the future, to find a satisfactory solution to the problem. At the EEC level, the Advisory Committee established under article 11 of the First Directive on coordination of the banking sector has begun to perform its institutional task, implementing the provisions of the directive concerning solvency and liquidity ratios. In this connection the Committee has requested the "Groupe de Contact" of EEC supervisory authorities to prepare proposals for the formulation of indices relative to the capital adequacy of banks to use for observation purposes. Still at international level, steps have been taken to define Italy's position regarding the review of the consensus concerning minimum interest rates on export credit. A tendency has emerged to increase minimum rates, in view of the evolution that has meanwhile taken place in the cost of funds on world markets and on the main national markets, along with a preference for the creation of a system that enables periodical and automatic adjustment of minimum interest rates on the basis of changes in the structure of rates on the capital market.
147 148 III. - THE GOVERNOR'S CONCLUDING REMARKS
Last October Paolo Baffi carried out his intention of relinquishing the office of Governor of the Bank "before the turn of the decade". The Board of Directors has appointed him Honorary Governor. Professor Baffi's service at the Banca d'Italia stretches over a period of more than forty years, for twenty of which he was a member of the Directorate. His work has had a far-reaching influence on the Bank throughout the second half of its existence. In March 1936 the Research Department managed to tempt him away from what promised, under the guidance of no less an economist and statistician than Giorgio Mortara, to be a brilliant academic career. From that moment on, without interlude, his contribution to the Bank has been of the highest value, combining technical expertise, keen analytical powers, moral stature and great discernment in the monetary management of the economy. The marks of his influence reflect the three stages of his activity at the Bank: that of economic analysis and counsel, that connected with the duties of Director General, and that of monetary and credit policy in his capacity as Governor. Among them, however, one may be noted in particular because it epitomizes and, one might say, is the source of all the others. Paolo Baffi's influence has been paramount in bringing to the Banca d'Italia the discipline of a method and hence of a style: the method whereby the soundness of a judgement, the validity of a choice and the proof of a strategy are measured solely on the basis of the coherence of the underlying logic, the wealth of supporting arguments and the reliability of the information on which they are founded or by which they are substantiated. Professor Baffi himself confirmed the value of strict adherence to this method through outstanding analytical and practical contributions from his first years in the Research Department. Under his direction economic research at the Bank was given new impetus in the post-war decade. The organizational framework of the Research Department was then consolidated; in particular, a fundamental approach was established, founded on the principle of the complementary role of theoretical and applied research. The refinement of the techniques of analyzing the determinants of the money stock and flows of funds, the ready adaptation to national accounts systems used abroad, the close attention dedicated to international economic and financial issues, the care devoted to the statistical accuracy and linguistic standards of the documents produced - these are some of the features of the work of the Research
149 Department established in that period and later successfully reconciled with the expansion of the Department and the development of new techniques and procedures. Between 1960 and 1975, when he was Director General in charge of the internal management of the Bank, Paolo Baffi and Governor Carli together formed a managerial team of exceptional distinction, whose prestige grew with the years. This was a time of growing problems for the Italian economy, culminating with the emergence of what is increasingly termed the international crisis of the 'seventies. Paolo Baffi himself deserves the twofold tribute that he addressed to Guido Carli in the early pages of the Governor's Concluding Remarks in the Report for 1975: of having brought an important contribution to the international economic policy debate and of having employed the instruments of monetary and foreign exchange policy to best effect. In August 1975 Professor Baffi became Governor, shouldering the burden of conducting monetary policy in a period in which the destabi- lizing forces within the international and domestic economies were lying dormant, only to re-emerge the following autumn and winter, revealing the precarious nature of demand expansion when the structural constraints that shackle an economy are not confronted. In January 1976 these forces reduced the foreign exchange reserves to 600 million dollars; in May they brought the exchange rate against the dollar to Lit. 916, and in February- May pushed the monthly rate of inflation above 2 per cent. The banking incidents in the United Kingdom, the Federal Republic of Germany and the United States, in some cases traumatic, had also demonstrated that economic stagnation, stock-market fluctuations and currency unrest had raised, in the most pressing terms, the question of the stability of the financial intermediaries and consequently their surveillance by the supervisory authorities. Once the worst of the crisis had been overcome with the introduction of a series of economic, credit and foreign exchange measures, Professor Baffi succeeded during the following three years of persisting problems in grasping every opportunity for further stabilization offered by the steadier, albeit modest, growth of world demand and the relative moderation of the increase in the price of oil. With the objective of securing lasting external balance and an adequate rate of utilization of productive potential, exchange rate management was combined with demand restraint in the mix necessary in an economy with widespread income indexation and a high degree of downward price rigidity, in particular in those sectors not exposed to international competition. By the end of 1978 inflation had been brought
150 back down close to the threshold of the long-term structural component and the short-term imported component. From 1977 a comfortable balance- of-payments surplus was achieved, making it possible to meet external debt-servicing commitments equivalent to 13 billion dollars in the three- year period 1977-79, as well as build up the foreign exchange reserves. This progress on the inflation and balance-of-payments fronts was achieved without complete stagnation; though still inadequate in terms of the country's social needs, real GDP growth was not much below that for the OECD area as a whole. Domestic monetary stabilization meant that Italy was ready to join the European Monetary System on the appointed date. It is thanks to Professor Baffi's untiring and fruitful efforts that the terms of partici- pation most closely accord with durable progress in forging a European entity and at the same time with Italy's capacity to form a stable element in that process. The imbalances that have re-emerged on the world economic and political scene make it a heavier but also more compelling obligation to undertake every effort to ensure that the progress Professor Baffi's endeavours have helped to achieve is not wasted. The advances made may prove to be short-lived if we do not utilize the margins still left, in terms of time and resources, for a co-ordinated attempt to tackle both short and long-term economic problems. The events that preceded Paolo Baffi's resignation as Governor leave us with another, no less demanding responsibility. They have given substance to the twofold misgiving that in Italy the scope for individuals of great competence, moral integrity and respect for the established institutions has become more confined, and that the tradition of central bank efficiency and autonomy may be undermined. We are conscious that it is also one of the Bank's tasks to dispel these misgivings through its own conduct. It can do so precisely by adhering to the method of strict ethical and professional discipline that Paolo Baffi's influence has helped to establish. The Banca d'Italia has consistently applied this method and disseminated it throughout its organization, deriving lasting benefits in terms of the ability to make a qualified and independent judgement, and hence of operational autonomy within its institutional competence. The Bank has been able to confront the particularly serious problems and formidable tasks presented by domestic and international economic developments over the past year by drawing on those values that are the result of the high professional and moral standards set by the generations that have served it, values that are also the guarantee to the country at
151 large of its proper functioning. Despite the feelings of great unease and, at times, bitterness there has been no lessening of devotion to duty. The Bank's normal activities have continued without pause and technical and organizational innovations have been adopted, some of considerable importance. Collaboration with government bodies, interna- tional institutions and research centres has certainly been no less in demand and no less active than in the past. For this the Directorate, to which the new Director General, Lamberto Dini, has brought his invaluable expertise and long-standing international experience, wishes to express its grateful recognition to the management and the entire staff. In performing its institutional functions in times of rapid change the Bank will be aided by the recent agreements reached with the trade unions. They open the way for the numerous innovations that can enrich, and be enriched by, the Bank's established traditions.
The new oil crisis
Following the 1974 - 75 recession and the recovery in 1976 the OECD countries experienced three years of growth at a rate of just under 4 per cent, accompanied by an average rate of consumer price increase of over 9 per cent. 1980 opened in a climate of slower growth and accelerating inflation. A major contributory factor to both of these trends was the further increase in the prices of primary commodities, in particular that of oil which more than doubled between the end of 1978 and the early months of 1980. The new oil price rise has once again raised three pressing problems: the inflationary consequences, with a severe direct impact and dangerous secondary repercussions as attempts are made within the importing countries to recover the loss in real incomes and escape the oil levy; recessionary pressures, resulting from the gap between the transfer of resources to the OPEC countries and their capacity to import, which in 1980 will produce a current account surplus for the OPEC area of around 120 billion dollars; and finally, the implications for the international monetary system of recycling such a huge volume of funds. The immediate economic policy response of the major industrialized countries was to counter inflation, primarily through the use of monetary policy and exchange rate support.
