Perchè in Italia non c'è credito?

M O R G A N S T A N L E Y R E S E A R C H

Morgan Stanley & Co. International plc+

ECONOMICSDaniele [email protected] +44 (0)20 7425 8943

Tomasz Pietrzak

BANK EQUITY RESEARCHFrancesca [email protected]+44 (0)20 7425 9721

Adrian Reibert

FIXED INCOME RESEARCHMorgan Stanley & Co. LLC

Michael [email protected] +1 (212) 761 8609

Angela WangMorgan Stanley & Co. International plc+

Elaine [email protected]+44 (0)20 7677 0579

Jackie [email protected]+41 44 220 9246

September 24, 2012

ECONOMICS, BANKS & FIXED INCOME RESEARCH

Italy: Good Student, Good Grades?Policy Options and Investment Implications

Due to the nature of the fixed income market, the issuers or bonds of the issuers recommended or discussed in this report may not be continuously followed. Accordingly, investors must regard this report as providing stand-alone analysis and should not expect continuing analysis or additional reports relating to such issuers or bonds of the issuers.

Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision.

For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report.+= Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to NASD/NYSE restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.

Being a Good Student…Mario Monti’s government is pursuing an ambitious fiscal consolidation, in line with most European policymakers’ requests – but mixed success on the structural reforms.

…and Why it MattersNow that an effective European mechanism to reduce market pressures is in place as Mr. Monti recently advocated, its use – if such pressures were to be unbearable – could help Italy continue on its reform path.

What’s the HurdleExcessively harsh conditionality is an obstacle, but we think that Italy can meet many requests from the official lenders. A still unresolved political situation is a wildcard too.

Short-Term Pain, Long-Term Gain?Our growth numbers remain below the consensus, but we are more optimistic than most on Italy’s potential to reform.

Deep-Diving into Italy’s Banks and RegionsLow profitability and residual credit risk (large NPLs) cap bank values, downside risk outweighs upside potential in our bull / bear skew.

In this report we also look at the state of Italy’s regions.

Growth (or Lack Thereof)

Source: Eurostat, Morgan Stanley Research

Michael Zezas, Angela Wang, Elaine Lin and Jackie Ineke are Fixed Income Research Analysts and they are not opining on equity securities. Their views are clearly delineated.

Real GDP (% Y/Y)

-4

-2

0

2

4

6

Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12

Germany France

Italy Spain

For Detailed Trade Ideas See from Page 55

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2

Italy: Policy Options and Investment Implications September 24, 2012

Executive Summary What being a good student means… Italy has so far been a good student under Mario Monti’s government. It has been pursuing an ambitious agenda of fiscal consolidation and – with mixed success – structural reforms. Even though the former is predictably having negative effects in the near term, and the latter haven’t really reached ‘critical mass’ yet, the direction (but not necessarily the amount) of these measures is the right one, we think, and in line with what the European policymakers are keen to see.

…and why it matters for external support: The crucial risk, at this juncture, is the sheer size of government refinancing, which makes Italy very sensitive to changes in market sentiment, driven by both domestic events and progress / setback in the journey towards deeper European integration. Put differently, barring any unforeseen European policy response that goes way beyond our expectations, Italy can choose between pursuing its own (and Europe’s) fiscal and reform agenda with higher interest rates, or with lower interest rates.

What’s the hurdle… Some commentators seem to see the extra conditionality that will likely be imposed – and the quarterly deadlines that will

have to be met – as an insurmountable obstacle for Italy’s politicians to apply to the EFSF / ESM. We disagree and think that, while not the preferred option for Italy, market pressure is more important.

…and the key trade-off: With sovereign bonds no longer perceived as risk-free in the eurozone, most countries have already lost their ability to use fiscal policy in a countercyclical fashion – the smaller peripherals can’t even borrow in the market. So the key trade-off is not fiscal consolidation and reform vs. no fiscal consolidation and reform, and not even acceptable funding costs vs. unacceptable funding costs. It’s fiscal consolidation and reform plus acceptable funding costs vs. no fiscal consolidation and reform plus unacceptable funding costs. That’s what Mr. Monti wanted when he proposed, at the EU Summit in June, a European mechanism to reduce the funding costs of sovereigns complying with Europe’s demands, in our view.

So is conditionality an issue? We too believe that excessively harsh conditions over and beyond what’s already been agreed might be a political obstacle, especially for a technocratic government taking decisions exerting effects beyond its natural duration. Yet, Italy is not starting from scratch, and

we think that it can meet a good deal of requests from the official lenders. So conditionality, while surely an obstacle, is not an insurmountable one.

Market pressure – the trigger: Whether Italy will need some degree of sovereign support, and will ultimately apply for it, depends on a number of issues, including the national election to be held by April 2013. Yet the psychology of contagion is such that when a eurozone sovereign is ‘dealt with’, then investors naturally focus on the next weak link. So market pressures on Italy might intensify, once Spain applies for financial support to the European rescue funds. If markets remain well behaved, i.e., systemic risk diminishes, that might lower the incentive to request European support, but it might also lower the commitment to economic reform – thus increasing idiosyncratic risk.

Growth: We Are More Cautious than Most Fiscal Discipline Might Pay Off

Source: European Commission, Italian Ministry of Economy and Finance, Bank of Italy, ISTAT, Consensus Economics, Morgan Stanley Research

Real GDP (% Y/Y)

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

2012 2013 2012 2013

Morgan Stanley Consensus Italian Gov't/EU Commission

Italy Eurozone

Budget Balance & Gov't Debt (% of GDP)

-8

-4

0

4

8

2002 2004 2006 2008 2010 2012 2014

Interest spendingPrimary budget balanceOverall budget balance

MS Forecasts

In this report, we also look at various key risks for Italy’s economic outlook:1. Can growth come back at all? Yes, but not before mid-2013. But while we are comfortable with or below-consensus forecast, we are more optimistic than most on Italy’s potential to reform.2. Are the public finances being fixed? Yes, and the primary budget surplus is increasing. Asset sales is an area that might be further explored. Yet the sheer size of government refinancing is a main risk in the near term. 3. Is political uncertainty a worry? An unresolved political situation might turn into a further channel of contagion. With austerity taking a toll on an already weak economic fabric, discontent might well rise and potentially affect attitudes towards the euro.4. Regions: Regional financial conditions and credit quality remain closely tied to the nation. Credit quality relative to Italy should decline modestly.5: Banks: We take a fresh look at the biggest issues for the Italian banking system and what could be done to help solve them.

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Can Growth Come Back at All?

Yes, but not before mid-2013. Structural reforms are continuing, but they haven’t yet reached ‘critical mass’.

- The economic situation continues to be very fragile. We remain below the consensus and official forecasts for Italy’s economic prospects in 2012-13.

- The financial crisis and its economic fallout might have damaged the supply-side of the economy, thus further hitting Italy’s sub-par potential growth. It might now have dropped to 0.5%. Thus, extrapolating into the future the pre-crisis growth rate of potential GDP might be too far-fetched.

- Even though the structural reforms implemented recently are not necessarily as far-reaching as some investors might have hoped for – and are unlikely to exert significant effects in the near future – they might nonetheless boost GDP growth by 2.4ppt from now to 2020. And there’s scope to lift GDP by a multiple of that, if a broader package were adopted.

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Economy to Continue to Shrink at a Fast Pace for a Quarter or Two

- Even though 2Q economic activity fell at a slightly slower rate than in the previous quarter, high-frequency indicators, ranging from hard data to business and consumer surveys, suggest that the pace of GDP contraction has again accelerated lately.

- Purchasing managers’ indices (PMIs) – which are more coincident in nature – point to a further deterioration on the manufacturing side, where the corresponding PMI is now at just 43.6 in August, far below the threshold of 50 that separates expansions from recessions.

- The services PMI has shown some relative resilience in recent months but, at around 44 or so, it too points to shrinking activity in the services sector, but not falling off the proverbial cliff.

- More forward looking indicators, such as factory orders or surveys on Italian firms’ expectations on their order books and production, paint a similar picture, and suggest a worsening near-term outlook. For example, new orders are now as weak as at the trough of the recession back in 2009.- And Italian firms expect a further deterioration in their order books, both domestic and foreign, thus planning to cut back production. We expect this trend to continue for the whole of this year.

Conclusions: Even though the economy fared slightly better than expected in 2Q, it looks like GDP might shrink at a fast pace in the second half of the year too, and it might continue to contract – but at a milder rate – also in early 2013.Source: Eurostat, ISTAT, Markit, Morgan Stanley Research

Coincident and Forward-Looking Indicators Point to Renewed Economic Weakness

GDP & Composite PMI

-4

-3

-2

-1

0

1

2

1999 2001 2003 2005 2007 2009 201110

20

30

40

50

60

70

GDP (% Q/Q, LHS)

Composite PMI

Industrial Production (2005 = 100)

70

80

90

100

110

120

1999 2001 2003 2005 2007 2009 2011

Germany France

Italy Spain

http://linkback.morganstanley.com/web/sendlink/webapp/BMServlet?file=ug73ttiu-3of5-g000-add4-d8d3855a5100&store=0&d=UwBSZXNlYXJjaAA0NDk3MTY%3D&user=ba2kbw2z4lkz-2&__gda__=1471081221_cd254c52a448249d19b5ddd77338f918

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Industrial Production and Business Confidence Now Severely Hit by the Crisis

- Industrial production, after the slump in 2009, expanded at a fast pace for the first half of the subsequent year. But it started to decelerate, and then shrink again, thereafter. This trend seems to continue apace – and is probably related to Italy’s structural deficiencies too.

- Similarly, business confidence appears to have deteriorated considerably over the past several months. Initially, the fall – after some recovery earlier – was probably due to the uncertainty related to the political crisis last year.

- Yet, more recently, economic underperformance – on top of some degree of political uncertainty that hasn’t dissipated – has depressed and further delayed prospects for a sustained recovery.- Weak growth is mainly related to multiple rounds of fiscal austerity, a slow-motion credit crunch and weaker external demand for Italy’s goods and services.

- Morgan Stanley’s GDP indicator points to a sharp economic contraction in 3Q. This is an econometric tool that provides a timely estimate of GDP growth by synthesising the information contained in several leading and coincident indicators, ranging from industrial production and orders to retail sales and the yield curve.

- Likewise, a monthly ‘tracking estimate’ encompassing indicators such as electricity consumption, motorway traffic flow, etc. seems consistent with these estimates.

Conclusions: 3Q economic activity is likely to have weakened further – perhaps at a faster pace.Source: ISTAT, Consensus Economics, Morgan Stanley Research

Output and Sentiment Now Deteriorating Fast, thus Indicating Sharp GDP Contractions Ahead

Industrial Production (% Y/Y) & Business Confidence Indicator

60

70

80

90

100

110

120

1999 2001 2003 2005 2007 2009 2011-30

-25

-20

-15

-10

-5

0

5

10

15

Business confidence (LHS)

Industrial production

3Q GDP Estimates

-4

-3

-2

-1

0

Consensus MS GDP indicator MS forecast

% Q/Q % Y/Y


6


Sovereign-Banks-Real Economy Spill Over Effects

- Rising borrowing costs and tougher lending conditions result in a slow-motion credit crunch, thus adding to the recessionary impulse from other factors, e.g., fiscal austerity. In turn, this might lead to rising bad debts and further constraints on banks’ ability to borrow.

- To estimate the impact of different growth assumptions on the Italian banks’ bad debt, we build a small-scale econometric model.

- Based on our economic forecasts, bad debts might continue to increase over 2012-13 and likely approach 10% of the loan book at the end of next year.

Conclusions: The ‘Italian risk’ seems to be correlated with broader risk measures, especially since the intensification of the sovereign debt crisis. Higher sovereign yields have affected banks’ funding, with negative repercussion on loans to the private sector.

Financial Stress Continues to Transmit Itself to the Real Economy

- The Italian bond market seems to be driven by global, European and domestic news. At the same time, Italy’s bond market developments and the factors that drive them tend to have repercussions outside its borders.- For example, measures of global or European risk aversion / appetite are much more correlated with Italy’s bond market since the intensification of the sovereign debt crisis.- Higher sovereign yields make the banking sector’s access to wholesale funding markets more difficult, thus contributing to higher funding costs.

- In turn, these higher funding costs often translate into higher interest rates for, e.g., loans to non- financial corporations and households (mortgages, consumer credit, etc.). So the real economy gets impacted too.

Italian Gov't Bond Spread & VDAX

0

10

20

30

40

50

60

2009 2010 2011 20120

1

2

3

4

5

6

Impl. Vol. Dax (EUR, LHS)

10Y spread Italy vs. Germany (%)

10Y Sovereign Spread vs. Germany & Private Sector Lending Rates (%)

0

1

2

3

4

5

6

7

2009 2010 2011 2012

Non-financial corporations

Mortgages

10Y sovereign spread vs. Germany

Non-Financial Corporations Bad Debts* (% of Loan Book)

0

2

4

6

8

10

12

1999 2001 2003 2005 2007 2009 2011 2013

*Empty bars are Morgan Stanley Research estimates; this is not a bottom-up stress-test on the banks, but an econometric scenario using our macroeconomic forecasts. Source: ECB, Bank of Italy, ISTAT, Bloomberg, Morgan Stanley Research

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We Stay Below the Consensus this Year and Next

- Risks are balanced. We assign a 20% probability to our bear case of a similar GDP contraction of almost 3% both this year and next. This scenario encompasses a full-blown credit crunch, a less favourable external environment and an intensification of the euro crisis.

- We assign a 20% probability to our bull case of a milder contraction, especially next year. This scenario, while not very bullish, encompasses easing credit conditions, a more favourable external environment and risk markets doing better. Our growth forecasts are more cautious than the consensus and official forecasts.Conclusions: Deep GDP contractions are still ahead of us, in our view, and we are more cautious than most. Yet the recession is likely to ease going into next year.

Source: European Commission, Italian Government, ISTAT, Consensus Economics, Morgan Stanley Research

Easing Recession Towards Year-End and in the Early Part of 2013

- We think that GDP is likely to continue to shrink sharply for the remainder of the year, on the back of further implementation of the austerity plan, a slow- motion credit crunch and weakening external demand.

- But, while domestic demand is likely to shrink in 2013 too, its pace of economic contraction should ease, as most belt-tightening measures seem front- loaded. We see next year split in two parts: in the early months, the chances are that GDP will continue to fall, but less so than before; subsequently, we expect an eventual return to sub-par growth.

