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September 24, 2012 ECONOMICS, BANKS & FIXED INCOME RESEARCH MORGAN STANLEY RESEARCH

Italy: Good Student, Good Grades?

Morgan Stanley & Co. International plc+

ECONOMICS Daniele Antonucci

Policy Options and Investment Implications

Daniele.Antonucci@morganstanley.com +44 (0)20 7425 8943

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 Matters Now 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 Hurdle Excessively 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?

Growth (or Lack Thereof) 6

Real GDP (% Y/Y)

Low profitability and residual credit risk (large NPLs) cap bank values, downside risk outweighs upside potential in our bull / bear skew.

BANK EQUITY RESEARCH Francesca Tondi Franscesca.Tondi@morganstanley.com +44 (0)20 7425 9721

4

Adrian Reibert

2

FIXED INCOME RESEARCH Morgan Stanley & Co. LLC

0

-2

Michael Zezas Germany

France

Italy

Spain

Michael.Zezas@morganstanley.com +1 (212) 761 8609

Angela Wang Morgan Stanley & Co. International plc+

-4 Mar-10 Jun-10 Sep-10 Dec-10 Mar-11 Jun-11 Sep-11 Dec-11 Mar-12 Jun-12

Elaine Lin Elaine.Lin@morganstanley.com +44 (0)20 7677 0579

Source: Eurostat, Morgan Stanley Research

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 Regions

Tomasz Pietrzak

Jackie Ineke Jackie.Ineke@morganstanley.com +41 44 220 9246

For Detailed Trade Ideas See from Page 55

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

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.

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.


MORGAN STANLEY RESEARCH

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

Growth: We Are More Cautious than Most 8

Real GDP (% Y/Y) Morgan Stanley

Consensus

Fiscal Discipline Might Pay Off Budget Balance & Gov't Debt (% of GDP)

Italian Gov't/EU Commission

Interest spending Primary budget balance Overall budget balance

1.0 0.5

4

MS Forecasts

0.0 -0.5

0

-1.0 -1.5

-4

-2.0 -2.5 2012

Italy

2013

2012

Eurozone

-8 2013

2002

2004

2006

2008

2010

2012

2014

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. 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.

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

2


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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.

3


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Economy to Continue to Shrink at a Fast Pace for a Quarter or Two Coincident and Forward-Looking Indicators Point to Renewed Economic Weakness 2

70

GDP & Composite PMI

1

60

0

50

-1

40 GDP (% Q/Q, LHS)

-2

20

-4 1999

120

10 2001

2003

2005

2007

2009

2011

Industrial Production (2005 = 100)

110

100

France

Italy

Spain

80

70 1999

2001

2003

2005

- 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.

90 Germany

- 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.

30

Composite PMI

-3

- 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.

2007

2009

Source: Eurostat, ISTAT, Markit, Morgan Stanley Research

2011

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.

4


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Industrial Production and Business Confidence Now Severely Hit by the Crisis Output and Sentiment Now Deteriorating Fast, thus Indicating Sharp GDP Contractions Ahead 120

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

15 10

110 5 100

0 -5

90 -10 80

Business confidence (LHS)

70

Industrial production

-15 -20 -25

60

-30

1999

2001

2003

2005

2007

2009

2011

3Q GDP Estimates 0

- 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.

-1

-2

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

-3 % Q/Q

% Y/Y

-4 Consensus

MS GDP indicator

MS forecast

Source: ISTAT, Consensus Economics, Morgan Stanley Research

Conclusions: 3Q economic activity is likely to have weakened further – perhaps at a faster pace. 5


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Sovereign-Banks-Real Economy Spill Over Effects - 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.

- 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.

- 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.

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

- Higher sovereign yields make the banking sector’s access to wholesale funding markets more difficult, thus contributing to higher funding costs.

- 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.

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

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 60

Italian Gov't Bond Spread & VDAX

6

7

5

6

Impl. Vol. Dax (EUR, LHS) 50

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

40

4

30

5

Mortgages

4

10Y sovereign spread vs. Germany

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

10

Non-financial corporations

10Y spread Italy vs. Germany (%)

12

8 6

3 3

20

2

10

1

1

0

0

0 2009

2010

2011

2012

4

2

2 0 2009

2010

2011

2012

1999

2001

2003

2005

2007

2009

*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

2011

2013

6


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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 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 slowmotion 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 frontloaded. 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.