152 The rise in interest rates began in the Federal Republic of Germany and soon spread to other countries participating in the European Monetary System, starting with those with weak currencies. The movement escalated when it reached the United States, where historical peaks were recorded first in October, with the introduction of a package of measures to secure closer control of the monetary aggregates and to ease pressures on the dollar, and again in March this year, when monetary policy was temporarily tightened further. A cyclical turnround of the US economy was expected, after four years of expansion and worsening inflation since the summer of 1978. It was, however, anticipated that the role of sustaining global demand would be taken over by growth in Europe, Japan and the developing countries. Given the unexpected strength of the US economy in 1979 there is now concern that the incipient recession will coincide with the slowdown in the other industrialized countries, most of which have adopted policies of demand restraint. In this scenario of stagflation orderly recycling becomes crucial in order to ensure that the oil deficits can be financed without giving rise to excessive international liquidity creation. After the 1973 oil crisis the financing of the deficits proved to be more manageable than had been foreseen. In 1974-79 the international banking sector intermediated over a third of the OPEC current account surplus, meeting almost half of the net financing requirements of the developing countries. Moreover, the surplus itself was fairly quickly absorbed, in part because the prices of manufactured goods made up ground vis-à-vis that of oil. This time recycling promises to be a more intractable and longer-term problem, even though, by contrast with the earlier crisis, within the OECD those countries starting out with the largest deficits are those that are in the best position to finance them. OPEC's new supply policy makes it unlikely that the 1975-78 decline in the real price of oil will be repeated. Furthermore, a number of the developing countries face grave difficulties in servicing the debt they have already accumulated, while the international banking community itself perceives the risks connected with capital inadequacy and the concentration of the demand for and supply of funds among small groups of countri'es. In these circumstances the international institutions will have to play a greater role in financing the deficits, combined with more clearly defined adjustment policies. Joint initiatives with the private banking system could prove valuable.
153 The prompt action taken in most countries to restrain monetary expansion was necessary, not least to counter a wave of destabilizing expectations. But its cost and, indeed, its effectiveness very much depend on the determination with which economic policy is turned to tackling the structural constraints that, both within individual economies and between groups of countries, remain the chief obstacle to the restoration of lasting growth. The expansion of the world economy in the 'fifties and 'sixties occurred in an environment which reflected the paradigm of reproduci- bility. In a climate of falling relative prices for energy and primary products, production and demand were geared to increased consumption of basic resources. The past decade, on the other hand, has seen a shift towards conditions corresponding to the paradigm of scarcity, brought about by limitations on the supply of natural resources. Furthermore, since the end of the 'sixties far-reaching changes have taken place in the labour markets and in labour relations, with the result that the growth in money wages has far outstripped that in productivity and has become less responsive to sectoral productivity differentials. The pressures from primary product prices and nominal wages have disrupted the whole system of relative prices. The downward rigidity of prices and incomes linked with the spread of oligopolistic market forces has meant that the dramatic changes in relative prices have not been expressed in movements in absolute money prices in opposite directions but in a general upward trend. For the same reasons, exchange rate instability has had an asymmetrical and therefore globally inflationary impact on prices: in countries whose currencies have depreciated the acceleration of inflation has been greater than the deceleration that has occurred, with a decline in employment, in those countries whose currencies have appreciated. The predominance of the price component of income growth over the real component is not a recent phenomenon: it has been made possible by an elastic money supply and has been a feature of the whole of the last decade, in contrast to the preceding twenty-year period. The structural, and apparently sticky, threshold of inflation varies from one country to another. Its level is determined by differences in the direction and scale of changes in the terms of trade; in the degree of imbalance between the structure of demand and that of production; in the strength of wage pressures and their compatibility with productivity patterns; in the prevalence and forms of income indexation; in the structure of public sector finances and the mechanisms of State
154 intervention in the economy; and in the extent to which supply can meet peaks in demand. Among the objectives of economic policy lowering the threshold of inflation is no less essential, if less quickly attainable, than eliminating the occasional eruptions beyond it. Only this will secure stable employment and restore the incentive to invest. Some countries have taken the path of restoring elasticity to the supply and price mechanisms, scrutinizing the public sector finances and productivity, using State intervention to promote the progressive sectors of industry rather than prop up those that are no longer viable, with the implication that the work-force shares the fortunes of the company. Money supply control, to prevent excessive overall spending, has been the corollary of these remedial efforts. They are most likely to succeed if they are pursued without dogmatic inflexibility, with singleness of purpose and with perseverance. The alternative to this approach is to remain permanently at the mercy of scarcity and to rely simply on demand management, squeezing the economy into the straitjacket of stagflation. The industrialized countries must progressively escape from these constraints, by changing life-styles and the processes of production and developing their own sources of energy; but it is equally essential that they make every effort to reach a common understanding with the OPEC countries and the developing nations to ensure that a growing volume of petro-funds is channelled towards the developing world. This three- cornered relationship, linking technology and industrial goods, energy sources and primary products, would constitute a huge area with a common interest in the expansion of world trade, and therefore in the stability of exchange rates and of the international monetary system. The EEC itself can make a valuable contribution towards this goal, with the benefit of its economic, political, geographical and traditional links with the developing countries.
International liquidity
In the course of the 'sixties official international liquidity expanded by 40 per cent, reaching 80 billion dollars at the close of the decade; by the end of 1979, with the gold component valued at market prices, it had increased tenfold to stand at 830 billion; gold now accounts for almost 60 per cent of the total, compared with 50 per cent ten years ago. This explosion of international liquidity has been accompanied by changes in its composition and in the processes by which it is created and absorbed.
155 Between 1970 and 1973 the chief source of liquidity was the US balance-of-payments deficit, and reserve accrual, in dollars, was concen- trated predominantly in the industrialized countries. Since 1974 official reserve holdings have been boosted by the build- up of liquid balances with the international banking system by the OPEC countries. In addition, the growth of compensatory borrowing in the international financial markets has been accompanied by partial redeposit- ing of the proceeds by the monetary authorities. The main developments in 1979 were the sharp rise in the price of gold, the creation of ECUs within the EMS and the absorption of liquidity as a result of the decline in US official liabilities. During the past decade international liquidity ease has led to a relaxation of the prudential criteria governing bank lending, a growing proportion of which has been taken up by the developing countries. The results have been increased maturity transformation, larger individual loans, not necessarily linked to specific investment projects, and a narrowing of operating margins to levels considered by some to be too low. Easier borrowing conditions have delayed adjustment, allowing inflationary pressures to persist, and have heightened the risks for the international banking system. The central banks of the Group of Ten countries have agreed, in discussion at the Bank for International Settlements, to implement banking supervision on the basis of globally consolidated accounts, paying particular regard to the banks' capital adequacy, liquidity, maturity transformation and the concentration of risks. For this purpose it was felt that more detailed and up-to-date statistics on international banking operations were essential. It was also agreed that it would be desirable gradually to reduce the institutional competitive advantages of international banking activities and to monitor closely the development of the international financial markets and their significance for, and how they are affected by, domestic monetary policies. A further area of concern is the trend towards diversification of official reserves. The movement took on significant proportions chiefly as a result of the search by the oil-exporting countries for adequate investment outlets for large volumes of relatively long-term funds in an environment of inflation and uncertainty, following losses on their dollar assets. It was amplified by other countries, some with only small, or even negative, net reserves but large gross liquid balances. Finally, exchange rate flexibility itself was an inducement to holding multi-currency reserves more closely reflecting the currency structure of imports.