- Yet, apart from a still mixed cyclical situation, Italy’s long-standing structural deficiencies – which have hampered economic growth since the inception of the eurozone and even before – are likely to stay a constraint for years to come, even though the recent reforms might help.

Real GDP Growth

-4

-3

-2

-1

0

1

2

2001 2003 2005 2007 2009 2011 2013-8

-6

-4

-2

0

2

4

% Q/Q (LHS)

% Y/Y

MS forecasts

Real GDP (% Y/Y)

-3

-2

-1

0

1

2

2012 2013 2014-18

Bear Base Bull

Real GDP (% Y/Y)

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

0.5

1.0

2012 2013 2012 2013

Morgan Stanley Consensus Italian Gov't/EU Commission

Italy Eurozone

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Making Ends Meet

- Often overlooked, a highly negative net investment position is a crucial weakness of all the southern European countries – with the exception of Italy.- The accumulation of persistent current account deficits has caused the build-up of a large pile of external debt. The current account deficit is relatively small in Italy, and mostly due to a structural energy gap.

- Household and corporate leverage is moderate in Italy. Including government debt, Italy is less leveraged than the eurozone average.

Conclusions: Italy does not need to deal with a large pile of external debt. It’s current account deficit is narrow and seems narrowing further. Private sector leverage, in particular in the household sector, is low by European standards. Thus, Italy does not need to rebalance to a great extent, and is not far from leaving within its means.

- Unlike that of other southern European economies, as well as Ireland, Italy’s net investment position shows that it doesn’t owe foreigners much more than it owns abroad.- Basically, there are three groups of countries in the eurozone, based on their foreign assets vs. liabilities:

1. Debtor countries: Those that need to attract foreign capital to a great degree, because of (previously wide) current account deficits and substantial external debts.

Portugal, Ireland, Spain, Cyprus, Greece

2. Middling countries: Those with moderate external debts and contained current account deficits.

Italy, France, Austria

3. Creditor countries: Those with large current account surpluses and external assets exceeding liabilities.

Finland, Germany, Netherlands, Belgium

Source: Eurostat, Morgan Stanley Research

Italy is a Fairly Balanced EconomyNet Investment Position (% of GDP)

Portugal

IrelandSpain

CyprusGreece

ItalyFrance

Austria

Belgium

NetherlandsGermany

Finland

-150 -100 -50 0 50 100

Current Account Balance (% of GDP)

-20

-15

-10

-5

0

5

10

15

1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

GER FRA ITA

SPA NLD BELPOR GRE IRE

MS Forecasts Public & Private Sector Debt (% of GDP)

0

100

200

300

400

500

600

GER FIN FRA AUT BEL ITA SPA GRE NLD POR IRE

Non-financial corporations Government Households

Unconsolidated data for FRA, SPA and IRE; non-fin. corp. debt is not necessarily comparable

across countries, and includes domiciled foreign companies in the case of IRE


9


Current Account Rebalancing and Capital Flows

- Italy’s small current account deficit is now narrowing rapidly – having started to correct in late 2010. We expect this trend to continue, with a deficit of less than 1% at the end of next year.

- This is due to the effect of the recession, with domestic demand and imports shirking fast, and to Italy’s growing surplus in trade in goods excluding energy, with exports outgrowing imports since the inception of the eurozone – and from a large base.

- The deficit seems mostly due not only to a weak services sector – given an underdeveloped market for tradable services – but mainly to a structural energy deficit. And, apart from this long-term factor, the gyrations of the price of oil and the exchange rate can affect Italy’s rebalancing ability or pace.

- Persistent current account deficits make it difficult to finance the shortfalls, as investors find themselves with increasing amounts of that country’s debt in their portfolios and, to compensate for the rising exposure, they might require, .e.g., higher interest rates.

- The short-run capital flows that have previously financed the Italian economy, such as portfolio investments in stocks and bonds, have dried out during the crisis. So the SMP bond purchasing programme and the Target2 balances partly replaced these funding sources.Conclusions: Italy’s current account deficit is narrowing, and wasn’t that big to begin with. Funding for the overall economy has partly been replaced by official sources.Source: IMF, Bank of Italy, ISTAT, Morgan Stanley Research

Starting to Correct a Modest External Imbalance, Official Sector Replacing Private Capital

Current Account (€bn, 4Q Sum)

-120

-80

-40

0

40

80

1999 2001 2003 2005 2007 2009 2011-6

-4

-2

0

2

Trade bal. ex energy EnergyServices Current transfersFactor incomes CA (% of GDP, RHS)

Capital Flows (€bn, 4Q Sum)

-200

-100

0

100

200

300

1999 2001 2003 2005 2007 2009 2011

FDI Portfolio Inv. - Equity Portfolio Inv. - Debt Financial Derivatives Other Inv. - Mon. Authorities Other Inv. - Govt Other Inv. - Banks Other Inv. - Other


10


Persistent Demand Shortfalls Negatively Affect the Economy’s Productive Capacity

- In a ‘typical’ recession, demand falls short of supply. But when the recovery arrives, the resources left lying idle are brought back into production, making the economy grow faster than normal until it reaches the point where it would have been without the recession, thus running again at full potential.

- However, if the shortfall in demand persists long enough, it can do lasting damage to supply, i.e., to the economy’s productive capacity, and reduce the level of potential output or even its rate of growth.

- When this happens, the economy will never regain its lost ground compared to the baseline in which recession had not occurred, even after demand accelerates during the subsequent recovery.

- This is crucial for investors, because their expectations for a country’s economic performance – and hence on aggregate corporate profits – will be disappointed if they simply extrapolate into the future the pre-crisis growth rate of potential GDP.

- If the recession lowered the pace at which an economy can sustainably expand, the rate of growth of aggregate corporate profits, at least over the long term, will be lower too.Conclusions: Italy’s sub-par potential growth is likely to have taken a further hit, in our view. The financial crisis and its economic fallout might have damaged the supply- side of the economy. Thus, extrapolating into the future the pre-crisis growth rate of potential GDP might be too far-fetched, we think. Source: ISTAT, Morgan Stanley Research

Aggregate Corporate Profits Might Be Lower If Italy’s Future GDP Path is Weaker than Before

Real GDP (% Y/Y)

-8

-4

0

4

8

12

1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011

1961-70 = 5.7% 1971-80 = 3.7%1981-90 = 2.4% 1991-00 = 1.5% 2001-10 = 0.4%

GDP & Gross Operating Surplus(Nominal, % Y/Y)

-15

-10

-5

0

5

10

15

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012-6

-4

-2

0

2

4

6

8

Gross Operating Surplus GDP (RHS)


11


Four Recession-Related Factors that Might Impact the Supply-Side of the Economy

opportunities or tighter lending standards – encouraging firms to use less capital per unit of output, thus negatively affecting the economy’s productive capacity.

4. Protectionism: Governments might decide to shield firms and workers from foreign competition through restrictions on foreign trade – such as tariffs on imported goods or restrictive quotas – or on foreign takeovers of local firms. This might complicate the restructuring of the economy or encourage firms to relocate elsewhere.

Conclusions: These factors can have a significant impact on Italy’s medium-term prospects. An IMF analysis of the impact of the banking crises over the past four decades shows that, seven years after a bust, an economy’s level of output was on average 10% below where it would have been without the crisis – a huge gap, in line with Italy’s economic outturn after the crisis.

Unemployment Rate and the NAIRU (%)

2

4

6

8

10

12

14

1970 1976 1982 1988 1994 2000 2006 2012

NAIRU

Unemployment rate

- A persistent shortfall in demand hurts the economy’s productive capacity through four channels:

1. Atrophying skills: If the period of joblessness is too long, the skills of the unemployed will atrophy, partly because of the lack of training on the job. When demand strengthens, they will struggle to find a new job, or a job providing the same earning power, thus resulting in an increase in structural unemployment (i.e., the NAIRU).

2. Capital scrapping: If firms perceive that the lower level of activity will last for a long while, they will cut investment aggressively, thus ceasing to add to the capital stock. And they may even start scrapping some of it, either voluntarily or because they go out of business.

3. Financial constraints: An impaired or over-regulated financial system might result in a higher cost of capital – perhaps because of competition for limited funding

Source: European Commission, OECD, Bank of Italy, ISTAT, Morgan Stanley Research

Capital Stock & GDP per Worker (% Y/Y)

-4

-2

0

2

4

6

8

10

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Capital stock per worker

GDP per worker

Credit Standards to Non-Financial Corporations (Net of % Responses)

-40

-20

0

20

40

60

80

100

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Past 3 months

Next 3 months

Tightening std.

Loosening std.

Italy’s Medium-Term Prospects Might Be Negatively Affected by the Scar Left by the Recession


12


Steady Decline of Italy’s Potential Growth

- In trying to assess a country’s productive potential in one individual year the key distinction is between cyclical, or demand-side, factors and structural, or supply-side, factors – which affect productive capacity.

- For example, a drop in foreign and domestic spending might cause a cyclical drop in Italy’s fixed investment; but as and when demand recovers, these dynamics will reverse. However, constraints on the supply of credit might have caused firms to cut back their investment by more than the decline in demand alone would imply, thus reducing the economy’s potential growth.

- Italy is suffering from chronically low economic growth. According to the IMF, OECD and European Commission, potential growth has declined from about 4% in the 1970s to less than 1.5% before the crisis, one of the slowest rates of expansion across DMs.

- Any measure of potential growth, being a concept that cannot be observed directly, is subject to considerable estimation errors and backward revisions. Thus, we would take any such measure with a pinch of salt.

- As a ballpark estimate, an update of our analysis on Italy’s labour productivity and labour force (see Assessing the Damage, October 26, 2009), suggests that Italy’s potential growth might now have decelerated to close to the lower bound of between 0.5% and 1%.

Conclusions: Italy’s potential growth rate might have declined further – and from one of the weakest paces of expansion in the developed world. It might now be at around half a percentage point.Source: ISTAT, European Commission, Morgan Stanley Research

Italy’s Potential Growth Rate Might Now Be Close to the Lower Bound of Between 0.5% and 1%

Italy: Potential GDP & Output Gap

-1

0

1

2

3

4

5

1966 1971 1976 1981 1986 1991 1996 2001 2006 2011-6

-4

-2

0

2

4

6

Output gap (% of potential GDP)

Potential GDP (% Y/Y, LHS)

Real GDP (1Q 2008 = 100)

76

80

84

88

92

96

100

104

2008 2009 2010 2011 2012 2013

GER FRA ITA

SPA GRE IRE

POR

https://secure.ms.com/fidweb/firLink/webapp/openFile.jsp?action=stream&filename=mtb44551.pdf


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Difficult Environment for Doing Business

- Italy’s attractiveness as a foreign direct investment (FDI) destination seems quite limited. As a percentage of GDP, inward FDI stock amounts to around 15%, higher only than in Greece within the eurozone. And outward investment too is quite low relative to virtually all eurozone members (again with the exception of Greece).

- The World Bank’s 2012 “Doing Business” report ranks countries based on measures of business regulations and their enforcement, as well as administrative burdens, among others.

- By looking at the performance across many indicators among the OECD countries, Italy’s overall score is such that it ranks last before Greece.- Italy seems to underperform particularly in the areas of contract enforcement, paying taxes and getting electricity. It does somewhat better relative to its own ranking – i.e., it remains an underachiever among the OECD countries – at protecting investors, resolving insolvency and starting a business.

- Expecting to see a notable impact from the structural reforms so soon is probably to much to hope for. They would probably need to reach ‘critical mass’, as well as seeing their scope increase. Yet these reforms go in the right direction, and might begin to address some of Italy’s economic and institutional deficiencies.

Conclusions: Italy’s structural deficiencies are such that it’s one of the least preferred destinations, within the eurozone, for FDI. And its companies’ seem to struggle to open new factories abroad. *For each topic, Italy’s ranking among 31 OECD countries is reported.

Source: UNCTAD, IMF, World Bank, Morgan Stanley Research

Italy Attracts Limited Foreign Capital and Doesn’t Invest Much Abroad

Foreign Direct Investment (% of GDP)

0

40

80

120

160

200

GRE ITA GER FIN FRA AUT SPA POR NLD IRE BEL

Outward Inward

Ease of Doing Business: Italy vs. OECD Average*


14


What Italy Has Done to Reform Its Economy Objective Area Measures

Product Market ReformEnhance competitionand liberalise economicactivity

Energy Gas industry: Ownership separation of ENI from gas distribution activity; lower tariffsfor vulnerable customers; promote strategic investments

Electricity: Promote investment in the transmission network; increase transparencyPetroleum products: Eliminate restrictions on contractual arrangements and activities;replace outdated systems; improve information transparency

Transport Railways: Introduce competitive tender process for local railway services

Highways: Review tariffs systems for new concessions

Taxi services: Limit entry and activity restrictions

Professional services Abolish tariffs for regulated professions; reform professional orders to ease entryand activity restrictions; separate administrative, education, and disciplinary functionswithin orders

Increase the number of pharmacies and notaries; abolish some restrictions

Local public services Require competitive tendering and territorial consolidation in service provision toincrease efficiency/reduce costs

Reduce administrative constraints to establishing and running a business; liberaliseopening hours for retailers

Enhance the role ofcompetition bodies

Regulatoryframework

Strengthen the powers of the Antitrust Authority, especially to scrutinise and issuebinding opinions for activities at the sub-national levels

Establish independent Transport Authority; strengthen the role of CommunicationAuthority in the postal sector and Energy and Gas Authority in the water sector

Local publicservices

Strengthen enforcement of competition rules and sanctions for non-compliance;monitoring by the Presidency of the Council of Ministers

Reduce public sectorownership

Define a privatisation plan (earlier target: at least €5 billion revenue per year over2012-14, now €15-20bn); improve public asset management; plans to sell shares in state-ownedcompanies and establish a real estate fund to manage disposal of public assets at alllevels of government

Labor Market ReformReduce labour market dualism

Employment protection Modify job protection on standard contracts to reduce costs of individual dismissalby limiting the compulsory reinstatement in case of dismissal for economic reasons

Contracts Encourage stable employment relationships (tax disincentives for fixed-termcontracts; control abuse of atypical contracts) and promote apprenticeship contracts

Social safety net Reorganise social safety net to make the coverage more uniform (within the overallfiscal constraints); extend wage guarantee funds; early retirement schemes

Raise labour participationPromote female employment (protection against illegal 'blank resignations' andvouchers for baby-sitting services); strengthen activation policies

Existing measures focus on tax deductions for hiring of women, youth, and newemployees, and establishing a special type of company for young entrepreneurs

Non-exhaustive list. Source: IMF, Morgan Stanley Research

- Italy has implemented various labour and product market measures – even though they could have been more far reaching, and a few of them appear somewhat less incisive in their final version than in their initial one.