- 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.

- Yet, apart from a still mixed cyclical situation, Italy’s long-standing structural deficiencies – which have Conclusions: Deep GDP contractions are still ahead of hampered economic growth since the inception of the us, in our view, and we are more cautious than most. Yet eurozone and even before – are likely to stay a the recession is likely to ease going into next year. constraint for years to come, even though the recent reforms might help. Easing Recession Towards Year-End and in the Early Part of 2013 2

4

Real GDP Growth

2

1

MS forecasts

0

2

Real GDP (% Y/Y)

Real GDP (% Y/Y) Bear

Base

Morgan Stanley

Bull

1

0.0

0

-0.5

-2 -1

-2

% Q/Q (LHS)

-4

-3

% Y/Y

-6

Italian Gov't/EU Commission

0.5

0

-1

Consensus

1.0

-1.0 -1.5

-4

-8 2001

2003

2005

2007

2009

2011

2013

-2 -2.0 -2.5

-3 2012

2013

2014-18

2012

Italy

2013

2012

Eurozone

2013

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

7


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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.

- 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.

- 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.

- 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.

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

Portugal, Ireland, Spain, Cyprus, Greece

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

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.

Italy, France, Austria

3. Creditor countries: Those with large current account surpluses and external assets exceeding liabilities. Finland, Germany, Netherlands, Belgium

Italy is a Fairly Balanced Economy 15

Net Investment Position (% of GDP) Belgium

Current Account Balance (% of GDP)

MS Forecasts

10

500

Netherlands Germany

5

Households

300

France

-5

Italy Greece

200

-10

Cyprus Spain

-15

Ireland Portugal

GER

FRA

ITA

SPA

NLD

BEL

POR

GRE

IRE

100 0

-20 -50

Government

Unconsolidated data for FRA, SPA and IRE; nonfin. corp. debt is not necessarily comparable across countries, and includes domiciled foreign companies in the case of IRE

0

Austria

-100

Public & Private Sector Debt (% of GDP) Non-financial corporations

400

Finland

-150

600

0

50

100

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

GER

FIN

FRA

AUT

BEL

ITA

SPA

GRE

NLD

POR

IRE

Source: Eurostat, Morgan Stanley Research

8


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Current Account Rebalancing and Capital Flows Starting to Correct a Modest External Imbalance, Official Sector Replacing Private Capital Current Account (€bn, 4Q Sum) Trade bal. ex energy Services Factor incomes

80

Energy Current transfers CA (% of GDP, RHS)

40

2

0

0 -2 -40 -4

-80 -120

-6 1999

2001

300

2003

2005

2007

2009

2011

200

- 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.

Capital Flows (€bn, 4Q Sum) FDI Portfolio Inv. - Debt Other Inv. - Mon. Authorities Other Inv. - Banks

- 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.

Portfolio Inv. - Equity Financial Derivatives Other Inv. - Govt Other Inv. - Other

100

- 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.

0

-100

-200 1999

2001

2003

2005

2007

2009

Source: IMF, Bank of Italy, ISTAT, Morgan Stanley Research

2011

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.

9


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Persistent Demand Shortfalls Negatively Affect the Economy’s Productive Capacity Aggregate Corporate Profits Might Be Lower If Italy’s Future GDP Path is Weaker than Before 12

- 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.

Real GDP (% Y/Y) 1961-70 = 5.7% 1971-80 = 3.7% 1981-90 = 2.4% 1991-00 = 1.5% 2001-10 = 0.4%

8

- 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.

4

0

- 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.

-4 -8 1961

15

1966

1971

1976

1981

1986

1991

1996

2001

2006

2011

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

10

8 6 4

5

2 0 0 -5 Gross Operating Surplus

GDP (RHS)

-2

-10

-4

-15

-6

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

Source: ISTAT, Morgan Stanley Research

- 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 supplyside of the economy. Thus, extrapolating into the future the pre-crisis growth rate of potential GDP might be too far-fetched, we think.