156 The trend was moderated by the major industrialized countries, which informally agreed not to diversify their reserves through the Euro-currency markets. In addition, on the supply side, the German, Japanese and Swiss central banks took measures to discourage the acquisition of domestic official liabilities by foreign monetary authorities. This policy has now changed with the negative shifts in their external accounts, opening up the possibility of direct financing of the deficits, thereby reducing the recycling burden for the international capital markets. The interplay of factors encouraging diversification and those working against it have led to fluctuations in the currency composition of interna- tional reserves. There has not, however, been a significant contraction in the dollar component, which between 1970 and 1978 remained fairly stable at around 75 per cent; in 1979 it declined by over ten percentage points, but chiefly as the book-keeping counterpart of the creation of ECUs. The share of the German mark rose over the decade from 1.5 to 11 per cent, while that of sterling contracted; assets in German marks at present amount to the equivalent of some 35 billion dollars, about two thirds of which are held in the international financial markets. The benefits to be gained from a co-ordinated approach to the issue of reserve diversification have revived the earlier proposal of creating a dollar/SDR substitution account at the International Monetary Fund. Notwithstanding the progress made, problems remain in connection with the apportionment of potential losses in the event of a depreciation of the dollar vis-à-vis the SDR that is not offset by an adequate nominal yield differential between the two assets. A combination of factors, including the acceleration of inflation, exchange rate uncertainty and international political tensions, triggered the sharp climb in the price of gold, which then fed on itself. The price per ounce soared from 260 dollars in June 1979 to a peak of 850 dollars last January, subsequently falling back, with wide fluctuations, to around 500 dollars. With official gold holdings of around one billion ounces, the value of official international reserves consequently recorded an unprece- dented increase. The very instability of the gold market seems to rule out rernoneti- zation of the metal; the re-establishment of a gold pool by the Group of Ten central banks could, in the face of erratic behaviour by resident and non-resident holders and buyers, transform the system of orderly intervention on the gold market into a mechanism that could not be fully controlled, with negative repercussions on domestic and international liquidity management.
157 The course that must be taken is that already noted, of striking with greater determination at the roots of inflation, both domestically and through active international co-operation, and of restoring currency confidence. Pending the achievement of greater stability, the question of the role of gold in official reserves will require a pragmatic approach, with international co-ordination to promote its mobilization, drawing also on methods already used.
The European Monetary System and the exchange rate
The first year of operation of the EMS can be considered satisfactory when measured against the objective of securing greater cohesion of participating currencies. In establishing the System the European Council had also looked forward to broader goals, including the promotion of monetary stability and balanced growth as a basis for relaunching the process of European economic and monetary union. In this respect, progress was inevitably affected by the far-reaching changes on the world economic and financial scene. There was no advance in economic convergence and no reconciliation of views regarding the role of the Community budget and the implementation of reforms agreed in principle. The intention of steering the budget more effectively towards narrowing regional income disparities, strengthening economic potentials and, in short, promoting lasting monetary stability has been squeezed between the lack of autonomous sources of Community finance and the demand on resources for regulating the agricultural markets. Steps must be undertaken to loosen at least one jaw of the vice. • The conflict of views on the Community budget was an obstacle to Community-wide participation in the exchange rate mechanism. Significant advances have been made in the operation of the exchange rate arrangements, thanks in part to collaboration between the central banks in their daily contacts. Two aspects in particular have been the subject of intensive debate: the definition of an intervention policy vis-à-vis the dollar and the evaluation of the functioning and role of the unilateral indicator of divergence vis-à-vis the ECU. These two problems could not be resolved on the basis of a fixed set of rules and procedures while the range of inflation rates, rather than narrowing downwards, was in fact tending to widen upwards. In these circumstances the intervention policies actually
158 pursued, especially vis-a-vis the dollar, were bound to reflect the sometimes conflicting requirements of containing inflation and countering the centrifugal pressures within the exchange rate mechanism, signalled by the indicator of divergence. With specific reference to the movement of the dollar against the ECU, experience with the EMS can be divided into three phases. Between 13th March and early June the Deutsche Bundesbank undertook large-scale sales of dollars in the market in order to counter the appreciation of the US currency and check imported inflation. During this period, while the problems of the weakest EMS currencies worsened, the lira, supported by a large balance-of-payments surplus, became the strongest currency. Intervention purchases of dollars were necessary to prevent the upper divergence threshold from being reached, notwithstanding the 6 per cent margin. The second phase, coinciding with the decline of the dollar, covers the period up to 23rd September, when the first realignment of currencies took place and the German mark was revalued. As part of their counter- inflationary policy the German authorities were tightening interest rates. The lira, still fundamentally firm during the summer, showed signs of weakening in the second half of September as a result of seasonal factors and capital movements caused by the erosion of interest rate differentials. In the last eight months, apart from the devaluation of the Danish krone at the end of November, cohesion within the EMS was maintained both through differential increases in interest rates and through exchange market intervention in Community currencies and, on a larger scale, in dollars. The main purpose of these interventions was to moderate the upward pressure on the dollar in the wake of the improvement in the US external accounts and the measures taken by the Federal Reserve, which triggered the spiralling of interest rates during the first quarter of 1980. More recently, the decline in US rates and the stabilization of European rates at high levels, or indeed their further rise, together with renewed political tensions, have led to a recovery of EMS currencies, in particular the French franc, which moved to the top of the EMS exchange rate band. In this third phase the lira weakened not only against the dollar but also in terms of the ECU. This reversal, which in recent months has taken the Italian currency into the lower segment of the EMS band, coincided with the deterioration in the balance of payments, which in the six months from October 1979 to March 1980 registered an overall deficit of 2,100 billion lire, compared with a surplus of 2,300 billion in the corresponding period a year earlier. The deficit was financed by increased foreign borrowing by the banking system. The next forty-five days closed with an
159 overall deficit of 950 billion lire, with an almost equivalent inflow through the banking system. While the experience of the first fourteen months' operation of the exchange rate arrangements can be considered broadly positive, lasting progress in monetary and financial convergence and in exchange rate stability will only be possible if the domestic causes of inflation differentials are brought under better control. There has been discussion at both technical and political levels of the question of consolidating the existing provisions and procedures governing the exchange rate and credit mechanisms into a definitive system via, inter alia, the full utilization of the ECU as a reserve asset and means of settlement. The transition to this final system, entailing the formal and effective creation of the European Monetary Fund, was envisaged within two years after the start of the System. A number of alternatives have been outlined regarding the functions and consequent structure of the Fund. It is our firm belief that, as a contribution to European integration, the monetary role to be assigned to the Fund should include the most immediate and important functions of. extending the role of the ECU and analyzing and co-ordinating monetary and exchange rate policies both within the EMS and vis-à-vis the dollar. The complexity of the legal and institutional problems involved will depend on the scope of the powers it is intended to place with the Fund, and they will no doubt require time to resolve. Moreover, the need for parallelism in progress in monetary and in economic integration means that sharp differences in pace between the two must be avoided. In the present climate of international economic uncertainty the necessary qualitative jumps must not be tied too rigidly to a predetermined timetable which might prove too tight and thereby risk undermining the foundations of the definitive system.