- The reform agenda aims at reviving growth from a medium-term perspective and make Italy’s economic fabric more dynamic. There’s still considerable scope to raise productivity and labour participation, and in some areas the structural reforms have not yet reached ‘critical mass’.- But Italy also needs time and stability for its adjustment and reform efforts to bear some visible fruits. Thus, equally important is progress at the European level in creating a more integrated monetary union with greater fiscal coordination and banking sector supervision, combined with further monetary easing and unconventional measures as needed by the ECB.

Conclusions: Italy is pursuing a reform agenda. The measures haven’t always been as far-reaching as possible, but are a step in the right direction. But for this to bear its fruits, stability at the European level is needed too.


15


Some Impact on Growth from Current Structural Reforms

- Some measures aimed at opening protected markets might have negative repercussions on consumption in the short to medium-term, and some on reducing entry barriers might depress investment for some time.

- Yet these reforms might boost GDP growth by 2.4ppt from now to 2020, with an average annual effect of 0.3ppt. Half of the boost might come in the first four years, with investment set to benefit considerably.

Source: European Commission, Italian Ministry of Economy and Finance, Morgan Stanley Research

- Italy’s technocratic government has implement a number of structural reforms mainly aimed at boosting the country’s medium-term growth potential.

- Two packages of reforms, converted into law recently, focus on increasing domestic competition by reducing entry barriers in some sectors and lowering the mark-up, and on cutting red tape – thus lowering the burden that an often inefficient bureaucracy puts on firms.

Effect of Current Structural Reforms (% Dev. from Baseline)

-1

0

1

2

3

4

5

2012 2013 2014 2015 2020 2012 2013 2014 2015 2020 2012 2013 2014 2015 2020 2012 2013 2014 2015 2020

GDP Consumption Investment Employment

Reducing entry barriers - eliminating business constraints, improving the economic environment

Lowering the mark-up - favouring competition, opening protected marketsCutting red tape - cutting administrative charges, modernising public administration


16


Significant Potential Boost from Deeper Structural Reforms

expenditure from transfers to investment, might raise GDP by more than 20ppt in the long term. Thus, economic growth might benefit substantially if the recent reform drive continued and intensified.- There seems to be a payoff from doing all the reforms at the same time, i.e., the impact of the total simultaneous reform packages is greater than the sum of the individual components.

Source: IMF, Morgan Stanley Research

- Beyond product market reforms, Italy has recently passed a labour market reform. Even though it could have been more far-reaching, it is a further attempt to deal with the rigidity and duality of the job environment.

- In its latest country review, the IMF calculates that thorough reforms in product and labour markets, thus going beyond the current ones, along with shifting taxation from direct to indirect taxes and

Effect of Deeper Structural Reforms (% Dev. from Baseline)

0

5

10

15

20

25

Year 1 Year 2 Year 5 Long run

Synergy factorShifting expenditure from transfers to investmentShifting taxation from direct to indirect taxesStrengthening active labout mkt policiesIncreasing female labour participationEasing employment protectionIncreasing competition in tradable product mktsIncreasing competition in professional servicesIncreasing competition in non-tradable product mkts

Product market reforms

Labour market reforms

Fiscal reforms


17


Forecasts at a Glance

- The jobless rate is likely to trend higher, thus negatively affecting prospects for some recovery in consumer spending – despite lower inflation in 2013.

- Reforms have been implemented more successfully on the fiscal side. The pro-growth measures haven’t yet reached ‘critical mass’ to boost economic activity, but they might have some effect.

Source: Bank of Italy, ISTAT, Morgan Stanley Research e = Morgan Stanley Research estimates

- Although we expect the Italian economy to continue to shrink on average in 2013, we think that the pace of deterioration is likely to abate. Some fractional growth might even return at some point next year.

- The belt-tightening plans appear ambitious to us. We expect the government to execute on its fiscal agenda, but to miss the deficit reduction goal.

2008 2009 2010 2011 2012e 2013e 2014-18eReal GDP -1.2 -5.5 1.8 0.5 -2.5 -1.0 1.0 Private Consumption -0.8 -1.6 1.2 0.2 -3.1 -1.4 Government Consumption 0.6 0.8 -0.6 -0.9 -1.5 -1.9 Gross Fixed Investment -3.8 -11.7 1.7 -1.2 -8.3 -1.0

Construction -2.9 -10.4 -3.6 -1.7 -8.9 -0.3

Contributions to GDP Growth (%) Final Domestic Demand -1.2 -3.2 0.9 -0.3 -3.7 -1.4 Net Exports 0.0 -1.2 -0.4 1.4 2.4 0.8 Inventories 0.0 -1.1 1.2 -0.6 -1.2 -0.4

Unemployment Rate (% of Labour Force) 6.8 7.8 8.4 8.5 11.0 12.0Inflation (CPI) 3.3 0.8 1.5 2.8 3.1 2.0 1.5

Current Account Balance (% of GDP) -2.9 -2.2 -3.6 -3.3 -2.8 -1.5General Government Balance (% of GDP) -2.7 -5.4 -4.6 -3.9 -2.8 -1.7Primary Government Balance (% of GDP) 2.5 -0.8 0.0 1.0 3.0 4.5General Government Debt (% of GDP) 105.8 116.1 118.6 120.1 123.5 125.2


18


Are the Public Finances Being Fixed?

Yes, and the primary budget surplus is increasing further. But the sheer size of government refinancing is a main risk.

- Italy’s fiscal policy has historically been quite effective at maintaining large primary surpluses for several years in a row. We expect a gradual return to such situation, thus providing a meaningful offset to high interest spending.

- Continuing to fight the ‘shadow economy’, implementing extra measures to increase efficiency and reduce waste in the public sector, and further monetising government assets are areas where there’s significant scope to reap benefits, and the pension reform might deliver short-term savings and contribute to long-term sustainability.

- A key concern in the near term has to do with the rollover of government debt in large size, which makes Italy vulnerable to sudden changes in market sentiment.


19


Sizeable Primary Surpluses to Offset Interest Expenses Almost Entirely Going Forward

- Over the past two decades, Italy has had a primary budget deficit in only one year (2009). It has generally maintained substantial primary budget surpluses, averaging 5% of GDP in the second half of the 1990s – with a peak of 6.5% in 1997.

- This budgetary strategy had negative repercussions on economic growth, i.e., the little growth that came from Italy was not due to deficit financing. But it also ensured some degree of fiscal sustainability by providing a partial offset to substantial interest expenses.- Italy seems likely to return to large primary surpluses in due course, after having engineered one of around 1% last year. Austerity is one driver behind our below- consensus growth forecast.

- Yet the net impact of the belt-tightening is such that the projected savings are likely to exceed the loss of revenues and extra expenditures due to the policy- induced recession.

- This fiscal setup should result in a situation where the overall budget deficit narrows substantially over time, but at a slower pace than projected in the official planning documents.

Conclusions: Italy’s fiscal policy has historically been quite effective at maintaining large primary surpluses for several years in a row. While we are conscious of the risks that such strategy entails for economic growth – and hence for the public finances – we expect a gradual return to such situation, thus providing a meaningful offset to high interest spending. Source: Bank of Italy, Italian Ministry of Economy and Finance,

ISTAT, Morgan Stanley Research

Fiscal Discipline Might Pay Off, and Bring Back Substantial Savings Over Time

Budget Balance & Gov't Debt (% of GDP)

-8

-4

0

4

8

2002 2004 2006 2008 2010 2012 2014

Interest spendingPrimary budget balanceOverall budget balance

MS Forecasts

Interest Expenditure & Cost at Issuance

0

3

6

9

12

1995 1997 1999 2001 2003 2005 2007 2009 2011

Interest expenditure (% of GDP)

Average weighted cost at issuance (%)


20


Solvency Risk vs. Liquidity Risk

- Italy, a highly indebted sovereign, is very sensitive to swings in market interest rates, given its heavy refinancing needs of ~ €350bn per annum.

- Yet, our simulation, based on an assessment of the full impact of an immediate and permanent upward shift of the Italian yield curve, shows that with the current level of (relatively low) market yields, Italy’s debt trajectory is likely to trend downwards after 2013, even if market yields were to rise by 250bp across the curve.- While non-negligible, an extra interest cost of, say, 100bp, would hardly be a heavy burden – although debt/GDP is of course quite high already. This is because the sensitivity of Italy’s debt servicing costs to rising yields is quite gradual, given the relatively high average maturity of its debt – about 6.5 years. On average, a 100bp rise in yields only raises debt servicing costs by 17bp in the first year, we estimate.

- For debt/GDP to stabilise at 120% in 2012-13, and start decreasing thereafter, interest rates would have to drop by 200bp in the near term. Even so, this analysis suggests that the most immediate risk has little to do with uncontrolled debt dynamics. Rather, it’s the large rollover of government debt that Italy has to take care of that remains a critical vulnerability.

Debt Trajectory on Sustainable Path, Ample Cushion for Near-Term Interest Cost Volatility

Gov't Debt (% of GDP)

110

115

120

125

130

2011 2012 2013 2014

MS base case With B/E interest cost

+250bp across the curve

Interest Cost (% of Total Debt)

0

1

2

3

4

5

2012 2013 2014

B/E interest cost to stabilise debt

Current interest cost

Source: National Treasuries, Morgan Stanley Research Note: Content on this page is from Fixed Income Research


21


Refinancing Needs – Ongoing Challenge

- Italy faces the biggest refinancing needs in Europe, at approximately €200bn of bonds and €200bn of bills per year.

- Even though it’s more than halfway through, 2012 YTD issuance has been lagging behind its peers, and also versus its usual issuance pattern.- Stabilisation of the eurozone sovereign markets post the ECB’s master plan could help Italy to step up its issuance plan in the last quarter of 2012.

- But uncertainty is still out there. We think that market stability is a key factor for further progress on the issuance front, but country-specific risks might matter again.

- Put differently, risks are asymmetric, we think. ‘Good’ policies are unlikely, alone, to exert a significant beneficial effect on market sentiment without a systemic risk reduction. ‘Bad’ policies might negatively affect sentiment to a great extent.


Italy’s Issuance Lagging Behind its PeersOngoing Refinancing Needs (€bn)

Bills Bonds * Bills Bonds * Bills Bonds2009 275 172 268 265 -8 932010 211 170 215 246 4 762011 196 156 216 207 0 51

2012e 196 193 216 236 0 432013e 196 159 216 185 0 262014e 196 182 216 201 0 192015e 196 211 216 227 0 16

* Include MS estimate of net issuance and refinancing from 2012 onwards

Redemptions Gross Issuance Net Issuance

CountryBond

Planned €bn

Bonds Issued

through Sep 20, €bn

Issuance Remaining

€bn

Bonds Issued through Sep 20, %

of Planned

Austria 22.0 17.3 4.7 78.8%Belgium 38.3 30.9 7.3 80.9%Finland 8.0 9.5 -1.5 118.8%France 178.0 156.3 21.7 87.8%Germany 178.0 141.1 36.9 79.3%Italy* 236.0 139.3 96.7 59.0%Netherlands** 60.0 53.9 6.1 89.8%Spain** 86.0 69.6 16.4 80.9%EMU 16 806 618 188 76.6%EMU 4 678 506 172 74.7%* Morgan Stanley estimate.Germany: €170bn Nominal + €8bn LinkersAustria : €20-24bnSpain** €86bn based on off icial target, possible additional €20bn funding requiredfor revised budget deficit and funding requirement for regional debt repayment


22


The Magic of the OMT

- Italy’s sovereign bond market has benefited substantially from the ECB’s announcement of its new bond purchasing programme (the OMT, Outright Monetary Transactions). For example, the 2yr spreads versus Germany has tightened by ~ 200bp since the “whatever it takes” speech by President Draghi.- However, activation of the OMT programme for Italy would be conditional upon:

i. the negotiation of fiscal and other reforms in a Memorandum of Understanding, with periodical compliance checks

ii. The activation of the EFSF / ESM in the bond market when exceptional financial market circumstances and risks to financial stability exist

- This implies that any support from the ECB will be subject to Italy’s official request for EFSF / ESM assistance, either through a macroeconomic adjustment programme or a credit line (both subject to strict conditionality).

- This, if required, could come in the form of either primary (more likely) or secondary market support, and should primarily focus on the 5-10yr sector to facilitate issuance.

- OMT, which operates in the 1-3yr sector, is in principle unlimited in size, and so could absorb all the outstanding €240bn of 1-3yr BTPs. But the likely selling flow will probably be smaller, as the front-end is largely owned by domestic investors, who might be less keen to sell. So actual buying size may be less than €100bn.

Italy’s Gov’t Debt Has Gained from the ECB Announcement on Bond PurchasesTerm Structure of Italy Spreads vs. Germany

150

250

350

450

550

2013 2018 2023 2028 2033 2038

Inte

rpol

ated

Spr

ead

vs. G

ER

Italy - Germany (Current) Italy - Germany (July 26th)

Cumulative 1-3yr BTPs & Proportion Owned by Foreigners

38

143

240

11

43

72

0

50

100

150

200

250

300

2H 2013 2014 2015

€bn

Italy (BTPs) Italy 1-3y sectorowned by foreign investors



23


What Italy Has Done to Fix Its Public Finances

- The Italian government has implemented three austerity packages in 2011, and is in the process of putting into practice the decisions of a spending review approved during this summer. More measures are likely to follow in the coming months, we think.

- The main goal is to support debt reduction and to cut structural inefficiencies in the public administration. These packages include some offsetting measures to cushion the downturn, such as modest reductions in the taxation of labour and capital and support to local transport and infrastructure. Ministries were allowed to direct the cuts to their budgets towards the least productive expenditure areas, and the reductions in health expenditure is underpinned by policies to harmonise pharmaceutical spending and increase patient co-pay.

- The spending review further reduced waste, and allowed to postpone a planned VAT rate hike to July next year. Further cuts in spending, up to €6.5bn, will have to be found to eliminate it altogether. All these fiscal measures go a long way towards improving Italy’s debt dynamics, given the large primary surplus that is likely to result (3% this year from 1% last year) – although not as large as in the official forecasts.