10


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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.

- 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).

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.

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.

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.

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

Italy’s Medium-Term Prospects Might Be Negatively Affected by the Scar Left by the Recession 14

10

Unemployment Rate and the NAIRU (%)

12 10

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

8

Capital stock per worker

6

GDP per worker

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

100 80

Past 3 months

60

Next 3 months

4 8

40 2

6

20

NAIRU

Tightening std.

0

0

Unemployment rate

4

Loosening std.

-2

2

-20

-4 1970

1976

1982

1988

1994

2000

2006

2012

-40 1960

1965

1970

1975

1980

1985

1990

1995

2000

2005

2010

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

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

11


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Steady Decline of Italy’s Potential Growth Italy’s Potential Growth Rate Might Now Be Close to the Lower Bound of Between 0.5% and 1% 104

- 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.

Real GDP (1Q 2008 = 100)

100

- 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.

96 92 88 84 80

GER

FRA

ITA

SPA

GRE

IRE

POR

76 2008

2009

5

2010

2011

2012

2013

6

Italy: Potential GDP & Output Gap

4

4

3

2

2

0

1

-2 Output gap (% of potential GDP)

0

-4 Potential GDP (% Y/Y, LHS)

-1

-6 1966

1971

1976

1981

1986

1991

1996

2001

2006

Source: ISTAT, European Commission, Morgan Stanley Research

2011

- 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.

12


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Difficult Environment for Doing Business Italy Attracts Limited Foreign Capital and Doesn’t Invest Much Abroad 200

- 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).

Foreign Direct Investment (% of GDP) Outward

Inward

160

- 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.

120

80

- By looking at the performance across many indicators among the OECD countries, Italy’s overall score is such that it ranks last before Greece.

40

0 GRE

ITA

GER

FIN

FRA

AUT

SPA

POR

NLD

IRE

BEL

Ease of Doing Business: Italy vs. OECD Average*

- 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.

*For each topic, Italy’s ranking among 31 OECD countries is reported. Source: UNCTAD, IMF, World Bank, Morgan Stanley Research

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.

13


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

What Italy Has Done to Reform Its Economy Objective

Area

Enhance competition and liberalise economic activity

Energy

Measures Product Market Reform Gas industry: Ownership separation of ENI from gas distribution activity; lower tariffs for vulnerable customers; promote strategic investments Electricity: Promote investment in the transmission network; increase transparency Petroleum products: Eliminate restrictions on contractual arrangements and activities; replace outdated systems; improve information transparency

Transport

Railways: Introduce competitive tender process for local railway services

- 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.

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 entry and activity restrictions; separate administrative, education, and disciplinary functions within orders

Local public services

Require competitive tendering and territorial consolidation in service provision to increase efficiency/reduce costs

Increase the number of pharmacies and notaries; abolish some restrictions

Enhance the role of competition bodies

Regulatory framework

Reduce administrative constraints to establishing and running a business; liberalise opening hours for retailers Strengthen the powers of the Antitrust Authority, especially to scrutinise and issue binding opinions for activities at the sub-national levels Establish independent Transport Authority; strengthen the role of Communication Authority in the postal sector and Energy and Gas Authority in the water sector

Local public services

Define a privatisation plan (earlier target: at least €5 billion revenue per year over 2012-14, now €15-20bn); improve public asset management; plans to sell shares in state-owned companies and establish a real estate fund to manage disposal of public assets at all levels of government

Reduce public sector ownership

Reduce labour market dualism

Raise labour participation

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

Employment protection

Labor Market Reform Modify job protection on standard contracts to reduce costs of individual dismissal by limiting the compulsory reinstatement in case of dismissal for economic reasons

Contracts

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

Social safety net

Reorganise social safety net to make the coverage more uniform (within the overall fiscal constraints); extend wage guarantee funds; early retirement schemes Promote female employment (protection against illegal 'blank resignations' and vouchers for baby-sitting services); strengthen activation policies Existing measures focus on tax deductions for hiring of women, youth, and new employees, and establishing a special type of company for young entrepreneurs

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

- 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.

14


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Some Impact on Growth from Current Structural Reforms - 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.