The domestic economy
The large current account surplus, which at 4,250 billion lire was only slightly less than in 1978, provided a basis not only for keeping the external value of the lira stable but at the same time reimbursing 2,050 billion of compensatory borrowing and improving the net official external position. By contrast with the previous year, however, the surplus stemmed mainly from tourism, since the visible trade balance swung from a surplus of 2,450 billion lire to a shortfall of 850 billion. This swing on merchandise trade account, which was first registered in the third quarter
160 and took the whole current account into deficit in the fourth, was due to the progressive worsening of the oil deficit, which widened by 2,150 billion over the year, to the steady rise in domestic demand and the erosion of competitiveness as a result of the sharp acceleration in inflation. Imports rose almost three times as fast as gross domestic product, which expanded by 5 per cent in real terms and by 21 per cent at current prices. However, exports were also once again a major component of the growth of overall demand and, despite considerable production losses through industrial disputes and a generally high rate of capacity utilization, Italy's share of world markets rose further to 7.2 per cent, compared with 5.9 per cent in 1973. The surplus on trade in manufactured goods owed even more than in 1978 to traditional industries such as textiles, clothing, footwear, skins and leather, whose positive balance moved up from 6,450 billion lire to 7,700 billion, overtaking that of the mechanical engineering sector. The position of two industries in crisis worsened: the deficit of the chemical sector widened from 1,250 to 2,150 billion, while the small surplus of the basic metals industry was transformed into a deficit of 1,350 billion. The changes in sectoral balances are reflected in the composition of trade: in particular, the proportion of total exports accounted for by the traditional industries rose from 18.5 to 19.1 per cent, while that of mechanical engineering fell from 25.2 to 23.8 per cent and that of basic metals from 9 to 8.2 per cent, confirming the decline of the more capital intensive sectors. In the years that followed the first oil crisis, a combination of slow growth, the world crisis affecting sectors that are major capital investors, unpredictable market developments, limitations on the flexible use of plant and the public sector's growing demand on financial resources led to a marked decline in fixed capital formation. The risk element associated with the rise in fixed costs caused a great many large and medium-sized firms to delay modernization and expansion, with the result that the industrial base was strengthened only by companies whose type of product and size enabled them to increase capacity rapidly and with modest capital outlays. The ratio of investment to income fell from 25 per cent in the 'sixties to 21 per cent in the 'seventies and now stands at 19 per cent — 2 percentage points below the OECD average. With the improvement in profits and capacity utilization rates, fixed investment picked up last year, though the rate of growth was no higher than that of gross domestic product. The recovery was confined chiefly to the private corporate sector, whereas the scale of public investment remained modest. While the sluggishness of public investment may be less serious in a year of steady expansion, institutional shortcomings and
161 a lack of co-ordination between central and local government deprive economic policy of a basic instrument with which to regulate and strengthen the economy. Consumption accounted for much of the growth in demand. The sharp increase in disposable income in the last few months of 1978, followed by new wage settlements and a steady increase in hours worked, encouraged higher personal spending, while in a climate of rising inflationary expectations planned purchases of consumer durables were brought forward. The growth in output halted the uninterrupted decline in industrial employment since the second half of 1977. However, the improvement was not fully reflected in the employment figures because of the wide margins of underemployment of existing labour forces. On an annual average basis and excluding the construction sector, industrial productivity per man-hour rose by about 8 per cent. Nonetheless, the average rate of productivity growth in the last five years came to only 3 per cent, against 8 per cent in the previous five-year period. By comparison, among the other major industrialized countries the sharpest deterioration between the two periods was the slowdown from 8 to 5 per cent in Japan, while France at the other end of the scale registered a decline from 6 to 5 per cent. This poorer productivity performance has been due not only to the slowdown in economic growth but also to inadequate capital investment, economic obsolescence caused by the change in relative prices and rigidity in the employment of productive resources. Furthermore, this last factor, by preventing the optimum utilization of plant, leaves little room for holding down costs through additional, more productive investment. This itself deters new investment and the vicious circle is complete. In the second half of 1979 multiplier-accelerator effects were pronounced. Compared with the depressed levels of a second quarter crippled by labour disputes, in the fourth quarter gross domestic product rose by 5 per cent, industrial output by about 7 per cent, investment in equipment and vehicles by 20 per cent and imports by 12 per cent. At the same time industrial employment showed a rise of 1.5 per cent, hours worked per employee one of 3 per cent and productivity per man-hour one of 2.5 per cent. The upturn continued in the first quarter of 1980, with a further 3 per cent increase in production, while the current account deficit widened, according to provisional estimates, to about 700 billion lire on a seasonally adjusted basis. The fear remains that the encouraging results in terms of production, employment and investment in the second half of 1979 and
162 the first few months of this year may prove to be short-lived, not only because of the more pessimistic outlook for world demand but also because they were achieved in a climate of accelerating inflation. For the economy was hit by an extremely violent resurgence of inflation last year, even though, by comparison with the peaks recorded in 1974 and 1976, the role of the exchange rate was marginal and wage-push factors were much less pronounced. Between December 1978 and March 1979 the rise in wholesale prices, which had been running at an annual rate of 8-9 per cent since the second quarter of 1977, doubled as a result of the tripling, from 13 to 40 per cent, of the rate of increase in industrial commodity prices, with non-oil products in the lead; from the summer onwards higher oil prices became the predominant factor. The inflationary repercussions of the sharp rise in the cost of imported raw materials were compounded early in the year by the fact that cost increases were more quickly passed on to the prices of manufactured goods, which were themselves rising on world markets. In the autumn the effects of high and rapidly rising rates of capacity utilization, especially in the consumer goods industry, also began to make themselves felt. At the end of the year both the general wholesale price index and that for industrial products were 20 per cent higher than twelve months earlier, while the non-food retail price index was 23 per cent up. The rate of price increases for Italian manufactured goods progres- sively outpaced that of major competitor countries. With the effective exchange rate declining by 4 per cent year on year but stable over the year, this led to a loss of competitiveness of 1 per cent on an annual average basis and one of 7 per cent between the end of 1978 and the end of 1979. The increase in the prices of industrial manufactures continued at an even faster pace in 1980, while consumer price rises have shown signs of slowing down since March. In the first quarter of this year the overall development of production, prices and the balance of payments indicated that the economy was still expanding fast under the stimulus of domestic demand. The rate of capacity utilization was equal to the high recorded at the peak of the 1974 expansion. On merchandise trade account, apart from the negative impact of the repeated raising of oil prices, there was a substantial deterio- ration in the balances on transactions with the main industrial countries, and especially those of the EEC, owing to a substantial increase in imports and a weakening export performance.
163 The roots of inflation
During the second half of the 'seventies the annual rate of consumer price increase was at no time less than 8 per cent in the OECD, 5 per cent in the European Economic Community (excluding Italy in both cases), 3 per cent in the Federal Republic of Germany, 9 per cent in France and the United Kingdom — and 12 per cent in Italy. These figures suggest that in the Italian economy the effects of destabilizing pressures are more severe or are more liable to result in protracted inflation. Even though its share in total energy sources has been reduced through substitution by natural gas and coal and savings in consumption, a high dependence on oil continues to make the economy especially vulnerable to increases in its import price. In fact, oil still accounts for 68 per cent of energy consumption, a proportion similar to that in Japan but considerably higher than the 54 per cent in the Federal Republic of Germany, 48 per cent in the United States and 46 per cent in the United Kingdom. The position of dependence on foreign sources for non-oil raw materials is no less acute and offers no better prospects for the future. When their relative prices are rising, the economic weight of primary commodities has an inflationary impact not only directly but, in two ways, via the deterioration in the terms of trade. The worsening of the trade balance leads to a decline in the exchange rate, producing further inflationary pressures and forcing a reduction in the rate of economic expansion. Slower income growth aggravates conflicts over its distribution, discourages investment and curbs improvements in productivity, thus making it more costly to transfer real resources abroad. Imported pressures have been compounded by those of domestic origin. Since 1969 labour market developments and changes in industrial relations have triggered and sustained an increase in money wages that has been much faster than in other countries, even taking account of produc- tivity patterns. In the last decade there has been an annual increase in industrial unit labour costs of 15 per cent, more than twice the average for the main industrialized countries. The consequent relative price pressures and accompanying inflationary and recessionary repercussions are accentuated by factors specific to the Italian economy. Economic dualism — regional, sectoral and dimensional — is pronounced. However, institutional and wage structures do not take due account of this fact but have, on the contrary, been made more uniform