- The fiscal packages also introduced additional pension reforms that should generate savings of around 1.2% of GDP annually during 2020-30, including immediate extension of contributory system to previously grandfathered workers and an earlier rise in the retirement age, especially for women, to 67. Source: Italian Ministry of Economy and Finance, IMF, Morgan Stanley Research

Italy’s Fiscal Plan

€bn 2012 2013 2014Increase in revenue 50.1 64.5 68.7

Of whichIncreased taxes on consumption 17.5 26.9 30.4

Increase in VAT (20% to 23% and 10% to 12%) 7.5 17.4 20.6Fuel excises, tobacco and lottery 10.0 9.6 9.7

Increased taxes on wealth 15.3 16.2 15.0Property tax with revaluation of tax base 10.7 10.9 11.3Stamp duty on financial assets; tax on assets abroad 4.2 4.9 3.3Luxury asset tax 0.4 0.4 0.4

Other increase 8.6 10.6 11.4Increased social security contributions 1.2 1.6 2.0Capital income taxation 1.4 1.5 1.9Regional income tax surcharge 2.2 2.2 2.2Tax collection measures/anti-evasion/gaming 3.7 5.3 5.3

Changes to the Domestic Stability Pact – special statute regions 0.6 1.2 1.5Reduction in revenue -12.5 -17.8 -23.4

Of whichIncentives for Capital and Labour -3.0 -5.0 -6.0

Reduced tax on labour (IRAP) -2.0 -4.0 -3.0Allowance for Corporate Equity (ACE) -1.0 -1.0 -3.0

Reduction of VAT -3.3 -6.6 -9.8Other 0.0 0.0 0.0

Reduction in expenditure 28.3 38.2 43.7Of which

Ministerial expenditure 7.1 6.6 4.9Sub-national government expenditure 7.0 9.2 9.2Other State departments and non-territorial entities 0.8 0.6 0.6Changes to the Domestic Stability Pact – ordinary statute regions and local authorities 1.7 4.0 4.0Health expenditure 0.9 4.3 7.0Pension measures 3.2 8.5 10.5

Increase in expenditure -15.3 -9.3 -7.6Of which

Transport, Infrastructure and other growth Funds -1.9 -2.2 -2.5Credits to truck hauliers -1.1 -1.1 -1.1IRAP deductability -1.0 -1.0 -1.0Extension of existing legislation and non-deferrable expenditure -0.5 -2.7 -0.1Transfers to the Earthquake Reconstruction Fund 0.0 -1.0 -1.0Other 0.0 -0.1 -0.2

Net fiscal impact (consolidation) 50.6 75.6 81.4% GDP (MS F'cast) 3.2 4.7 5.0Share of net revenue measures (%) 74.3 61.7 55.7Share of net expenditure measures (%) 25.7 38.3 44.3


24


Fighting the ‘Shadow Economy’ – Progress, but More to Do

- Efforts to fight tax evasion and tax fraud are starting to show tangible results. Revenues from these measures increased by around 15% in 2011 from a year earlier – an increase of €12.7bn.

- A first package of measures has to do with, among other things, more thorough tax assessments, the easing of banking secrecy, extra disclosure obligations, stepped up sanctions, and strengthened controls through the processing of specific lists based on information sent to the tax authorities by financial institutions, etc.

- A second package of measures has to do with a reward system for small business and self-employed workers – if their tax declarations are consistent with estimates based on the activity they carry out, limitations in the use of cash, obligation for banks to make available to the tax authorities the entries made to all accounts with customers, and generally tougher rules.

- Yet there is significant scope for improvement, in our view. For example, the ‘shadow economy’ that the tax authorities are facing might represent over 20% of GDP in Italy – down from 25% in the mid-1990s, but still second only to Greece.

- In a specific estimate for Italy, ISTAT calculates that the value added of activities where tax evasion or tax fraud take place is between €255bn and €275bn.Conclusions: One of the areas where Italy can do more to reduce the fiscal burden further down the line is fighting the ‘shadow economy’. There’s been progress, but there’s still scope to do a lot. Source: F. Schneider – various papers, Italian Revenue Agency, Morgan Stanley Research

Revenues from Anti-Tax Evasion Measures Have Increased, but Problems Still Remain

Italy: Revenues from Anti-TaxEvasion Measures (€bn)

6.47.0

9.1

11.0

12.7

0

3

6

9

12

15

2007 2008 2009 2010 2011

Shadow Economy (% of GDP)

0

5

10

15

20

25

30

UK AUT NLD USA FRA IRE FIN DNK GER SWE BEL POR SPA ITA GRE

Mid-1990s Latest


25


Monetising Government Assets – How Much?

immediately, but also weighs on future deficits. But the private sector is generally more efficient in allocating and managing resources than the public sector; and domestic competition might increase. So this should not only be seen as a fiscal measure to boost revenue; it’s also a structural reform that might exert beneficial effects on growth and raise the return on these assets.

- The first phase of the plan has to do with accelerating the sale of three companies belonging to the Finance Ministry, i.e., Sace, Fintecna, and Simest, to state-owned Cassa Depositi and Presiti (CDP), which is outside the perimeter of the public administration. The government estimates that this will raise €10bn.

Conclusions: A multi-year privatisation plan, which might be announced in the near term, would be an important step towards improving debt sustainability.

- The Italian government has recently announced the first stage of its programme of asset sales. The proceeds will be used for debt reduction, either through buybacks, or by paying arrears, thus improving Italy’s debt path. While this is just a first step, we have argued that Italy’s potential for privatisation is large, especially at the regional level (see The Full Monti, November 17, 2011).

- Based on estimates presented at a seminar of Italy’s Ministry of Economy and Finance, we think that the market value of government assets that could be privatised or managed by the private sector plus receivables might amount to €812bn. In the medium term, about €240bn might be extracted through the monetisation of this pool of assets.- Privatising, in a sense, means giving up the revenues from that asset; this reduces the debt burden

*Book value; non-exhaustive list. Source: Italian Ministry of Economy and Finance, E. Reviglio (2011), Morgan Stanley Research

Central Government Debt vs. Regional Government AssetsGov't Assets (% of Total)

33%

67%

Central gov't

Regional & local gov'ts

Gov't Liabilities (% of Total)

6%

94%

Central gov't

Regional & local gov'ts

Gov't Assets (€bn)

0

200

400

600

800

1000

Market value Free / Recoverable

Real estate

Concessions

Non-listed holdings*

Listed holdings

Participations

Receivables

http://linkback.morganstanley.com/web/sendlink/webapp/BMServlet?file=1dutkn3k-3o8h-g000-ab82-d8d3855ae100&store=0&d=UwBSZXNlYXJjaAAzODk1OTQ%3D&user=nap7p059jt-2&__gda__=1447671675_14f3b912682a07b3e69efeeca9607071


26


Fiscal Sustainability at a Glance

- We expect this year’s budget deficit to continue to narrow – after having been in line with the fiscal target in 2011. But fiscal slippages to the tune of 1ppt of GDP might well materialise, given the ongoing recession.

- The primary surplus is likely to increase to 3% of GDP. And government debt should peak at 125% of GDP next year. The pension reform should contribute to lower sustainability risks in the long term, and puts Italy ahead of many of its peers in this area.

Conclusions: Italy’s fiscal efforts are likely to pay off. But the fiscal targets are unlikely to be met in full, we think. With the focus now shifting to ‘how to grow’, that’s a secondary concern, in our view.

Source: Bank of Italy, ISTAT, Morgan Stanley Research e = Morgan Stanley Research estimates

- The Italian government is in the process of implementing substantial spending cuts, worth about €26bn (1.6% of GDP) in 2012-14. More might follow, thus leading to a substantial extra belt-tightening.- The projected spending cuts appear credible, and they seem structural on the whole. Yet the ongoing recession, which we expect to remain deep 2H, might make the revenue target too ambitious. - The cost of servicing the debt is high and rising. At nearly €80bn at the end of last year (roughly 5% of GDP) and likely to approach €100bn over the next several years, this is a sizeable expenditure that limits the re- direction of resources to productive uses.

2011 2012e 2013e 2014e 2015eNominal GDP, % 1.7 0.4 0.4 2.8 3.2Nominal GDP, €bn 1580 1587 1594 1638 1690

General Govt Balance, % of GDP -3.9 -2.8 -1.7 -1.3 -1.0General Govt Balance, €bn -62.4 -44.4 -27.3 -20.5 -17.3Primary Govt Balance, % of GDP 1.0 3.0 4.5 5.0 5.1Primary Govt Balance, €bn 15.7 47.6 71.7 81.9 86.2

Interest Payments, % of GDP 4.9 5.8 6.2 6.3 6.1Interest Payments, % of Revenue 10.6 12.2 12.7 12.6 12.3Implicit (Net) Interest Rate, % 4.1 4.9 5.1 5.2 5.2

Government Expenditure, % of GDP 50.5 50.3 50.7 50.8 50.6Total Revenue, % of GDP 46.6 47.5 49.0 49.5 49.6General Gross Govt Debt, % of GDP 120.1 123.5 125.2 122.9 120.2


27


Given fiscal control pacts between the central and regional governments, the credit quality of Italy, and by extension its ability to support and control its regions, is the key driver of their credit quality relative to alternative credit options. The expected impact of growth and austerity on region-specific factors, such as debt affordability, appears modest.

- Regional financial conditions and credit quality remain closely tied to the nation as a whole, despite recent moves to fiscal federalism.

- However, ‘federal’ austerity programmes and weak national growth do hurt regional programmes relative to Italy.

- With that said, in the near term, the negative impact on Italy’s regions appears modest.

What Does the Fiscal and Economic Adjustment Mean for the Regions?

Note: Content on pages 27 – 33 is from Fixed Income Research


28


Regional Government Credit | BackgroundPolitical Organisation

20 regional governments, granted political autonomy by the 1948 Constitution

Each region has an elected parliament and president

15 regions with ordinary legislative powers

5 autonomous regions with extra ‘home rule’ that gives them greater financial discretion1

Primary Functions

Administer health, town planning, education, and social services

Fund capital for civil engineering and transportation projects

Fiscal Powers

Productive Activity Tax – Taxes value added of firms in its jurisdiction. Basic rate is 3.9%, but regions have discretion to increase or reduce the rate by 1%

Personal Income Surtax – Ability to apply an incremental tax in addition to the national income tax, typically at a rate of 0.9%-1.4%

Regional Governments of Italy by Credit Rating

Note: Autonomous regions are in greySource: Moody’s, S&P, Morgan Stanley Research

1The autonomous region of Trentino Alto Adige is made up of two autonomous provinces, Bolzano and Trento, for which we account for separately in some of our calculations given their special provincial autonomy status


29


Regional Government Credit | Credit Risk Largely Tied to Italy’s Overall Outlook

Institutional framework protects against credit negative decisions; ties credit health to central government…

Strict fiscal controls: The Domestic Stability Pact and the Health Pact give the central government power to constrain regional spending and ensure proper budget balance.

Restrictions on use of debt: Regions are not permitted to use debt for operating purposes. Thus, government operations are typically not reliant on capital market funding, reducing the reliance of their credit profile on market conditions relative to corporate credit counterparts. This is seen in the relatively extended debt profile of regional issuers, illustrated below.

Long duration of maturities: Debt is issued in amortising structures to match useful life of the capital it is financing. Consequently, regions’ WAM averages between 11 and 12 years1, compared to about 10 years for investment-grade corporates.

…but there are variables that can cause some credit deterioration in the current environment

A weak growth outlook: Italy’s poor growth outlook is a concern for the revenue base of the regions, and its ability to support the regions’ long-term liability commitments.

Funding cuts to regions and fiscal federalism: Regional reliance on central government transfers is increasing at a time when debt source is weakening as a result of central government austerity and decentralisation efforts. Italy’s move towards fiscal federalism means regions will have greater autonomy over tax revenue levels. However, this means that regions have greater discretion to choose credit positive or credit negative policies.

The Domestic Stability & Health Pacts: Tying Regional Credit Quality to Italy as a Whole

• A series of Italian laws makes it difficult for regions to quickly fall into default-like stress unless the country or its banking system become similarly stressed. The Domestic Stability Pact (DSP) was introduced in 1999 to improve the control mechanisms of the central government in ensuring fiscal discipline at the regional government level, as it pertains to financing of general government operations. Similarly, the Health Pact enables the central government to set limits for healthcare-related operating and capital expenditures.

• Constrains budgets: Binds regions to balance expenditures against revenues in an attempt to minimise the potential for fiscal imbalances and, by extension, increased regional credit risk and / or the need for extra central government assistance.

• Enforcement mechanisms: Governments that are in breach of either pact are legally required to cure deficits, typically through one of the following options: 1) cutting back expenditures, 2) suspend capital projects borrowing, 3) forced increase in tax rates to raise revenue. Regions may also be forced to pay a penalty and, in severe cases, the central government can replace local officials with appointed commissioners.

• Mandates assistance in difficult fiscal periods: Given that revenue projections can fall short of collections, and central government transfer payments can be mismatched from the timing in which they are to be spent, regions have the right to seek temporary credit extensions from Italian banks when deposits fall below target thresholds.

1 Moody’s


30


400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

1,600,000

1,800,000

40,000 60,000 80,000 100,000 120,000 140,000 160,000 180,000

Revenues (€mn)

GD

P (€

mn)

Revenues Grow, Shrink, With Broader EconomyOver the past 20 years, there has been a tight correlation between changes in Italian GDP and regional tax revenues

Source: ISTAT, Bloomberg, Morgan Stanley Research

Revenue growth is highly correlated to GDP growth. Not surprisingly, tax revenue, typically derived from income and wealth, tends to grow in line with the broader economy. Thus, despite some oscillation in tax rates over the years, tax revenue growth has mostly hewed to the change in size of the economy.

Thus, a weak growth environment risks weaker regional fiscal positions. Directly levied tax revenues make up about 47% of total regional revenues. Weaker growth leaves the regions susceptible to a decrease in debt affordability and greater risk of cash flow mismanagement. While the latter can often be addressed from a credit standpoint by revenue triggers in the Domestic Stability Pact, this type of solution can lead to less financial discretion at the regional level, typically considered a credit negative and further tying the credit fate of the regions to the larger Italy story.

Key Variable | Credit Quality Levered to Growth, Which Remains Weak


31


0%

20%

40%

60%

80%

100%

March

eAbru

zzo

Piemon

teVen

etoCala

bria

Valle d

'Aosta

Sardeg

naTren

toUmbri

a

Friuli-V

enez

ia Giul

iaBas

ilicata

Bolzan

oTos

cana

Campa

niaLo

mbardi

aPug

liaSicil

iaLig

uria

Emilia-R

omag

naMoli

se

2005 2010

More Regions Increasingly Rely on Central Gov’t Aid

Note: Lazio not included because of insufficient financial data.