- 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.

Effect of Current Structural Reforms (% Dev. from Baseline) Reducing entry barriers - eliminating business constraints, improving the economic environment Lowering the mark-up - favouring competition, opening protected markets 5

Cutting red tape - cutting administrative charges, modernising public administration

4 3 2 1 0 -1 2012 2013 2014 2015 2020 2012 2013 2014 2015 2020 2012 2013 2014 2015 2020 2012 2013 2014 2015 2020 GDP

Consumption

Investment

Employment

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

15


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Significant Potential Boost from Deeper Structural Reforms - 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.

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.

- 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

- 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.

Effect of Deeper Structural Reforms (% Dev. from Baseline) Synergy factor 25

Fiscal reforms

20

Labour market reforms

15

Product market reforms

Shifting expenditure from transfers to investment Shifting taxation from direct to indirect taxes Strengthening active labout mkt policies Increasing female labour participation Easing employment protection Increasing competition in tradable product mkts Increasing competition in professional services Increasing competition in non-tradable product mkts

10

5

0 Year 1

Year 2

Year 5

Source: IMF, Morgan Stanley Research

Long run

16


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Forecasts at a Glance - 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.

- 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.

Real GDP Private Consumption Government Consumption Gross Fixed Investment Construction

2008 -1.2 -0.8 0.6 -3.8 -2.9

2009 -5.5 -1.6 0.8 -11.7 -10.4

2010 1.8 1.2 -0.6 1.7 -3.6

2011 0.5 0.2 -0.9 -1.2 -1.7

2012e -2.5 -3.1 -1.5 -8.3 -8.9

2013e -1.0 -1.4 -1.9 -1.0 -0.3

Contributions to GDP Growth (%) Final Domestic Demand Net Exports Inventories

-1.2 0.0 0.0

-3.2 -1.2 -1.1

0.9 -0.4 1.2

-0.3 1.4 -0.6

-3.7 2.4 -1.2

-1.4 0.8 -0.4

Unemployment Rate (% of Labour Force) Inflation (CPI)

6.8 3.3

7.8 0.8

8.4 1.5

8.5 2.8

11.0 3.1

12.0 2.0

Current Account Balance (% of GDP) General Government Balance (% of GDP) Primary Government Balance (% of GDP) General Government Debt (% of GDP)

-2.9 -2.7 2.5 105.8

-2.2 -5.4 -0.8 116.1

-3.6 -4.6 0.0 118.6

-3.3 -3.9 1.0 120.1

-2.8 -2.8 3.0 123.5

-1.5 -1.7 4.5 125.2

Source: Bank of Italy, ISTAT, Morgan Stanley Research

e = Morgan Stanley Research estimates

2014-18e 1.0

1.5

17


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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.

18


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Sizeable Primary Surpluses to Offset Interest Expenses Almost Entirely Going Forward Fiscal Discipline Might Pay Off, and Bring Back Substantial Savings Over Time 8

Budget Balance & Gov't Debt (% of GDP) Interest spending Primary budget balance Overall budget balance

4

MS Forecasts

- 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.

0

- 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 belowconsensus growth forecast.

-4

-8 2002

12

2004

2006

2008

2010

2012

2014

- 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 policyinduced recession.

Interest Expenditure & Cost at Issuance Interest expenditure (% of GDP)

9

Average weighted cost at issuance (%)

6

3

0 1995

1997

1999

2001

2003

2005

2007

2009

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

2011

- 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.

19


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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 5

130

Interest Cost (% of Total Debt)

Gov't Debt (% of GDP)

4 125 3 120 2

B/E interest cost to stabilise debt 115

Current interest cost

1

MS base case

With B/E interest cost

+250bp across the curve 0

110

2012

2013

Source: National Treasuries, Morgan Stanley Research

2014

2011

2012

2013

Note: Content on this page is from Fixed Income Research

2014

20


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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. Ongoing Refinancing Needs (€bn) Italy’s Issuance Lagging Behind its Peers

2009 2010 2011 2012e 2013e 2014e 2015e

Redemptions Bills Bonds * 275 172 211 170 196 156 196 193 196 159 196 182 196 211