164 over the years in the mistaken belief that the dualism can thereby be rectified. Indexation of nominal incomes is high and affects relative income positions. In response to the deterioration in the terms of trade attempts are made to preserve living standards by escaping the inevitable transfer of resources, and to attain the unattainable objective of offsetting the loss in real income through increases in money incomes instead of seeking an equitable distribution of the costs in order to contain inflation. The Italian economy has also been slow to react to the factors of destabilization because the rules of the economic and institutional game have become blurred. The signals that the market and the public sector transmit to consumers and producers have become less clear; producers in turn have become less responsive in directing investment choices towards new types of product and technologies; and finally, it has become harder to translate such choices into action. The very large firms are handicapped by limitations on manpower flexibility, compulsory employment, a reduction in working hours without a corresponding cut in costs, large debts and intervention by the public authorities that has crystallized elements of inefficiency. The need to adapt to shifts and fluctuations in demand and exploit the competitive advantages offered, inter alia, by the depreciation of the lira, in a time horizon shortened by uncertainty, has prompted decentral- ization towards smaller units of production in an attempt to loosen the rigidities that sustain inflation. The employment of techniques and organizational methods that are often highly productive, greater freedom in the use of manpower, the ability to respond quickly to a shift in market preferences, the closer link between the company's prosperity and wage improvements for its work- force, together with simplified decision-making procedures have enabled small businesses to outgrow the subordinate role of cushioning the cyclical problems of large companies and win a place of their own even on world markets. Indeed, much of the success of the country's exports is due to them. These are positive developments, though they cannot be expected to solve the underlying problems of Italian industry. But economic and administrative cost pressures have also had adverse effects, encouraging the circumvention of regulations and creating a new form of dualism in the economy. On the labour supply side this has been the outcome of long- term unemployment, the taking of second jobs, frequently accompanied by a tendency to view the formal job as a source of welfare benefits, in some instances worker preference for more flexible duties and hours, and the
165 bite of inflation. The so-called underground economy is a response that should not be ignored, not least because it can represent a reaction to over-severe constraints and a lack of understanding of the social and economic realities. It cannot, however, be the basis for renewing the industrial apparatus, not only because it narrows the perspective of initiative but also because it offers solutions that the community cannot in the long run accept. Public sector expenditure and the methods by which it has been financed have also been among the causes of the high rate of inflation. The fact that general government has made a late and limited contri- bution to a better utilization of resources is principally due to the quality of expenditure. In addition, the public purse has had to bear the cost of resolving conflicts over income distribution and finding the means to compensate for, rather than rehabilitate, the unprofitable areas of production. Coming on top of existing trends, this has led to a rapid increase in spending, especially on current and capital transfers. Between the beginning of the 'sixties and the last two-year period the ratio of spending by general government and autonomous government agencies to gross domestic product rose from 32 to 47 per cent, with the rate of growth accelerating in the 'seventies. In the same period outlays on social services increased from 12 to 20 per cent of GDP; in particular, the cost of the pension system rose from 6 to 12 per cent and that of the health service from 3 to 6 per cent. The provision of public services has expanded, particularly in the field of education and hospital care, as has the number of employees. During the 'seventies the public sector as a whole employed over 900,000 people, that is, about two thirds of the new labour force. This expansion, however, does not appear to have been accompanied by an increase in efficiency, or by any appreciable improvement in the quality of the services provided. Although the ratio between fiscal revenues and income increased from 26 to 33 per cent, between the early 'sixties and the last two years the public sector's current balance moved from a surplus equivalent to 3 per cent of GDP to a deficit of 6 per cent, while the overall deficit rose from 1 to 10 per cent. Precisely because certain fundamental imbalances were corrected on a provisional basis only, with public financing and with little regard for economic criteria, they have been perpetuated and have rooted inflation firmly in the economy. The volume of credit and liquid assets that had to be created to meet the large public sector borrowing requirement, which has sometimes considerably exceeded budget estimates, and at the same time to ensure
166 that private sector production and investment were not crowded out has resulted in a growth in income in which the major element has been the price component. The large volume of financial assets held by households has led to a substantial redistribution of wealth towards the public and corporate sectors, since the tax levied by inflation is the least likely to be offset by higher personal income demands. The recent and past components of price movements, which combine and merge into current inflation, have been analyzed individually only so as to provide a guide to the steps to be taken. In the last half of 1979 the acceleration of inflation, the steady expansion of production, the emergence of pressures on the exchange rate and the repercussions of international economic developments formed the background against which the restrictive monetary measures described in the following section were formulated and implemented from October onwards. Continued monetary policy action along these lines, supported by a consistent fiscal and budget policy, may be able to slow down the present rate of inflation. It cannot, however, achieve a degree of stability equal to the EEC average, which must be our goal. If more far-reaching and lasting results are to be obtained economic policy must tackle the underlying factors that continuously induce a higher rate of inflation in Italy. The appropriate line of attack in each case, which must be followed gradually and with determination, is shown by the above analysis. Regional development policy must exploit processes already under way and encourage labour intensive investment, steer firms towards branches of activity with high added value and promote efficiency rather than merely injecting subsidies. An energy consumption and investment policy must make energy production less dependent on oil and economic growth less dependent on energy consumption. Industrial relations must be established that allow productivity to be raised to levels compatible with the wish to safeguard jobs and firms. The underground economy must be brought into the open, not suppressed, and in particular there must be a policy for large businesses, which a modern industrial economy cannot do without and which must be subject to uniform economic rules whether they are publicly or privately owned. Indexation mechanisms must be moderated and more rational, and at least cease to reflect indirect taxation which can then resume its function as an instrument of economic policy. Public expenditure reduced to general European proportions must be matched by public services of a general European standard, and the deficit must be held within limits that are compatible with investment requirements and consistent with a policy that is truly counter-inflationary.
167 Monetary and credit developments
Last year monetary policy once again had to contend with the conflicting requirements of fostering the recovery in production and combating the acceleration in inflation. The recent economic debate in Italy and abroad has revealed a wide range of views and conclusions with regard to the transmission mechanism, the effects of monetary policy on nominal income, and especially its impact on production and prices. There is, however, broad agreement that the uncertainties resulting from sudden and frequent course corrections and the time lags that occur before their effects are felt can in fact increase the cyclical variability of the economy instead of reducing it. Monetary policy therefore tends to be determined against a fairly long time scale on the basis of macro-economic forecasts. Consid- eration of the destabilizing effects that can result from following an erratic monetary course sets a limit to the constant revision of intermediate objectives; greater strictness in holding to quantitative targets means accepting larger movements in interest rates. The quarterly report on the borrowing requirement of the enlarged public sector presented to Parliament by the Minister of the Treasury in March last year was based on the assumption that in 1979 gross domestic product would increase by 5 per cent, prices would rise by 14 per cent and that there would be a current account balance-of-payments surplus of 3,000 billion lire, smaller than that recorded the previous year but apparently the highest of any industrial country. These forecasts took account, in particular, of the weakening of world demand that was expected to occur during the year, mainly as a result of the anticipated recession in the United States. The macro-economic framework was considered to be consistent with monetary base creation of 8,000 billion lire (net of postal deposits), a domestic borrowing requirement of the enlarged public sector of 35,200 billion lire and total domestic credit expansion of 53,300 billion. The differential between the yield on short-term Treasury paper and the net return on bank deposits as well as the liquidity situation of the economy at the end of 1978 were such that in the first half of 1979 the public made net purchases of Treasury bills and Treasury credit certificates totalling 9,400 billion lire, compared with 6,800 billion in the whole of 1978. The total amount of government paper placed on the market during the first half of the year, including medium-term securities, came to 16,600 billion lire, about half of which was drawn from the Banca d'I talia's portfolio.