Regions’ reliance on central government transfer payments has been increasing. Over the past 5 years, the share of total revenue derived from transfers from the central government has increased from 49% to 53% in aggregate, and has increased for more regions than it has decreased. This suggests that regions in aggregate have less discretion over their financial condition, and therefore, their credit quality is more tightly tied to that of Italy.

Yet transfer payments are set to be cut, thus weakening the revenue base. As a result of Italy’s ongoing efforts at deficit reduction in response to the sovereign debt crisis in Europe, regional and local governments are set to sustain €20bn in incremental cuts to regions during 2012 through 2014. While the plans offer limited details at this point, for the purposes of testing the potential credit effect we assume that regional revenues will sustain cuts proportionate to their relative population size.

Key Variable | Austerity Weakens Regions’ Financial Base

Decline in Projected Revenues due to Transfer Cuts1

1Cuts are derived from Decree Law No. 98/2011, Decree Law No. 138/2011, and Decree Law 95/2012 (Spending Review Plan).

Region 2012 2013 2014Campania 3.59% 6.53% 7.18%Veneto 3.21% 5.81% 6.32%Piemon te 3.00% 5.42% 5.90%Abruzzo 2.98% 5.39% 5.85%Marche 2.97% 5.37% 5.83%Emilia -R omagna 3.00% 5.41% 5.79%Umbria 2.94% 5.32% 5.78%Lazio 2.99% 5.40% 5.77%Puglia 2.92% 5.28% 5.74%Toscana 2.92% 5.27% 5.71%Calabria 2.82% 5.09% 5.53%Liguria 2.72% 4.91% 5.30%Lomb ardia 2.70% 4.84% 5.15%Basilicata 2.43% 4.37% 4.71%Mo lise 2.42% 4.36% 4.69%Sic ilia 2.00% 3.58% 3.79%Sardegna 1.67% 2.99% 3.19%Friuli-Venezia Giulia 1.42% 2.52% 2.67%Tren to 0.83% 1.47% 1.55%Bolzano 0.77% 1.36% 1.42%Valle d'Aosta 0.61% 1.08% 1.13%Ita lian Region s (all) 2 .64% 4.76% 5.11%

Though we recognise that increased local autonomy through legislation such as Law 42 increases revenue-raising flexibility, we emphasise that this places the burden for recovering lost transfer revenues on the regions. Furthermore, there is uncertainty around the levels at which taxing capacity can be increased given laws stating that “the devolution of taxing powers to sub-national governments must not produce any increases of the national tax burden2.” Thus, for the purpose of our analysis, we assume that transfer cuts are not replaced by local option revenues.

2IMF Public Financial Management Division.

Source: ISTAT, Moody’s, Bank of Italy, Italian Ministry of Economics and Finance, Morgan Stanley Research


32


Credit Impact | Expecting Modest Credit Negatives; Some Macro-driven Differentiation

Debt Affordability Should Weaken SlightlyCuts in the revenue base due to slow growth and austerity appear to be manageable given debt expectations

Regions w/ Higher Industrial Concentrations May Relatively Outperform on Credit QualityEmployment by Sector per Region

Source: ISTAT, Bank of Italy, Italian Ministry of Economics and Finance, Morgan Stanley Research

Despite a weakening operating environment, we see only a modest credit impact for regions in the near term. When we combine the assumption that tax revenues will grow in line with our nominal GDP forecasts (0.4% in 2012, 0.5% in 2013, 2.7% in 2014) and haircut transfer revenue for expected cuts from the central government’s austerity programme, regions’ debt servicing capacity appears to weaken only modestly. We borrow from Moody’s rating methodology and use debt service as a percentage of revenue as a proxy for measuring this factor. We also assume that debt costs will remain flat given the modest capital plans of the regions under the central government’s austerity mandate and the normal roll off of debt given regions’ amortising debt schedules.

Industrial sectors, ex-construction, should grow faster relative to other Italian economic sectors. This may allow some regional credit quality outperformance.Morgan Stanley expects that, given Italy’s slow growth relative to the global economy, export-led sectors of the economy should grow more quickly relative to others. Accordingly, regions with a higher percentage of employment in industrial sectors, ex-construction, could experience faster relative income growth near term, a credit positive. However, we note that is a minor credit factor relative to the impact of the national economy.

'11-'14Region 2011 2012 2013 2014 ChangeAbruzzo 5.81% 5.98% 6.31% 6.64% 0.83%Lazio 5.43% 5.58% 5.87% 6.07% 0.64%Umbria 4.30% 4.43% 4.67% 4.91% 0.61%Campania 3.17% 3.29% 3.51% 3.74% 0.57%Piemonte 3.96% 4.07% 4.30% 4.53% 0.57%Liguria 3.60% 3.70% 3.88% 4.06% 0.45%Sicilia 6.03% 6.13% 6.34% 6.48% 0.45%Puglia 2.26% 2.32% 2.45% 2.57% 0.32%Marche 2.21% 2.28% 2.40% 2.52% 0.31%Basilicata 2.68% 2.74% 2.87% 2.99% 0.31%Calabria 2.20% 2.26% 2.38% 2.50% 0.30%Friuli-Venezia Giulia 5.03% 5.10% 5.22% 5.33% 0.30%Toscana 2.17% 2.23% 2.35% 2.47% 0.30%Sardegna 3.50% 3.56% 3.66% 3.77% 0.27%Molise 1.93% 1.98% 2.07% 2.15% 0.22%Emilia-Romagna 1.46% 1.50% 1.58% 1.64% 0.17%Veneto 0.78% 0.81% 0.85% 0.90% 0.12%Lombardia 1.12% 1.15% 1.20% 1.23% 0.11%Valle d'Aosta 4.61% 4.64% 4.69% 4.72% 0.11%Bolzano 0.60% 0.61% 0.61% 0.62% 0.02%Trento 0.14% 0.14% 0.14% 0.15% 0.00%Italian Regions (all) 2.96% 3.04% 3.18% 3.30% 0.34%

Debt Service as a % of RevenuesNon-

constructionConstruction

Marche 2.74% 31.20% 7.91% 58.14%Veneto 3.22% 27.89% 8.29% 60.61%Friuli-Venezia Giulia 2.56% 27.22% 7.30% 62.92%Emilia-Romagna 4.08% 26.81% 6.87% 62.24%Lombardia 1.64% 26.47% 7.82% 64.07%Piemonte 4.07% 25.65% 7.54% 62.74%Umbria 3.53% 20.92% 9.78% 65.76%Abruzzo 3.85% 20.08% 9.13% 66.94%Molise 7.34% 19.27% 11.01% 62.39%Toscana 3.60% 18.98% 8.94% 68.47%Trentino-Alto Adige 5.32% 16.81% 8.72% 69.15%Basilicata 8.11% 15.14% 11.35% 65.41%Puglia 8.91% 14.79% 9.07% 67.24%Campania 4.23% 12.49% 9.97% 73.31%Liguria 2.19% 12.23% 7.99% 77.59%Lazio 1.82% 10.82% 8.91% 78.46%Valle d'Aosta 3.51% 10.53% 12.28% 73.68%Sardegna 5.05% 9.93% 9.43% 75.59%Sicilia 7.50% 8.40% 8.47% 75.63%Calabria 10.65% 7.50% 10.30% 71.55%Italy 3.90% 20.03% 8.44% 67.64%

IndustryAgriculture ServicesRegion


33


Lombardia

Liguria Umbria

SardegnaAbruzzo

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100

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300

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0% 10% 20% 30% 40% 50% 60%Total Debt/Total Revenue (%)

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ead

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unds

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LombardiaLiguria

UmbriaAbruzzo

Sardegna

0

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600

-5% 0% 5% 10% 15%Operating Margin (%)

Spr

ead

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unds

(bps

)

Credit Impact | Expect Current Relative Credit Rankings, Market Opportunities, to Hold

Conclusions:

• The macro / Italy environment is the biggest regional credit driver: Given fiscal control pacts between the central and regional governments, the credit quality of Italy, and by extension its ability to support and control its regions, is the key driver of their credit quality relative to alternative credit options.

• Credit quality relative to Italy should decline modestly: The expected impact of growth and austerity on region- specific factors such as debt affordability appears modest.

• Thus, we suggest evaluating region spreads against current relative strengths: The current dynamic in terms of relative credit strength, as indicated by fiscal flexibility measures like operating margins and debt burdens, should be a fair indictor of relative regional credit quality based on our expectations for Italian GDP growth and austerity measures.

• Key Risk I – Broader deterioration of central government or banking system: Weaker growth and / or stricter austerity should strongly correlate with regional weakening. Similarly, a weaker banking system would reduce credit quality by limiting the flexibility of regions to manage cash flow mismatches.

• Key Risk II – An accelerated and unbalanced move to fiscal federalism: The current process of decentralisation of fiscal and administrative powers appears measured, with transfer cuts being mitigated by increased revenue raising autonomy. However, accelerated moves toward lower transfers and taxing discretion risks testing the political capacity of regions to raise sufficient revenues consistent with their current credit quality.

Spreads vs. Operating Margin (%)

Spreads vs. Total Debt/Total Revenue (%)

Note: Showing only spreads on regional bonds with available Bloomberg yield pricing. Source: Moody’s, Bloomberg, Morgan Stanley Research


34


Political Uncertainty and the Euro – Do We Need to Worry?

A still unresolved political situation might turn into a further channel of contagion. Thus, political risk may return.

- With austerity taking a toll on an already weak economic fabric, discontent might well rise. The risk is that the uncertainty in the run-up to the election, which has to happen by April 2013, might result in less willingness or ability to maintain a sound reform path.

- Changes in attitudes towards the monetary union represent a further risk. Polls indicate that Italy is the country with the highest percentage of people thinking that a return to their national currency would be preferable. Italians might think that they lost out from the monetary union, but they are also keen to see budget sovereignty migrating at the European level.

- The psychology of contagion is such that when a eurozone sovereign is ‘dealt with’, then investors naturally focus on the next weak link. Thus, market pressures on Italy might intensify once Spain applies for financial support to the European rescue funds.

- Given significant financial linkages, Italy has some bargaining power – should it need to negotiate the conditions for sovereign support. And this might also push the European policymakers to seek a more durable solution to the crisis.


35


Politics – An Often Overlooked Channel of Contagion

- One source of contagion that is frequently overlooked has to do with the political channel. With austerity taking a toll on an already weak economic fabric, discontent might well rise.- Italy’s domestic policies have generally surprised positively, even though the reform momentum has now slowed. Yet the risk is that the uncertainty in the run- up to the election, which has to happen by April 2013, might well result in less willingness or ability to maintain a sound reform path.- Mr. Monti’s government has seen diminished, but still relatively high, support in voters’ intentions. Confidence in the prime minister himself, which – while higher than in the government – was on a downtrend too, but seems to have picked up again lately. - Risk of an early election cannot be dismissed altogether. But apart from the opposition of the president of the Republic of Italy, we think that politicians prefer to negotiate the pace of reform with Mr. Monti, rather than with the Troika – which is what might happen if a political crisis were followed by financial turmoil.

- So there are grounds to believe that minimising political volatility is in the common interest. Yet political risk might re-emerge as we approach the next election, with no party currently able to command an absolute majority, and the rising importance of fringe parties.

Conclusions: A still unresolved political situation might well turn into a further channel of contagion. Support for the current government has diminished.Source: DataMonitor, IPR Marketing & La Repubblica, Morgan Stanley Research

Decreasing Confidence in Government and No Clear Political Majority

Voting Intentions (% of Total)

0

5

10

15

20

25

30

Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12 Jul-12

PD PdL UdC LN

M5S IdV SEL Other

% of Voters with Confidence in...

30

35

40

45

50

55

60

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70

Jan Feb Mar Apr Jun Jul Sep

...Prime minister Monti ...Monti's government

N/A


36


On the Return of the Political Risk Premium…

- Political events might again exert a substantial influence on Italian financial markets – as has been the case over the past several decades, as suggested by various econometric analyses (see On the Return of the Political Risk Premium, September 20, 2010). This factor might again play a significant role.

- Political stability or credibility could be interpreted as some form of capital stock, which various adverse shocks depreciate little by little. The impact of each individual shock may be small, but their overall effect is a significant depreciation of the capital stock.

- In Italy, in the two weeks before and after a government collapse, the cumulative rise in short- term interest rates is about 24bp – controlling for other factors. Similarly, equity markets fall by around 5% over the same period.

- These effects have tended to reverse, based on past evidence, after a government change, i.e., there seems to be a positive reaction close to the inauguration of a new government – given that political stability will again be there for some time.

- The impact of natural disasters, accidents and truly unexpected events are not anticipated by investors. Thus, markets have tended to react immediately after such events, rather than shortly before (and in anticipation of) them.

Conclusions: Some kind of political risk premium may again return. In the wake of, and shortly after, periods of heightened political volatility, asset prices tend to decline.*Cumulative responses (1973-2007). Source: Adapted from Fratzscher and Stracca (2009),

Does It Pay to Have the Euro? ECB Working Paper No. 1064, Morgan Stanley Research

Political Events Have Exerted a Significant Impact on Italian Markets in Recent Decades

Asset Prices Before / After Gov't Changes*

24

39

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8

-5.0 -4.1

0.63.0

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-2.6-10

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2 weeks beforeend of old

Same day and2 weeks after

end of old

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start of new

2 weeks beforestart of new

Same day and2 weeks afterstart of new

Short-term interest rates (bp)

Equity returns (%)

Asset Prices Before / After External Events*

11

8

-0.4 -0.4

3

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-5

0

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1 week before event 1 week after event 2 weeks after event

Short-term interest rates (bp) Equity returns (%)

http://linkback.morganstanley.com/web/sendlink/webapp/BMServlet?file=dgkj554a-3nu4-g000-808f-002655211200&store=0&user=j1qgzd8bavch-1391&__gda__=1411099456_3d7a169f8251a2ff852a8735371fcdc5

http://linkback.morganstanley.com/web/sendlink/webapp/BMServlet?file=dgkj554a-3nu4-g000-808f-002655211200&store=0&user=j1qgzd8bavch-1391&__gda__=1411099456_3d7a169f8251a2ff852a8735371fcdc5


37


…the Issue of Political Stability…

government changes, i.e., governments replaced one another almost once a year on average, though the frequency of changes has declined more recently.