Gross Issuance Bills Bonds * 268 265 215 246 216 207 216 236 216 185 216 201 216 227

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

Net Issuance Bills Bonds -8 93 4 76 0 51 0 43 0 26 0 19 0 16

Country

Bonds Bond Issuance Bonds Issued Issued Planned Remaining through Sep 20, % through Sep €bn €bn of Planned 20, €bn

22.0 Austria 38.3 Belgium 8.0 Finland 178.0 France 178.0 Germany 236.0 Italy* Netherlands** 60.0 86.0 Spain** 806 EMU 16 678 EMU 4

17.3 30.9 9.5 156.3 141.1 139.3 53.9 69.6 618 506

4.7 7.3 -1.5 21.7 36.9 96.7 6.1 16.4 188 172

78.8% 80.9% 118.8% 87.8% 79.3% 59.0% 89.8% 80.9% 76.6% 74.7%

* Morgan Stanley estimate. Germany: €170bn Nominal + €8bn Linkers Austria : €20-24bn Spain** €86bn based on official target, possible additional €20bn funding required for revised budget deficit and funding requirement for regional debt repayment

Source: National Treasuries, Morgan Stanley Research

Note: Content on this page is from Fixed Income Research

21


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

The Magic of the OMT Italy’s Gov’t Debt Has Gained from the ECB Announcement on Bond Purchases Term Structure of Italy Spreads vs. Germany Interpolated Spread vs. GER

550

450

- However, activation of the OMT programme for Italy would be conditional upon:

350

i. the negotiation of fiscal and other reforms in a Memorandum of Understanding, with periodical compliance checks 250

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

150 2013

2018

2023

2028

Italy - Germany (Current)

2033

2038

Italy - Germany (July 26th)

300

Cumulative 1-3yr BTPs & Proportion Owned by Foreigners 240 250

143

150 100 50

72 43

38 11

0 2H 2013

Italy (BTPs)

- 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.

200 €bn

- 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.

2014

2015

Italy 1-3y sectorowned by foreign investors

Source: National Treasuries, Morgan Stanley Research

- 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. Note: Content on this page is from Fixed Income Research

22


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

What Italy Has Done to Fix Its Public Finances Italy’s Fiscal Plan €bn Increase in revenue Of which Increased taxes on consumption Increase in VAT (20% to 23% and 10% to 12%) Fuel excises, tobacco and lottery Increased taxes on wealth Property tax with revaluation of tax base Stamp duty on financial assets; tax on assets abroad Luxury asset tax Other increase Increased social security contributions Capital income taxation Regional income tax surcharge Tax collection measures/anti-evasion/gaming Changes to the Domestic Stability Pact – special statute regions Reduction in revenue Of which Incentives for Capital and Labour Reduced tax on labour (IRAP) Allowance for Corporate Equity (ACE) Reduction of VAT Other Reduction in expenditure Of which Ministerial expenditure Sub-national government expenditure Other State departments and non-territorial entities Changes to the Domestic Stability Pact – ordinary statute regions and local authorities Health expenditure Pension measures Increase in expenditure Of which Transport, Infrastructure and other growth Funds Credits to truck hauliers IRAP deductability Extension of existing legislation and non-deferrable expenditure Transfers to the Earthquake Reconstruction Fund Other Net fiscal impact (consolidation) % GDP (MS F'cast) Share of net revenue measures (%) Share of net expenditure measures (%)

2012 50.1

2013 64.5

2014 68.7

17.5 7.5 10.0 15.3 10.7 4.2 0.4 8.6 1.2 1.4 2.2 3.7 0.6 -12.5

26.9 17.4 9.6 16.2 10.9 4.9 0.4 10.6 1.6 1.5 2.2 5.3 1.2 -17.8

30.4 20.6 9.7 15.0 11.3 3.3 0.4 11.4 2.0 1.9 2.2 5.3 1.5 -23.4

-3.0 -2.0 -1.0 -3.3 0.0 28.3

-5.0 -4.0 -1.0 -6.6 0.0 38.2

-6.0 -3.0 -3.0 -9.8 0.0 43.7

7.1 7.0 0.8 1.7 0.9 3.2 -15.3

6.6 9.2 0.6 4.0 4.3 8.5 -9.3

4.9 9.2 0.6 4.0 7.0 10.5 -7.6

-1.9 -1.1 -1.0 -0.5 0.0 0.0

-2.2 -1.1 -1.0 -2.7 -1.0 -0.1

-2.5 -1.1 -1.0 -0.1 -1.0 -0.2

50.6 3.2 74.3 25.7

75.6 4.7 61.7 38.3

81.4 5.0 55.7 44.3

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

- 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.