168 If the central bank had at that time kept the growth of the monetary base on the path initially set, interest rates could have been reduced. However, the target variable continued to be total domestic credit, which in the middle months of the year was slightly below the volume foreseen. Conversely, the strength of the lira within the EMS and vis-à-vis the dollar and the current account balance-of-payments surplus made it inadvisable to adopt a monetary policy that would lead to an increase in interest rates in the immediate future. Although the differentials between rates in Italy and those abroad were narrowing, they were still large, thus inducing an expansion in foreign currency borrowing; as a result, the banks' net external liabilities increased by more than 2,000 billion lire in the first half of 1979. During the same period the monetary base contracted slightly and the growth in the money stock decelerated markedly. In the course of the year, as the magnitude of the oil shock and the extent of the tensions on raw material markets were revealed and demand showed more sustained growth, the monetary authorities in the main industrial countries reacted to the inflationary pressures by introducing measures aimed at preventing monetary expansion and credit growth from financing the spread of the increase in prices; as a result, interest rates rose further everywhere. This trend was also apparent in interest rates in Italy. Initially the action taken by the Banca d'Italia on the domestic markets was aimed at encouraging an increase in medium and long-term yields. The reversal of the inflow of funds from abroad through the banks from June onwards increased the demand for loans denominated in lire, the supply of which was subject to the credit ceiling. In September the international markets came under increasing pressure, which led to the realignment of European currencies and the announcement of further measures by the Federal Reserve in the first few days of October. Italy's balance of payments began to show signs of deteriorating, the lira came under pressure, credit demand remained high and the monetary and credit aggregates began to diverge from the planned path, partly as a result of the public's temporary preference for bank deposits. At the beginning of October the discount rate was increased by one and a half percentage points to 12 per cent; in the same month the ceiling on the growth of bank lending was extended until July 1980, the permitted increase in loans subject to the ceiling being set at an annual rate of only 10.6 per cent and the exemption threshold being raised from 100 to 130 million lire. The acceleration in the rate of domestic price increases and the uninterrupted rise in interest rates abroad, which accentuated the pressures
169 on the balance of payments exerted by seasonal factors, made it necessary to raise interest rates again in December in order to avoid jeopardizing the strength of the lira and exacerbating inflation. The increase of three percentage points brought the discount rate back to the historical peak recorded in the autumn of 1976. The yield curve showed the falling trend typical of periods of credit restraint. The reduction in liquidity as a result of the partly intentional deferment of Treasury expenditure compelled the banking system to have large-scale recourse to the lender of last resort and helped to ensure that the increase in official interest rates spread rapidly to the banks' lending rates. During the same period new techniques for market intervention were introduced and the markets' operating procedures were modified. The introduction of contracts for the spot sale and forward repurchase of securities has provided the central bank with a flexible instrument that enables it to regulate liquidity more rapidly and with greater accuracy. The establishment of a system for the collective deposit of securities in the two main financial centres and the connection of computer terminals at the Banca d'Italia to a network for the transmission of financial information to market participants have simplified trading and extended the interme- diaries' scope for action. The final outturn for 1979 shows that the flow of total domestic credit was in line with the forecasts made in March. The reduction in budget expenditure and the higher receipts from taxation and social security contributions, which were partly attributable to the more rapid rate of price increase, were only partly offset by the increase in the bank balances of public sector agencies, which had been expected to decline; consequently, the public sector's borrowing requirement to be financed domestically fell by about 3,000 billion lire. Direct financing granted to the private sector increased by the same amount. After adjustment for public sector transfers to businesses, the proportion of total domestic credit flowing to the private sector was slightly smaller than had been predicted in March. On the other hand, the predominant public sector involvement in the credit circuits as a result of the Treasury's growing role as an intermediary does not have a beneficial effect on the allocation of resources. One indication of the restraint imposed by monetary policy can be seen in the ratio between total domestic credit expansion and gross domestic product, which declined from 22.2 per cent in 1978 to 19.8 per cent last year. In addition, the average ratio between bank liquidity and bank deposits fell from 1.9 per cent in 1978 to 1.5 per cent. The tendency towards a narrowing of the specific credit function of
170 the banking intermediaries has been checked. On the other hand, the fact that the lending ceiling was exceeded in the latter part of 1979 aroused fears that the restrictive effect of monetary policy would be weakened. It was considered advisable to continue to seek the necessary stabiliza- tion by use of the ceiling rather than by placing exclusive reliance on indirect control exercised through interest rates. Experience both in Italy and abroad has shown that in the short term the demand for credit may have a low interest rate elasticity. If the desired results were to be achieved interest rates would presumably have had to move to an extent that would have jeopardized the stability of the financial markets, particularly as in Italy they do not yet have the breadth, depth and flexibility of markets in the large industrial economies. Even in the United States, where the financial markets are among the largest and most efficient in the world, the measures introduced by the Federal Reserve in order to keep the growth of the monetary aggregates within the limits included the imposition of direct controls on certain sectors of the credit market in addition to the restrictions exerted through the monetary base and interest rates. One admittedly minor and partial indication of the difficulties that could have arisen came at the beginning of 1980 as a result of the increase in the discount rate in December. The switching of funds from bank deposits to securities by the public reached major proportions; at the Treasury bill tender in January demand exceeded the amount of maturing bills by 3,000 billion lire, provoking a fall in yields and accentuating the increase in interbank rates. This abnormal situation persisted until the next tender, partly because only a few banks were prepared to sell customers securities from their own portfolios. Not even a market as broad as the Treasury bill market can cope sufficiently quickly with such large shifts in demand. The conviction that it was essential to increase the effectiveness of the ceiling did not reduce the awareness of the dissatisfaction with a mechanism that forced a uniform rate of growth on the loan portfolio of every bank. It was these considerations and requirements, which are partly conflicting, that induced the monetary authorities in March of this year to require banks that exceed the ceiling to deposit a sum in relation to their excess lending in a non-interest-bearing account at the Banca d'Italia. The intention was to confirm the Bank's determination to keep credit expansion under direct control and at the same time to create an incentive for the banks not to stray from the growth path indicated by the ceiling; however, the ceiling has ceased to be an absolute limit, so that by means
171 of the progressive rates it can be applied in such a way that sudden peaks in demand may be absorbed, albeit at rapidly increasing costs. The lending and borrowing activities of the special credit institutions slowed down further in 1979. Loans remained at their 1978 level but declined in proportion to investment. Net of repayments and instalments in arrears, lending expanded by 10.5 per cent, or by three percentage points less than in the previous year. There is cause for concern at the
•increase in the volume of overdue instalments and bad debts, which reflects the crisis in certain sectors of industry and large industrial con- glomerates. A number of institutions have considerably increased their capital. Difficulties in fund-raising have emerged in the past few months, but during the year as a whole this was not the cause of the slowdown in lending; the financial markets have inevitably been adversely affected by inflationary pressures and the squeeze on liquidity. As international experience has shown, the volume of fixed rate securities issued diminishes sharply in such circumstances, with the partial exception of markets on which it is normally possible for securities to be redeemed in advance of maturity. The desirability of curbing double intermediation was one of the factors that led the Banca d'Italia to propose that the security investment requirement should be extended for the first half of 1980 only at the modest rate that has applied since the second half of 1978. Although we advocate the orderly attainment of equilibrium rates on the market, we have begun to encourage the special credit institutions and ENEL to issue variable rate debt instruments, which have been current on international markets for some time now. On the one hand these offer investors coupons that adjust to prevailing market conditions, thus shielding them from sharp fluctuations in market quotations, and on the other they reduce the risk that the debt-servicing burden borne by the ultimate debtors will prove excessive. A variety of technical formulae and arrangements have been devised or are under consideration. The linking of yields to prices can usefully satisfy the demands of specific sectors; we are, however, firmly opposed to the generalization of such an approach on the grounds that it could be regarded as a capitulation to inflation and could further reduce the room for manoeuvre in the conduct of economic policy. As far as financial indexation is concerned, the fact that the money market is not yet sufficiently developed to be able to guarantee undistorted rates argues for partial reference to the yields on long-term securities. We do not favour the use of debt instruments pegged to foreign currencies. This is not the case, however, with solutions of the type adopted by international
172 institutions whereby both current yields and capital value are linked to the ECU, as the EMS is based on this basket-type unit, one of the components of which is the lira. The acceleration in prices, the deterioration in the external accounts in the early months of 1980 and the expected development of these variables in the remainder of the year confirm the need to curb the supply of credit. The quarterly report on the public sector borrowing requirement that the Minister of the Treasury presented to Parliament in April foresees that during the current year total domestic credit will expand by 59,300 billion lire, an amount that is consistent with a domestic public sector borrowing requirement of 40,500 billion lire. As a percentage of gross domestic product, credit expansion will slow down by approximately two percentage points for the second year in succession. While taking account of any significant changes that might occur in the real variables and in external factors, the central bank will hold to its present course, continuing to oppose developments that jeopardize the achievement of a slower rate of inflation and exchange rate stability. The stronger the pressures that magnify the spurious component of income, the greater will be the degree of restraint and the adverse effects on economic activity.
Financial intermediation, business finance and the State
In the modern economy, in which there is a growing dichotomy between investment and saving, two separate acts of choice combine to implement an investment project: one, of a productive nature, to make the outlay; the other, of a financial nature, to provide the necessary means. The independence of these two choices ensures the efficient use of resources, while their dialectic contraposition results in a single final decision. Between the purely market-oriented investments of public and private corporations and collective investment in the strict sense of the term lies the whole range of projects that constitute the essence of the Italian mixed economy, such as those whose purpose is to ensure that production of basic materials will meet future needs, to support technological research in strategic sectors and to promote the development of the less prosperous areas. Which is not to say that such projects should be exempt from evaluation in economic terms. But they belong to the sphere of collective objectives and over time have led to the creation of the various instruments of State intervention.