- These frequent turnovers were associated with a period without a formal government for an average of 35 days, i.e., Italy has been without a formal government for more than three years (close to 10% of the time).

- The various political parties are in the process of negotiating a new election system that might help create broader – and perhaps more stable – majorities in parliament. - Naturally, these negotiations have to take into account many instances and involve a careful examination in various committees in parliament, before an actual vote in both chambers no earlier than mid-October, we think.

- To the extent that these negotiations and votes lead to a mechanism capable of ensuring more political stability and governability via a stronger majority, uncertainty surrounding the direction and pace of Italy’s policies might subside over time.

- Whether a new election system in place means that there’s scope to rethink the election calendar (deadline for new election is April 2013) is something we leave to the political commentators. What matters here is that markets seem to value the commitment to reform, along with a clear sense of direction, in our view.

Conclusions: Political instability has been and, once again, might be a concern for investors. The end indicates the actual collapse of the government coalition or the resignation of the

Prime Minister. Source: News agencies, Morgan Stanley Research

Italy’s Governments (1972 – Present)Government Start End Government Start EndAndreotti II 26-Jun-72 02-Jun-73 Goria 27-Jun-87 11-Mar-88Rumor IV 07-Jul-73 03-Mar-74 De Mita 13-Apr-88 19-May-89Rumor V 14-Mar-74 03-Oct-74 Andreotti VI 22-Jul-89 29-Mar-91Moro IV 23-Nov-74 07-Jan-76 Andreotti VII 12-Apr-91 24-Apr-92Moro V 12-Feb-76 30-Apr-76 Amato 28-Jun-92 22-Apr-93Andreotti III 29-Jul-76 16-Jan-78 Ciampi 28-Apr-93 16-Apr-94Andreotti IV 11-Mar-78 31-Jan-79 Berlusconi 10-May-94 22-Dec-94Andreotti V 20-Mar-79 31-Mar-79 Dini 17-Jan-95 17-May-96Cossiga 04-Aug-79 19-Mar-80 Prodi 17-May-96 09-Oct-98Cossiga II 04-Apr-80 27-Sep-80 D'Alema 21-Oct-98 18-Dec-99Forlani 18-Oct-80 26-May-81 D'Alema II 22-Dec-99 19-Apr-00Spadolini 28-Jun-81 06-Aug-82 Amato II 25-Apr-00 31-May-01Spadolini II 23-Aug-82 13-Nov-82 Berlusconi II 11-Jun-01 20-Apr-05Fanfani V 01-Dec-82 29-Apr-83 Berlusconi III 23-Apr-05 16-May-06Craxi 04-Aug-83 07-Jun-86 Prodi II 16-May-06 07-May-08Craxi II 01-Aug-86 03-Mar-87 Berlusconi IV 08-May-08 12-Nov-11Fanfani VI 17-Apr-87 28-Apr-87 Monti 16-Nov-11 Incumbent

- The magnitude of these short-term effects, taken individually, might seem small, but the cumulative impact of political events is to have put upward pressure on Italy’s short-term interest rates by 550bp and downward pressure on Italy’s equity markets by more than 40% over 40 years – all else being equal.

- One caveat is that the actual market impact of a government change is of course difficult to assess based on historical evidence. This is because the sovereign debt crisis might have created a structural break in many such relationships.

- Yet the fact is that political instability does create an extra element of uncertainty for market participants. Since the early 1970s there have been nearly 35


38


…and Attitudes Towards the Euro

- Not all views on Europe are negative. For example, Italians’ views on the European Union and – somewhat contradictorily – on the ECB are in line with the median.

- But one might venture that what this might mean is that there’s some degree of trust in the European institutions, while the process of integration is perhaps perceived to have damaged the economy because of the way it has been managed domestically.

- Therefore, if this assumption were correct, that might suggest that the Italians would actually prefer more Europe, i.e., decisions taken at the European level to have a bigger influence domestically, not less.

- This seems to be corroborated by the Italians’ willingness, one of the highest, to give the EU more authority over national budgets, even if this means limiting the influence of domestic policy.

Source: Pew Research Center’s Global Attitudes Project, Morgan Stanley Research

Do You Think We Should Keep € or Return to National Currencies?

0%

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40%

60%

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Greece France Germany Spain Italy

Keep € Return to national currencies Don't know

What Do You Think About Giving the EU More Authority Over the National Budgets?

0%

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100%

France Italy Spain Germany Poland Czech Greece UK

Favour Oppose Don't know

What People Think About Europe

- The political landscape is likely to be influenced by the Italians’ support for the monetary union. Just like austerity might trigger discontent among the people, recent surveys show that Italy is the country with the highest percentage of people that think a return to their national currency would be preferable – even though such percentage is still below 50%.

- Italians might think that they lost out from the monetary union, as suggested by quite a small percentage of people thinking that EU integration has strengthened the economy, and the lowest percentage thinking that the single currency is a good thing.

- This is crucial, in our view, because one of the biggest risks to the recently started reform path would be the rise of anti-European sentiment, which would make it difficult for any government to continue to pursue economic, fiscal and institutional change.


39


Not Really Peripheral… at the Core of the Next Leg of the Crisis- Our bear case encompasses a much deeper recession in both years, with GDP contracting by around 3% next year (20% probability).

- Should this materialise, and accounting for the repercussion across the other southern European countries, eurozone GDP might fall by around 1% in 2012 and 0.5% in 2013 – even assuming that Germany and France expand as in the base case.

- The impact of a deeper than expected downturn in Italy on the region as a whole might give the Italian government a stronger bargaining position – should a request for help materialise and conditions be negotiated.

Conclusions: As the crisis moves from the small countries to the large ones, the European policymakers’ decisions will have to take into account the economic costs for the region as a whole that this might entail.

Source: Eurostat, IMF, Morgan Stanley Research

A More Severe Downturn in Italy Might Significantly Impact the Eurozone

- The size of the Italian economy does matter – and quite a lot. Italy is the third largest eurozone member, and accounts for nearly 17% of the region’s GDP.

- Thus, should the Italian economy face considerably more hardship, much more would be at stake for the monetary union as a whole relative to the impact that the smaller peripheral countries might exert.

- What’s more, Italy is a major export market for the rest of southern Europe, and an important trading partner for Germany, France and Austria. So significance distress in Italy might translate in weaker export performances in some parts of the eurozone.

- How would our base case for growth in the region as a whole change if the growth outlook in Italy were to weaken more than expected? We expect the Italian economy to shrink by 2.5% this year and 1% next.

Eurozone GDP (% of Total)

1.9

1.8

11.1

3.1

3.8

2.021.0

28.5

6.5 1.7

16.6

2.1OTH GRE

IRE ITA

POR SPA

AUT BEL

FIN FRA

GER NLD

GDP Growth (% Y/Y)

-6

-4

-2

0

2

4

6

1996 1998 2000 2002 2004 2006 2008 2010 2012

EMU BaseEMU Base & ITA Bear Cases

EMU Base & Periphery Bear CasesEMU Bear Case

Exports to Italy (% of Exporter Total)

2.4

3.4 3.7

4.6 4.8

6.2

7.88.3 8.3

9.5

0

2

4

6

8

10

FIN IRE POR BEL NET GER AUT FRA SPA GRE


40


Size Matters- About two-thirds of Italian general government debt is now held by domestic financial institutions and other residents. This is because, since the intensification of the sovereign debt crisis, Italian investors have replaced foreigners, similar to other countries in the spotlight, in buying government bonds.

- Still, Italy accounts for 5% of the global stock of government bonds, thus having an important role in the global financial system. A recent IMF analysis of global financial (and trade) flows suggests that Italy can be a conduit of shocks to the core eurozone countries, central and eastern Europe, and beyond.

- So contagion through the financial channel is a risk of a different order of magnitude relative to the smaller peripheral countries, i.e., Italy has some bargaining power, should the conditions for a sovereign support programme be negotiated.

- On the positive side, this might create the incentive to find more decisive solutions to fix the eurozone’s institutional flaws, i.e., the lack of a common fiscal policy and a joint issuance mechanism. On the negative side, a ‘political accident’ might lead to Italy’s dragging its feet excessively – perhaps in an attempt to extract better bailout terms.

Conclusions: Given the size of its government bond market and significant financial linkages, Italy has some bargaining power – should it need to negotiate the conditions for sovereign support. But this might also push the European policymakers to seek more durable solution to the crisis. Source: Eurostat, Morgan Stanley Research

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Italian Gov’t Debt Now Becoming More Domestic, but a Significant Amount is Still Held by Foreigners


41


A European Programme for Sovereign Support: Pros, Cons, and Catalysts

CONS: Don’t Use ESM to buy / insure gov’t bonds + ECB intervention- Helps maintain some areas of economic policy within

the national boundaries, thus determining the pace and extent of reform.

- Avoids potential subordination concerns, among bond investors, related to official lenders being senior to private sector investor, and the uncertainty surrounding a full comeback in the market without official support.

- Italy’s private sector wealth is substantial, as is the pool of assets that might potentially be privatised. This might perhaps give the Italian government a chance to ‘fight back’ for a while. But the fact that Italian bonds are no longer perceived to be risk-free will remain.

- Too stringent extra conditions / timeframe for the belt- tightening that will have to happen anyway, might make it difficult for the government to muster domestic consensus, and perhaps trigger a political crisis.

- Maintaining a situation where the official sector remains or is perceived to be senior might decrease an already low appetite for entering a sovereign support programme.

PROS: Use ESM to buy / insure gov’t bonds + ECB intervention- Keeps funding costs from spiralling out of control, prevents an illiquidity situation from morphing in an insolvency one, enforces a reform path on Italy.

- Helps stabilise market sentiment, by triggering a more active role of the ECB, and further fostering the debate around fiscal control at the federal level and debt mutualisation.

- The psychology of contagion is such that market focus might shift to Italy – if Spain were to apply for sovereign support – thus exerting pressure for this country to seek European help too. The impact of a eurozone breakup would fall in this category too.

- Limited or no extra conditionality, perhaps respecting the fiscal and reform commitments of the Stability Programme, might probably help limit the domestic opposition to a sovereign support request.

- A credible commitment to maintain pari passu status, might alleviate concerns of a difficult re-entry in the market.

CATALYSTS: What Could Trigger / Delay Sovereign Support

Contagion

Negotiation

Seniority

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42


Would a European Support Mechanism to Lower Italy’s Funding Costs Make Sense…

- Very harsh conditions would probably be a political hurdle for a technocratic government taking decisions exerting effects beyond its natural duration. Yet, Italy has already started to fix its economic problems (but not all). Thus, we believe that it can meet a good deal of requests from the official lenders.- With sovereign bonds no longer perceived as risk-free in the eurozone, most countries have already lost their ability to use fiscal policy in a countercyclical fashion – and the small peripherals can’t borrow in the market.

- The key trade-off is not fiscal consolidation and reform vs. no fiscal consolidation and reform. It is fiscal consolidation and reform plus acceptable funding costs vs. no fiscal consolidation and reform plus unacceptable funding costs. That’s what Mr. Monti wanted when he proposed, at the EU Summit in June, a European mechanism to reduce the funding costs of sovereigns complying with Europe’s demands.- For a technocratic government taking decisions that might affect the country for a long while, coupled with a still unresolved political situation, the hurdle to apply for support – if needed – is probably higher than elsewhere. Yet we think that market pressure might be a bigger force – and some, domestically, might even be tempted to pursue this strategy to ‘lock in’ a clear reform path.

Conclusions: The hurdle is still high, but should market pressure intensify again, Italy too might be pushed towards asking for sovereign support. If this allows to pursue reforms and achieve lower funding costs, markets might not necessarily take a negative view.

“The sustainability of efforts […] for us to get a solid budgetary consolidation and growth through the removal of structural constraints to growth is going to be very difficult in its sustainability through the months and the delivery of the expected results unless there is some return”

“[We need] sufficiently effective governance of the eurozone that is able to eliminate the risk markets now associate with the eurozone, in terms of the much- observed spread between Italian Treasury bonds and the German Bund”

“This is the living proof that if one does one’s own homework […] that is not sufficient in the present policy environment for a country to be able to reap the benefits […] in terms of lower interest rates […] This has hugely negative political and economic consequences”From Mario Monti’s Speech at the LSE “The EU in the Global Economy: Challenges for Growth”, January 18, 2012

- The sheer size of government refinancing, coupled with high interest rates, makes Italy very sensitive to changes in market sentiment, especially when they are driven by systemic factors.

- In this context, Italy might struggle to pursue its own (and Europe’s) fiscal and reform agenda with higher interest rates – which might not necessarily have to do with its own policy decisions, but reflect a weak eurozone intuitional setup, as well as breakup risk.

http://www.youtube.com/watch?v=rC3QOW4CXXk

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43


…and What Investors Think About It- Whether Italy inevitably needs – and eventually requests – some form of sovereign support, either a full bailout or a precautionary credit line (both subject to conditions on fiscal and structural reforms), depends on many moving parts.

- The timing too – should this happen – looks quite vague. Absent broader polls of market participants, one way to assess investors’ thoughts on this key risk is to look at the interactive polling results from Morgan Stanley’s Global Strategy & Economics Day, 13 September, 2012.

- Only 13% of the investors we polled thought that Italy will need sovereign support soon after Spain, while for 22% no help will be needed. More than half thought that Italy might well apply for such support, but only in response to specific triggers: for 20% it was renewed market stress in Europe, for 45% – the highest percentage – a resurgence of Italy-specific problems.- Thus, the key factor to watch is not only whether systemic risk intensifies again in Europe, but also whether a deterioration of the economic outlook, an even stronger bank deleveraging or heightened political uncertainty materialise.

Conclusions: Our poll suggests that investors seem to think that – in one form or another – Italy might apply for sovereign support. Yet the timing of this key event – should this happen – looks very uncertain, with market participants in our poll indicating various triggers, the most important of which is idiosyncratic risk.

Source: Morgan Stanley Research

Polling at MS Global Strategy & Economics Day on Whether / When Italy and Spain Need Sovereign Support

When Will Italy Apply for Sovereign Support?(Full Bailout / Precautionary Credit Line)

22%

45%

20%

13%

0 10 20 30 40 50

Soon after Spain, as the benefits of doing soquickly become apparent

Only in response to broad and renewedsystemic concern across Europe as a whole

Only in response to Italy-specific problems(weak growth, bank deleveraging, political

uncertainty)

No programme will be required, as Italy willbenefit "in kind" from Spain's participation

When Will Spain Apply for Sovereign Support?(Full Bailout / Precautionary Credit Line)

7%

49%

41%

3%

0 10 20 30 40 50 60

Immediately

Soon, due to either rising market ordomestic funding pressures

Only following serious and prolongedexternal pressure (e.g., after sovereign

ratings junked)

No programme will be required due to thecombo of implied ECB support and

structural progress


44


What Are the Biggest Issues for the Banking Sector…

- Large NPLs (c. €207bn at banking system level with 14% NPL ratio, up 140% since end-2008) and low coverage (40%) remain a significant issue for Italian banks. NPLs net of cash reserve and collateral still absorb 20-90% of the tangible equity of our universe of banks. We first wrote about this issue in Italian Banks: Challenges and Issues, June 15, 2012.

- Funding remains difficult – banks have limited market access and need to gradually rebalance their 108% loan to deposit ratio, which may result in lending reduction for longer.

- RoNAV is depressed by high provisions and high structural costs, with the result that banks have limited resources to offset potential (credit) shocks and rebuild capital further.

…and What Could Be Done to Help Solve Them?

- Adjusting the values of NPLs could allow disposal / transfer, e.g., to a specially set up vehicle. This would free up resources for the banking sector to provide lending and support the economy.

- This may require up to €20-41bn equity (not an insurmountable amount, should the government be called to provide it at 1-2% of GDP) to help out with the ensuing capital erosion, in our estimates, but could unlock future profitability and improve banks’ valuations.

- Further substantial cost restructuring would also help profitability, as the Italian banking sector is still heavily over-branched.

- We estimate that reducing costs to an equivalent of 2% of loans for all banks will improve returns substantially – by 90-460bp. Clearly timing and feasibility remain key issues, given also the likely related social impact of reducing 16% of bank branches (or 5400) and staff.

- Sovereign spreads remain a key swing factor and we calculate that +/-100 spread change impacts the banks’ valuation by c. -/+10%.

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45


Large NPLs – c. €207bn at Banking System Level with 14% NPLs Ratio and Low Coverage (41%)Total problem loans at a banking system level increased by 140% since 4Q 2008 to €207bn with a 40% coverage

Our universe – NPLs have grown and reserve coverage has eroded we expect NPLs up another 30% by end-2014 but also some coverage build-up

Source: Company data, Bank of Italy, Morgan Stanley Research estimates (e) Note: Includes impaired, substandard and past due (excl. restructured)

- We think that deteriorating asset quality is a growing issue for Italian banks, especially as capital levels and internal capital generation do not provide a sufficient buffer.

- NPLs have doubled since the onset of the crisis; reserve coverage has deteriorated from c. 60% in 2007 to 44% for our universe.

- Based on economic deterioration we see NPLs increasing further (up c. 25% in total by end-2013) and peaking at c. 16% by end-2013 for our universe from 12.8% in 2Q 2012.

- The issues were also raised in a recent IMF report published on May 16: “Reducing impaired loans would free up resources for new lending. Banks’ buildup of impaired loans reflects both an inefficient legal process that delays loan write offs and the flow of new bad loans arising from the slowdown […] Supervisors should encourage banks to develop strategies for selling, restructuring or writing down impaired loans to free up resources for lending”.

Impaired loans in Italy, driven by corporate (c. 70% and up 150% since end-2008)

207

87

0

50

100

150

200

250

4Q08

1Q09

2Q09

3Q09

4Q09

1Q10

2Q10

3Q10

4Q10

1Q11

2Q11

3Q11

4Q11

1Q12

Impaired Substandard Restructured Past due+140% since 4Q 2008

0%

3%

6%

9%

12%

15%

18%

2002 2004 2006 2008 2010 2Q12 2013e35%

40%

45%

50%

55%

60%

65%Gross NPL ratio (rhs) Coverage ratio (lhs)

5080 92

117 12610

1214

1717

20

2731

3840

2

33

44

0

40

80

120

160

200

Q408 Q409 Q410 Q411 Q112

Corporate Household producers Household consumer other

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46


Net NPLs Absorb a Large Amount of Our Universe Tangible Equity and Are Growing

Source: Company data, Morgan Stanley Research

NPLs formation has slowed down in 2Q 12 but still significantly above 2011 levels

Net NPLs absorb a large amount of, or even exceed, NAV for most of the banks in our universe

- Italian Banks have increased collateral values, but uncovered / uncollateralised NPLs are still high.

- We would also argue that the true recoverability value of collateral remains questionable, as legal procedures for collateral recovery in Italy take several years.

- c. 90% of collateral for our universe is represented by real estate, but likely a large portion is industrial rather than commercial or residential real estate given that most of the NPLs are corporates as shown earlier.

- NPL formation in 2Q was lower than 1Q (which was affected by the move to 90-days past due classification) but remains 70% higher than a year ago and likely to continue to accelerate – given economic deterioration.

Asset quality for our coverage as of 2Q 2012

238%

157%

104%91%

67% 71%

24%25%28%39%45%44%

97%

17%

MPS BP UBI UCG BPM ISP MB

Net NPLs / NAV Post collateral NPLs / NAV

2Q 2012

47% 49%42%

29% 31%36%

40%

80%85% 81% 85%

74%79%

47%

0

20

40

60

80

100

UCG ISP MPS BP UBI PMI MB0%

20%

40%

60%

80%

100%

Reserves Collateral for NPLs Uncovered

Coverage Cov. + Collateral

0.57%

0.25%

0.0%

0.4%

0.8%

1.2%

1.6%

1Q11 2Q11 3Q11 4Q11 1Q12 2Q12

BPM BP ISP MPS UBI Total Italy UCG

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47


Running the Numbers on Increasing Provisioning Levels on Current NPLs StockA 20% increase in reserve coverage (just above 2007 peak) indicates €22bn capital erosion for our universe

- Increasing coverage by c. 20% for our universe (to just over the 2007 peak) would imply up to €22bn capital hit for our banks based on 2Q 12 NPLs stock.

- Sales of bad loans (the worst portion) have been recently done at c. 20% of face value (or 80% writedown) and thus a level of coverage for the whole portfolio (including watchlist and past due) of 60-70% would seem appropriate. We remain concerned with the low level of coverage in the smaller banks, which is apparently justified by higher collateral coverage values, on which we have no visibility.

- Given that our universe represents 53% of the Italian banking sector by assets, we could extrapolate that the capital erosion for the whole system could be in the region of €41bn. Admittedly, this is rather an approximation, as we do not have exact details of capital levels and profitability for the rest of the sector (which is largely non-listed).

Source: Company data, Morgan Stanley Research estimates

Increasing coverage ratio by 20% on average results in €22bn (post-tax) capital erosion for our universe and c.€41bn capital erosion at the banking system level

UCG group ISP MB MPS UBI BP PMI

MS cov.

Gross NPLs Q2 78 46 2 26 9 15 4 180

Gross NPLs ratio 13% 11% 7% 17% 10% 16% 10% 13%

% coverage 47% 49% 40% 42% 31% 29% 36% 44%

% collateral 33% 37% 7% 39% 43% 56% 43% 37%

% tot coverage 80% 85% 47% 81% 74% 85% 79% 81%

Additional 20% reserve 16 9 0.5 5 2 3 1 36

Cov. after 20% increase 67% 69% 60% 62% 51% 49% 56% 64%

post-tax capital erosion -9 -5 -0.3 -3 -1 -2 -0.4 -22

Cap ratios (2Q 2012, B3 CT1) for our universe after increase in reserve coverage - some low numbers (ex. gov’t hybrids)

5.53.2

1.8 1.1 0.4 0.3

9.3

21.6

UC

G g

roup

ISP

MP

S

BP

UB

I

PM

I

MB

MS

uni

vers

e

7.5% 7.5% 7.4%6.5% 6.4%

2.3%

7.2%

8.4%

ISP

UB

I

MB

UC

G

PM

I

BP

MP

S

MS

uni

vers

e


48


Once Values Are Adjusted, Sale / Deconsolidation is More Likely, Would Allow Some Capital Relief – We See €20-40bn Capital Need to Re-Establish a CT1 B3 Ratio of 9-10%Capital erosion, relief and net from deconsolidation of NPLs once sufficiently reserved - We calculate if banks were to deconsolidate or sell NPLs,

once written down further, they would benefit from capital relief by a total of €11bn.- This would help offset the capital erosion for coverage

increase and would leave a net capital erosion of €10bn or 90bp on average.- we think a credible response would require a recapitalisation of the banking sector to a level of 9-10% Basel 3 CT1. This would require €11-21bn of fresh capital for our universe.

- Given that our universe represents a little over half of the Italian banking sector by assets, this might imply that the net capital need for the whole banking system could be around €20- 40bn, with the caveat indicated earlier.

- Procrastination could increase the size of the problem as the same analysis run on end-2013 NPLs, the simple equity erosion from reserve increase would be €27bn for our universe and €51bn for the banking system, on our estimates (versus €22- 41bn as of 2Q12). The ultimate capital hit will depend on the earnings path.

Recapitalising our universe back to 9-10% (B3 CT1) would require additional €11-€21bn based on 2Q12

Source: Company data, Morgan Stanley Research estimates

-105bp-78bp

-30bp

-172bp

-40bp-69bp

-34bp-90bp

-400bp

-300bp

-200bp

-100bp

0bp

100bp

200bp

300bp

UCG ISP MB* MPS UBI BP PMI Total

Post-tax capital erosion, bp Capital relief from NPL saleNet impact

3.6

5.3

-

0.8 0.90.3 0.2

8.4

6.2

2.2

1.3 1.3 1.10.8

UCG MPS ISP MB* PMI UBI BP

recap 9% recap 10%

Total recap 9%: €11bnTotal recap 10%: €21bn


49


Issues on Setting Up a “Vehicle for the Management and Workout of Distressed Loans”


- What could be the trigger to effectively push banks to adjust valuations of NPLs? The market is becoming increasingly uncomfortable with the economic deterioration and NPL growth in Italy, and further increases (likely, in our view) may put pressure on the banks to act. Once the value of NPLs is adjusted, in our opinion, it also makes sense to transfer them to a separate vehicle to benefit from some capital relief and allow faster recovery.

- We find in our recent meetings with regulators, policymakers and market participants that the debate surrounding a “vehicle for the management and workout of distressed loans” is somewhat more open than it was three months ago when we started writing about this issue. Having said that, there remains key challenges and hurdles, which question its feasibility, but, we think, also benefits.

Challenges and key issues

“Stigma” attached to the need to increase reserve and possibly report a loss

Challenges in terms of finding the resources to replenish capital for the banks as private sources may not be forthcoming

Challenges in terms of finding the resources to finance the acquisition of the assets by the vehicle

Challenges in terms of finding the correct structure for the vehicle and the ownership of it

Banking system level participation may be difficult, but would ensure “level playing” field

“Sale” valuations would have to be externally validated to be credible

Benefits

Banks balance sheet quality and transparency is improved

Banks’ funding and equity valuation would likely improve as risk profile is improved

Banks have fresh resources to provide new loans, which would be beneficial for the economy

Provide “clearing prices” for distressed loans

Funding to the vehicle could be provided by the banks through government guaranteed bonds

Removing loans from the banks’ control may allow more efficient credit recovery procedures (as conflict of interest is removed)

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50


Funding Requires Some Rebalancing – Thus Credit Flows Remain Constrained

€123bn of market funding is required in next 2.5 years – Gross LTRO take up was €121bn, and has largely covered that

Source: Bank of Italy, ECB, Company data, Morgan Stanley Research

Ratios of loan / deposit and loan / retail funding

Our conservative approach sees €60bn maturing wholesale funding at risk of refinancing, which could force a ~6% deleveraging over next 2.5 years – loans are down 1.1% YTD

Deposits are still growing but savings rate in Italy has declined significantly and is now below the eurozone

Loansfunding 2012-14 at risk Deleveraging

ISP 374,953 28,000 8,400 -2.2%UCG Italy 223,000 21,061 6,318 -2.8%UBI 95,333 8,230 8,230 -8.6%MPS 144,461 12,050 12,050 -8.3%BAPO 91,028 9,300 9,300 -10.2%MB 35,268 9,400 2,820 -8.0%BPM 34,948 3,300 3,300 -9.4%Total 998,991 91,341 50,418 -5.0%

130%109% 103% 99% 97% 96% 93% 102%

312%

238%204%

150% 144%

230%

191% 193%

MB MPS ISP UCG Italy BPM BP UBI MSuniverse

L/D ratio 2Q12 L/D (just deposits) 2Q12

3745 41

123 121

2H 12012 2013 2014 total 2012-14 total LTROamount

Savings Rate (% of Disposable Income)

10

12

14

16

18

20

1999 2001 2003 2005 2007 2009 2011

Eurozone

Italy

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51


Funding Requires Some Rebalancing – Thus Credit Flows Remain Constrained (cont’d)

Customer loan trends: Worst six months in last 30 years

Source: Bank of Italy, Company data, Morgan Stanley Research

Customer loans down -3.2%Y on average for our universe of banks

- We see a potential risk for wholesale funding to not be fully renewed.- Assuming:

1) Markets do not reopen for our 4 mid-sized banks, and

2) Mediobanca and the two large names have to reduce their issuance by 30%

- This implies €60bn of upcoming wholesale funding is at risk of not being refinanced. This could force a deleveraging of up to 6% of their loan books.

- The LTRO injection did not result in increased lending to the real economy (worst 6-month period for loan growth in 20 years of data).

- Banks are shrinking their loan books, especially mid- cap banks reducing large corporate lending, and credit conditions are tightening. This continue to represent a risk for the real economy.

- Bank of Italy indicated that banks need to gradually reduce their loan to deposit / retail funding ratio (from the current 120% at banking system level on their calculation) to reduce dependence on wholesale markets.

-6%

-3%

0%

3%

6%

9%

12%

15%

18%

1988 1992 1996 2000 2004 2008 1H12

GDP Loans

Loan Growth 2Q11 - 2Q12

-8%-7%

-6%

-4%-3% -3%

1%

MPS UBI BP UCG Italy MB BPM ISP

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52


With Low Profitability, Reducing Capex Remains Key, as Macro Remains DifficultRoNAV remains depressed over time…

Source: Company data, Morgan Stanley Research estimates (e)

…and so does RoA (return on assets)

- Returns have declined significantly over the years and without significant intervention on restructuring will see little improvement, on our estimates.

- Profitability has been structurally depressed by a mix of stubbornly high costs (we argue capex is now wrongly sized for the sector) and, we argued back in November 2010 (see Italian Banks: Outlook Remains Foggy – Only Mediobanca Stands Out), by the banks’ inability to price risk correctly.