173 Here too, just as in the case of investment subject solely to market criteria, the decision of the financial intermediary must be based on an examination of the financial soundness of the project. The decision will in no way invalidate the project in itself but, if the results of its examination call for it, the lending institution must attach conditions, and above all financial conditions, to its involvement. The examination will be effective if the financial intermediaries are free to act autonomously: it is a matter of interest to the whole community that the law, administrative procedures and institutional and market structures secure this independence. Three aspects of the Italian financial system have taken on special importance with the passage of time: the institutional separation of ordinary and special credit-granting functions, the use of the financial intermediaries as channels for government incentives and aid to business, and the co-existence of private and public banks. Among others, these problems lie at the centre of an active debate which the Banca d'Italia is following with close interest. The different economic implications of current business expenditure and outlays for setting up new factories or modernizing or expanding existing ones are the basis of the distinction, which is one of degree and not of nature, between ordinary and special credit. The deferred return on capital, the greater risk element, the scale and the strategic importance to the company of the investment that is being financed are features of special as opposed to ordinary credit. Furthermore, in the case of special credit, the link between the outcome of individual investment projects and the credit institution's own operating results is closer, so that an analysis and evaluation of their economic prospects and even of their technical basis is of major importance. In order to make a meaningful examination of a project in the context of a company's overall activities, the credit institution must assess the balance between expenditure and revenue, scrutinizing financial plans that take into account any grants or other aid that will be received because the particular project is held to be of public utility. A loan is essentially different from an incentive, whether this be a straight subsidy or some form of relief, and if the difference is ignored it can be detrimental to the effective management of the economy. Credit employs savers' money and involves the acceptance of risk and an obligation to repay; incentives employ taxpayers' money and do not involve the acceptance of risk or any obligation to repay. If incentives are granted automatically for all eligible projects their true economic nature, which is that of an instrument of public finance even when they are linked to interest paid, is quite apparent.
174 But incentives still retain this nature when they are granted for only some of the projects that would be eligible. The discretionary assessment of those projects that most deserve to receive incentives must necessarily be made on the basis of the criteria established by the law, typical of which is the observance of clearly defined procedures. This assessment is not to be confused with the entrepreneurial evaluation and subsequent decision as to whether credit should be granted or refused, the key element in which is appraisal of risk. Linking the administration of incentives to that of credit implies an intermingling of functions which must be clearly recognized, and its compass, or at least its potential negative consequences, must be kept to a minimum. Incentives should be attached not so much to the credit element as directly to the investment itself and to the employment of labour. In this way a direct and exclusive relationship is established between the State and the beneficiary firm. More specifically, for the kind of company, especially those of small and medium size, whose investment projects might well be put at risk by procedural delays, greater use could be made of tax credits, thereby ridding the customer/banker relationship of the implications of a subsidy which leads to the growth of special forms of borrowing. Should it be found that the subsidized loan cannot be dispensed with entirely, there are many ways of improving the working of the present system, as the progress made with recent legislation shows. In general it is preferable that the granting of incentives should be automatic rather than discretionary. When it is necessary to choose between eligible projects the selection procedure should introduce an element of competition. Choices based on political considerations should be confined to cases in which this is justified by the special importance of the project. At all events, if the subsidized credit system is to function more effectively there must be strict separation not only of the agencies that administer the subsidy and the institutions that grant the credit but also of the channels through which these reach the company. While this' line of approach would increase the efficiency and transparency of efforts to promote new investment, it is equally important in the present situation that everything should be done to restructure existing productive capacity and solve the problems of large companies. The troubles of the chemical sector are particularly acute; its development was an attempt to reconcile the various objectives of improving social conditions, reducing regional imbalance and securing a sounder industrial base. The cataclysmic rise in oil prices and the consequent sharp slowdown in the growth of demand for oil derivates came at a time when the Italian chemical industry was still fragile. The process of restoring the industry to health has
175 been less problematic in countries which had embarked on industrialization earlier and had already established a structurally and financially solid basis. While the crisis of whole sectors of industry was recognized fairly soon, the necessary response has not been so prompt. The law on the restructuring of industry underwent a long gestation period and preparations for its implementation took even longer, partly because the reorganization plans had to be incorporated into overall industrial policy. The position of companies whose problems could have been set right with immediate intervention has meanwhile grown worse, with obvious repercussions for the creditor financial institutions. These delays have led to pressure to make use of Law No. 787 of 1978 beyond the scope of its original aims, which were to aid firms in primarily financial difficulties and therefore likely to recover with the help of temporary support from the financial institutions. In a number of special cases in which the problems went much deeper and such support had already been considered, additional legislation, and in particular Law No. 573 of 1979, recognized the need for a political evaluation, modifying some of the procedures of Law No. 787 and providing inadequately capitalized public financial institutions with the- means with which to intervene. When a company's survival is considered sufficiently important to override the judgement of the market it is preferable to undertake an industrial rescue operation with clearly defined aims, responsibilities and scope rather than stretch instruments designed for other purposes and founded on the freedom of decision of every financial institution within the limits of its uncommitted capital resources. At all events, whether the rescue operation leaves the company in the private sector or takes it into public ownership the aim must be a return to economic viability. What has been said holds good irrespective of whether a credit institution is publicly or privately owned. At present the most pressing need is to restore to the banking system the degree of security and certainty without which it cannot function normally and which recent events have even further undermined. For the public banks the risk of operational paralysis is added to the no less serious, albeit less immediate, danger of a decline in the standard of management. The co-existence of private and public banks is a basic feature of the Italian financial system, in which the business firm has been chosen as the model for banking. A reading of the law shows that, beyond the exigencies which led to their creation, the fundamental purpose of financial interme- diaries in which the State holds a capital interest lies in the need to secure a broadly based financial system, to preserve the autonomy of the individual intermediary and to prevent industry acquiring positions of control within
176 the banking system. Needs that can be linked with the more general one, which is the responsibility of the supervisory authorities, of regulating bank competition in order to keep it healthy. To transform the public financial intermediaries into institutional tools for the pursuit of particular economic policy goals would be to distort the basic criteria of bank management. It would undermine one of the mechanisms for the allocation of resources, namely a system of financial intermediation in which lending decisions are based on the principle of profitability. This fundamental principle must still hold, even when, in the case of the public and some private banks, its sphere of application is curtailed in view of the special objectives that the law and their own charters attach to their legal capacity. Accordingly, the supervisory authorities assess the operating results of the individual financial intermediaries, whether public or private, on the basis of identical criteria and essentially similar parameters of profitability, efficiency and solvency. However, some of the market tests of management, ranging from the judgement of shareholders to that of the stock exchange to take-over bids, do not function in the case of publicly controlled institutions, least of all in the case of those that are not in the form of joint-stock companies. But this disparity can be rectified in their statutes, through full use of the internal controls that can be incorporated in public law bodies and through structural changes to promote an entrepreneurial approach to banking on the part of the boards responsible for determining, monitoring and assessing the results of the institution's operations. One way of achieving this last objective would be to establish closer links, though still maintaining the separation of functions, between the banks and the special credit institutions which would, in particular, gain from a more regular flow of information about firms' situations and prospects. Professional banking expertise must also be furthered through the procedures for appointments to the governing boards of the credit institutions. The responsibility that has in some cases been placed with the Governor in this connection is viewed as a duty that will be performed, in the tradition of the Banca d'Italia, on the basis of technical criteria. The difficulties for the credit-granting institutions of translating into business practice technical rules that only experience can indicate how best to apply are equal to those of ascertaining whether there has been an intention to circumvent them. Therefore, when determining whether both public and private banking intermediaries have properly conducted the business permitted by their statutes, account must be taken of their operating requirements. Similarly, when determining whether they have acted within the law, the same criterion must be used in the case of both
177 public and private financial institutions in order to uphold not only the fundamental purpose of State involvement in the financial sector but also the truly entrepreneurial nature of banking. It is felt that this approach, which the Banca d'Italia constantly follows, must be given full legal enforcement to prevent a difference emerging between entrepreneurs who are subject to the same economic rules, a difference that may lead to inefficiency. The continuing day-to-day duties of banking supervision must be performed in an institutional framework that has become uncertain while the principles to be obeyed remain unchanged. The difficult circumstances in which the supervisory authorities have had to operate recently have caused no break in the consistency of their overall approach or of their decisions. During the past year they have been even more active in all sectors; the methods employed and the results obtained are described in the body of the Report. Special attention has been paid to the question of the role of the Italian financial system in the overall growth of international banking. In the context of the arrangements for surveillance of the international financial markets agreed amdng the central banks the position of the Banca d'Italia is not to encourage Italian banks to expand abroad through affiliates as long as the information necessary for effective supervision and, in particular, for a reliable consolidation of accounts is lacking. The banks concerned have agreed to provide that information. However, problems remain, principally in connection with the limitations imposed by interna- tional law and individual countries' domestic legislation. It is the Bank's intention to secure as quickly as possible the necessary transparency in a particularly delicate sector of banking intermediation. The basic function of the supervisory authorities is to regulate the financial system so that it is better attuned to the various requirements of the country's economic development. The purpose of their control and their promptings is to reconcile the market's spontaneous entrepreneurial responses with the need for stability and efficiency in the allocation of resources. The achievement of these objectives accords with the task of protecting savings and controlling credit which is embodied in the law, and with the other task, implicit in the law but explicit in the theory and practice of banking supervision, of preventing uncontrolled competition from leading to positions of dominance, for example through economies of scale. In order to perform this function discretionary decisions must be made within the supervisory authorities' institutional competence. These can be
178 based increasingly on parameters refined by methods of analysis and forms of intervention that can be improved through joint discussion and research with the financial institutions; they cannot, however, be divorced from a technical assessment of an institution's overall operating results without undermining the collaboration and flexibility that are essential for the proper performance of the supervisory function.