- This is even more evident today: core revenues minus LLP for our universe (as % of AIEA) was a mere 100bp in 2011, barely covering costs at c. 80bp. With increasing LLP this year the already thin safety margin is being eroded further.

- We see better RoNAV in our bull scenario of macroeconomic improvement, but we see a thin (10%) probability that the 2014 macro will allow +2/5% loan and fees growth and 15-20bp lower LLP which are the core assumptions of our bull case. A nearly symmetric bear case would see even more painful earnings reduction.

Our Bull / Base / Bear skew for 2014e RoNAV

-20%

-10%

0%

10%

20%

30%

40%

2002 2004 2006 2008 2010 2012e 2014e

BP BMPS UCG ISPMB PMI UBI

-0.4%

0.0%

0.4%

0.8%

1.2%

2002 2004 2006 2008 2010 2012e 2014e

ISP UCG

BP UBI

PMI BMPS

0%

2%

4%

6%

8%

10%

12%

MB ISP UCG MPS UBI BP PMI

Bull Base Bear

RoNAV 214e


53


An Over-Branched Banking Sector Offers Ample Opportunities for Restructuring

While the number of banks declined by 21% in the last 15 years, branches increased by 38% and are now not far below their peak level in 2008

Source: ECB, EU Banking Structure – Sep. 2010, Morgan Stanley Research estimates (e)

Spanish M&A has produced significant branch reduction

Branch penetration: Room for reduction in Italy - Italian banks have grown branches by 38% in the last 15 years, despite significant M&A that has reduced the number of banks – branch reduction has only been minimal. The reduction in Italy in the last few years has simply not been significant – in the context of the massive increase of capacity in the previous 10 years.- The Spanish example of recent branch reduction is a

good model with c. 25% reduction over 5 years to end-2013 largely thanks to M&A and restructuring.

- In the next slide we indicate how a meaningful cost reduction that would improve our universe of banks’ RoNAV by 90-460bp may require up to 2900 branch reduction or 16% of our universe. If extrapolated at the banking system level, a 16% reduction could mean 5400 branch closure, and potentially 35000-40000 staff layoffs – a significant restructuring with meaningful social implications.

Population ('000) / Branch

UKSweden

Finland

Portugal

Austria

Netherlands

Italy

Ireland

FranceSpain

Greece

Germany

DenmarkBelgium

0

1

2

3

4

5

6

0 10 20 30 40 50

Employee / Branch

Branches in Spain

10000

20000

30000

40000

50000

1995 1998 2001 2004 2007 2010 2013E10000

20000

30000

40000

50000

1996 1998 2000 2002 2004 2006 2008 2010600

700

800

900

1000Branches (lhs) Banks (rhs)


54


Meaningful Costs and Branch Reductions Could Improve Returns by 90-460bp but Require Extraordinary Measures (M&A) and Careful Consideration of Social Impact

Italian operating models are more cost intensive than Nordic and Spanish retail businesses, despite lower revenue generation

Source: Company data, Morgan Stanley Research estimates (e)

To achieve a 2% cost / loan ratio Italian banks need substantial further cost reductions (based on 1H 2012) – in some cases the cut required are dramatic

Achieving a 2% cost to loan ratio would require the closure of 2900 branches (16%) and all associated costs for our universe of banks

Assuming 2% cost to loan is achieved by all banks by 2015 RoNAV would benefit substantially, as indicated below, but the feasibility of the cost cuts required remain a key issue

2015e implied NewRoNAV 2015e cost reduction RoNAV benefit RoNAV 2015eBPM 3.3% -29% 464bp 7.9%BP 4.4% -19% 335bp 7.8%ISP 7.3% -7% 93bp 8.2%MB 9.6% -8% 89bp 10.5%MPS 5.0% -14% 458bp 9.5%UBI 3.8% -15% 297bp 6.8%UCG 7.0% -13%/-5% 128bp 8.3%Note: UCG Italy reduced by 13% (5% group impact)

3.0%

2.3% 2.3% 2.3% 2.2%

1.9%

1.5%1.3% 1.3%

2.5%2.6%

2.9%3.0%

Socg

en -

Fren

ch R

etai

l

BNP

- Fre

nch

Ret

ail BP

M

UC

G It

aly

BP

MPS UBI

ISP

Italy

Med

ioba

nca

SAN

- Sp

ain

Ret

ail

Dan

ske

Bank

Nor

dea

Nor

dic

Bank

ing

BBVA

- Ib

eria

Ret

ail

Cost / Loans (2010-11)

-906

-531 -520 -435 -352-115

-2877

-18

UCG Italy UBI ISP BP BMPS PMI MBMS

universe

Cost Reduction Required

-29%

-21% -21%

-15%-13%

-9% -9%

PMI UCG Italy BP UBI BMPS ISP Italy MB


55


Trade Ideas

Note: Due to the nature of the fixed income market, the issuers or bonds of the issuers recommended or discussed in this report may not be continuously followed. Accordingly, investors must regard this report as providing stand-alone analysis and should not expect continuing analysis or additional reports relating to such issuers or bonds of the issuers.


56


Italian Bank Equity: Low Profitability and Residual Credit Risk Cap Valuations, Downside Risk Outweighs Upside Potential in Our Bull / Bear Skew (Francesca Tondi)

RoNAV, P/NAV and P/E 2012, 2013, 2014 for our universe of Italian banks

- We remain cautious on Italian banks and rate ISP and UCG EW and all the other names UW. We see significant macro headwinds driven by a weak economy, and low interest rates for longer. We think Italian banks need meaningful asset and cost restructuring to improve medium-term profitability.

- Additional decline in sovereign spreads and better macro would lift us to our bull case values that are 57% higher on average than our base cases. Similarly, our bear cases are 53% lower on average. - +/-10% flex in our target prices (slightly higher on the positive side) to

-/+100bp in changes in cost of equity driven by sovereign spread compression. The rest of our bull / bear scenarios for our PT is driven by macro assumptions that filter through our 2014e earnings but we see a thin (~ 10%) probability that the 2014 macro will allow +2/5% loan and fees growth and 15-20bp lower LLP which are the core assumptions of our bull case.

- Sovereign spread widening to summer peaks (+300bp) would risk a average value reduction in our bear case of c. 20%, on our calculations.

Risk-reward overview – at current prices downside risk outweighs upside potential

Italy

2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E14.4x 14.6x 8.5x 0.5x 0.5x 0.5x 4.1% 4.0% 5.9%

UCG 17.5x 19.9x 7.9x 0.4x 0.4x 0.4x 2.6% 2.2% 5.5%UBI 14.6x 15.2x 11.1x 0.5x 0.5x 0.5x 3.5% 3.3% 4.4%BMPS 22.0x 10.7x 6.4x 0.4x 0.4x 0.3x 2.0% 3.5% 5.3%MB 8.3x 7.1x 6.2x 0.6x 0.6x 0.5x 7.0% 8.4% 9.0%ISP 11.4x 11.5x 9.3x 0.6x 0.6x 0.6x 5.6% 5.3% 6.4%BP 14.3x 13.8x 9.6x 0.3x 0.3x 0.3x 2.3% 2.3% 3.3%PMI 13.0x 13.6x 10.3x 0.4x 0.4x 0.4x 3.4% 3.1% 4.0%

MS Estimates MS EstimatesMS EstimatesRoTNAVPrice to earnings P/NAV

For valuation methodology and risks associated with any price targets in our risk reward overview, please email [email protected] with a request for valuation methodology and risks on a particular stock. Source: Company data, Morgan Stanley Research estimates

P/NAV/RoNAV for European banks

-1% -7%-15%

PT

BASEcurrent

price

-44%-25%-23%-24%

BEAR

BULL

-100%

-75%

-50%

-25%

25%

50%

75%

100%

ISP UCG MPS Medio UBI BP BPM

RBI

ERSTE

HSBC

STAN

BARC

LLOY

RBS

SAN

BCIV

BTO

BKT

BBVA

CABK

POP

SAB DanskeDNB

NOR

SEB

SHB

SWED

PMI

BP

ISP

MB

BMPS

UBI

UCG

CSGN

DBK

UBS

CBK

INGKBC

BNP

ACA

NATIX

GLE

-

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

0% 2% 4% 6% 8% 10% 12% 14% 16%

RoNAV 2014e

P/N

AV

2012

e RBI

ERSTE

HSBC

STAN

BARC

LLOY

RBS

SAN

BCIV

BTO

BKT

BBVA

CABK

POP

SAB DanskeDNB

NOR

SEB

SHB

SWED

PMI

BP

ISP

MB

BMPS

UBI

UCG

CSGN

DBK

UBS

CBK

INGKBC

BNP

ACA

NATIX

GLE

-

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

0% 2% 4% 6% 8% 10% 12% 14% 16%

RoNAV 2014e

P/N

AV

2012

e


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Italian Bank Credit: Reviewing our Periphery Skew (Jackie Ineke)

Source: Bloomberg, Morgan Stanley Research, Pricings as per 19-Sep-12

- Our Equal-weight in bank debt has been skewed towards the periphery since June.

- With our Italian bank recommendations now being at or very close to 12-month highs, we are looking to reduce our periphery skew and move back to the core, mainly into UK and Dutch banks.- We understand tail risks have reduced but we are facing a slew of bank sector-specific risks, which are likely to hurt periphery bank debt more than the core. These include:

• Spain’s upcoming resolution of its non-viable banks and, in our view, the likely ensuing debate on senior bail-in;

• Barnier’s push to get broad bail-in power brought forward to 2015 instead of 2018;

• Further wranglings on the mutualisation of an EU deposit guarantee scheme and the link to the ESM being allowed (or not) to directly recapitalise banks – and the depositor preference which may well have to precede this;

• Ring-fencing – already coming in the UK, promised in France and debated at the EU level (Liikanen report).

Switch out of UCGIM and ISPIM callables LT2 into “core” banksB/O Ccy Ticker Coupon Next call Maturity Issue (m) Amt o/s (m) Steps Price YTC YTP/M 12m high 12m low Swap gains

B € UCGIM 6.125 19-Apr-21 750 750 94.6 7 98 67.1 15.2

O € CMZB 7.75 16-Mar-21 1,250 1,250 98.4 8 98.7 65 13.8

O € ABNANV 6.375 27-Apr-21 1228 1228 105.3 5.6 105.3 86.9 14.9

B € UCGIM 4.5 22-Sep-14 22-Sep-19 500 500 L +95 85.4 13.3 5.9 89.3 71.9 7

B € ISPIM 3.75 02-Mar-15 02-Mar-20 500 478 L + 89 87.0 9.9 5.3 88.5 71 7.8

O € INTNED 6.125 29-May-18 29-May-23 1,000 1,000 L +255 103.0 5.5 5.5 103 86.9 19.7

B € ISPIM 5.15 16-Jul-20 1250 1203 94.7 6.0 99 73.5 9.4

O € INTNED 3.5 16-Sep-15 16-Sep-20 1,000 1,000 L +136 94.9 5.4 4.3 94.9 80.9 7.4

B € UCGIM 5.75 26-Sep-17 1,000 1,000 98.66 6 101 72.2 17.5

O € RBS 4.625 22-Sep-16 22-Sep-21 1,000 1,000 L + 130 89 7.9 5.8 89 61 13.1

B $ UCGIM 6 31-Oct-17 750 750 93.5 7.6 94.5 73 20.5

O $ STANLN 6.4 26-Sep-17 1,000 1,000 114.9 3.2 114.9 102.1 21.1


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Italian Gov’t Bond Market – Applying PCA to Sovereign Spreads (Elaine Lin)


Systemic Sovereign Risk = Italy Sovereign Risk Short France vs. Italy and Germany (20:80)

- Principal Component Analysis (PCA) allows us to identify the level of systemic sovereign risk, and thus distinguish between systemic and idiosyncratic spread moves for each sovereign. PCA also allows us to derive hedge ratios for spread trades between sovereigns to minimise systemic risk exposure.

- Limitations: PCA relies on a stable covariance matrix, so monitoring changing PCA factor loadings is important. We find that sovereigns which lose market access should be excluded from PCA.

- PC1 (sovereign risk) is highly correlated with Italy’s credit premium, i.e., Italy poses significant contagion risk to the European sovereign markets, and vice versa. So trading Italy based on PCA loading factor and PC1-implied valuation vs. other sovereigns helps minimise systemic risk exposure.

- Trade idea: Long 5yr Italy and Germany (20:80) versus France to position for idiosyncratic richness of France vs. Germany and Italy.

-3

-2

-1

0

1

2

3

May-10 Aug-10 Nov-10 Feb-11 May-11 Aug-11 Nov-11 Feb-12 May-12 Aug-120

100

200

300

400

500

600PC1 (systemic sovereign risk)

5yr Italy swap spread (bp, RHS)

-250

-200

-150

-100

-50

0

50

100

Jun-10 Oct-10 Feb-11 Jun-11 Oct-11 Feb-12 Jun-12

Spr

ead

(bp)

-3

-2

-1

0

1

2

3

4

Sys

tem

ic R

isk

(PC

1)

PCA weighting

50:50 weighting

Systemic risk - PC1 (RHS)


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LLC makes a market in the securities of RBS. Morgan Stanley & Co. International plc is a corporate broker to RBS.


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Data include common stock and ADRs currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan Stanley received investment banking compensation in the last 12 months.Analyst Stock Ratings Overweight (O or Over) - The stock's total return is expected to exceed the total return of the relevant country MSCI Index or the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis over the next 12-18 months.Equal-weight (E or Equal) - The stock's total return is expected to be in line with the total return of the relevant country MSCI Index or the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis over the next 12-18 months.Not-Rated (NR) - Currently the analyst does not have adequate conviction about the stock's total return relative to the relevant country MSCI Index or the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months.Underweight (U or Under) - The stock's total return is expected to be below the total return of the relevant country MSCI Index or the average total return of the analyst's industry (or industry team's) coverage universe, on a risk-adjusted basis, over the next 12-18 months.Unless otherwise specified, the time frame for price targets included in Morgan Stanley Research is 12 to 18 months.

Coverage Universe Investment Banking Clients (IBC)

Stock Rating Category Count % of Total Count % of Total IBC % of Rating Category

Overweight/Buy 1108 37% 445 41% 40%Equal-weight/Hold 1283 43% 499 46% 39%Not-Rated/Hold 109 4% 34 3% 31%Underweight/Sell 469 16% 115 11% 25%Total 2,969 1093


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Perchè in Italia non c'è credito?

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