Ladies and Gentlemen,
Addressing the Ordinary General Meeting of Shareholders towards the end of the 'fifties, Donato Menichella clearly foresaw the need for a determined programme of public investment, from infrastructure to scientific research, to revitalize industrial development and the entire economic life of the country, dismissing the doubts of those who feared that the financial means would be lacking and insisting that "it lies in our own power". In the intervening twenty years of peace and international economic co-operation the country has made great strides, even if it has not always managed to make the best use of the resources available to it. The manufac- turing industry of a largely agricultural economy, though still weak and protected, has responded to the European challenge by carving out a share of world markets and securing for its work-force, which has grown by a third, an average per capita income that has tripled in real terms. The generation that joined the labour force at the end of the 'fifties, without having experienced the war, has had more than any previous one not only in terms of living standards but also as regards working conditions, health care, pension provisions and education opportunities for its children. And yet, despite these great strides forward, there is today a pervading feeling of apprehension. The new increase in oil prices has occurred in a complex and dangerous political context. The inequalities between nations are becoming more glaring, but the industrial societies seem to be blind to the fact, while there is no lessening of social conflicts within their own communities. Because of its greater dependence on imported energy sources and its processing function, Italy is more vulnerable than other countries to the dangers of a crisis in international trade and financial relations. And it faces these dangers without the necessary solid core in terms of productive base, administrative efficiency and infrastructure. Just over a year ago Italy decided to join the European Monetary System. It was a courageous decision which responded to sentiments rooted in the tradition of the Risorgimento. But it was a decision that
179 always implied consistent action, at the risk of degenerating into an empty ambition. This consistency has hitherto been lacking. External events have doubtless made it more difficult but they cannot bear the whole blame. The Italian economy is in danger of sliding back down the slope it so laboriously climbed in 1977 and 1978. The cancer of inflation that has been sapping its strength for years is now attacking with renewed violence. Italian products are losing competitiveness. The public sector deficit is draining available resources. The balance of payments has again moved into deficit. Serious crises in the business sector are dragging on and worsening, and new ones appear imminent. Monetary measures such as those taken in recent months can slow down the backward slide and mitigate some of its consequences but they cannot on their own reverse it, since the underlying ills are of an essentially "real" nature. The crisis of both private and public companies, which are accumu- lating loss upon loss, cannot be resolved with financial aid alone. Such aid can be beneficial, but only once the underlying problems relating to production and sales have been tackled and are being corrected. Otherwise subsidy follows subsidy and waste follows waste under the illusion that the problems are being remedied, whereas they are merely being postponed and allowed to deepen, making the real cure more difficult and more costly. There is still time, albeit limited, for corrective action. Inflation can be tamed; measures are urgently needed to curb the public sector deficit, promote productivity and reduce costs as the first stage of a programme aimed at quelling the recent upsurge of inflation and making a start on cutting out its deeper roots. For its part the Bank will pursue its policy of monetary stringency. The vitality of which there is evidence in all sectors of activity is the sign that the problems and conflicts in our society, which sometimes seem on the point of overwhelming it, are the maladies of an organism capable of reacting. It is possible, it lies in our own power, to direct that vitality towards goals selected through a process of debate that does not result in paralysis, to transform it into progress and keep it thriving and strong instead of dissipating it in discord or undermining it through debilitating uncertainty. In this way we can restore monetary stability, which is essential to the welfare of all and is the constant concern of the Bank.
180 IV. - THE BANK'S CAPITAL AND RESERVES
Capital. — There were no changes during the year in the amount of the Bank's capital or in the distribution of its shares, which on 31st December, was as follows:
181 182 V. - BALANCE SHEET
AND PROFIT AND LOSS ACCOUNT
183 BALANCE SHEET AS
184 OF 31st DECEMBER 1979 EIGHTY - SIXTH YEAR
185 GENERAL PROFIT FOR THE
186 AND LOSS STATEMENT YEAR 1979
187 ADMINISTRATION OF THE BANCA D'ITALIA AS OF 31st DECEMBER 1979
.B OARDOFDIRECT OR S
Carlo Azeglio CIAMPI - GOVERNOR ANO CHAIRMAN OF THE BOARD
Lamberto DINI - DIRECTOR GENERAL Mario SARCINELLI - DEPUTY DIRECTOR GENERAL Alfredo PERSIANI ACERBO - DEPUTY DIRECTOR GENERAL AND SECRETARY TOTHEBOARD
DIRECTORS Alessandro BARNABO' Callisto GEROLIMIOf Gaetano CARBONE * Giuseppe GIOIA Carlo d'AMELIO * Lucio MORODER Danilo de MIOfELI Remo MORONE Gaetano DI MARZO Giovanni Battista PARODI * Luigi FALAGUERRA * Giulio PONZELLINI Luigi FANTOLA * Member ai the Executive Cammittee.
BoARD OF AUDITORS Domenico AMODEO Antonio CONFALONIERI Michele BENEDETTI Giuseppe GUARINO Alberto CAMPOLONGO
ALTERNATE AUDITORS
Luigi GUATRI Enzo CAPACCIOLI
CENTRAL ADMINISTRATION
MANAGERS
Giuliano MONTERASTELLI - CENTRAL OPERATIONS MANAGER Giovanni MAGNIFICO - ECONOMIC ADVISER Pietro SALONICO - ACCOUNTANT GENERAL Carmelo QTERI - CENTRAL MANAGER FOR SUPERVISION OF BANKS Luigi PASSINO -I NSPECTOR GENERAL Alfonsino BARBIERI - CENTRAL MANAGER FOR TECHNICAL DEPARTMENTS Roberto MONTECOfIARI - SECRETARY GENERAL LIST OF ABBREVIATIONS
BI Banca d'Italia CICR Comitato interministeriale per il credito ed il risparmio - Interministerial Committee for Credit and Saving - ECU European currency unit EEC European Economic Community EMCF European Monetary Co-operation Fund EMF European Monetary Fund EMS European Monetary System ENEL Ente nazionale energia elettrica - National Electricity Agency- ENI Ente nazionale idrocarburi - National Hydrocarbon Agency- ESA European System of Integrated Accounts GATT GeneraI agreement on tariffs and trade GDP Gross domestic product GNP Gross nationaI product IMF International Monetary Fund INPS Istituto nazionale della previdenza sociale - National Social Security Institute - IRI Istituto per la ricostruzione industriale - Institute for Industriai Reconstruction - ISCO Istituto nazionale per lo studio della congiuntura - National Institute for Studies of the Economic Situation - Istat Istituto centrale di statistica - CentraI Institute for Statistics - LIBOR 'London interbank offered rate OECD Organization for Economic Co-operation and Development OPEC Organization of Petroleum Exporting Countries SACE Sezione speciale per l'assicurazione del credito aII'esportazione - Special department for the insurance of export credits - SCI Special credit institution SDR Special drawing right TOE Tons of oil equivalent VIC Ufficio italiano dei cambi -Italian Foreign Exchange Office - VAT Value added tax