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MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Fighting the ‘Shadow Economy’ – Progress, but More to Do Revenues from Anti-Tax Evasion Measures Have Increased, but Problems Still Remain 30

Shadow Economy (% of GDP) Mid-1990s

25

Latest

- 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.

20 15 10 5 0 UK AUT NLD USA FRA IRE FIN DNK GER SWE BEL POR SPA ITA GRE

15

Italy: Revenues from Anti-Tax Evasion Measures (€bn)

12

12.7

11.0 9.1

9 6.4

- 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.

7.0

- 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.

6

3

0 2007

2008

2009

2010

2011

Source: F. Schneider – various papers, Italian Revenue Agency, Morgan Stanley Research

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.

24


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Monetising Government Assets – How Much? - 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).

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.

- 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.

- 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.

- Privatising, in a sense, means giving up the revenues from that asset; this reduces the debt burden

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

Gov't Liabilities (% of Total)

1000

Gov't Assets (€bn)

Concessions

800

6%

Real estate

Non-listed holdings* 33%

600 Central gov't

Listed holdings

Central gov't

Participations 400

Regional & local gov'ts

Receivables

Regional & local gov'ts

67%

200 94%

0 Market value

Free / Recoverable

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

25


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Fiscal Sustainability at a Glance - 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.

- 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 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 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.

- 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 redirection of resources to productive uses.

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.

Nominal GDP, % Nominal GDP, €bn

2011 1.7 1580

2012e 0.4 1587

2013e 0.4 1594

2014e 2.8 1638

2015e 3.2 1690

General Govt Balance, % of GDP General Govt Balance, €bn Primary Govt Balance, % of GDP Primary Govt Balance, €bn

-3.9 -62.4 1.0 15.7

-2.8 -44.4 3.0 47.6

-1.7 -27.3 4.5 71.7

-1.3 -20.5 5.0 81.9

-1.0 -17.3 5.1 86.2

Interest Payments, % of GDP Interest Payments, % of Revenue Implicit (Net) Interest Rate, %

4.9 10.6 4.1

5.8 12.2 4.9

6.2 12.7 5.1

6.3 12.6 5.2

6.1 12.3 5.2

50.5 46.6 120.1

50.3 47.5 123.5

50.7 49.0 125.2

50.8 49.5 122.9

50.6 49.6 120.2

Government Expenditure, % of GDP Total Revenue, % of GDP General Gross Govt Debt, % of GDP

Source: Bank of Italy, ISTAT, Morgan Stanley Research

e = Morgan Stanley Research estimates

26


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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

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


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Regional Government Credit | Background Political Organisation

Regional Governments of Italy by Credit Rating

 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% 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

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

28


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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…

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.

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. 1

Moody’s

• 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. 29


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Key Variable | Credit Quality Levered to Growth, Which Remains Weak Revenues Grow, Shrink, With Broader Economy

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.

Over the past 20 years, there has been a tight correlation between changes in Italian GDP and regional tax revenues

1,800,000

1,600,000

GDP (â‚Źmn)

1,400,000

1,200,000

1,000,000

800,000

600,000

400,000 40,000

60,000

80,000

100,000

120,000

140,000

Revenues (â‚Źmn)

Source: ISTAT, Bloomberg, Morgan Stanley Research

160,000

180,000

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.

30


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Key Variable | Austerity Weakens Regions’ Financial Base More Regions Increasingly Rely on Central Gov’t Aid 100%

2005

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.

2010

80% 60% 40% 20%

M ar Ab che Pi ruz em zo on Ve t e n V a C a et o lle lab d' ria A S a os rd ta eg Fr na iu T r liV e U ent ne m o zi br a ia Ba Giu sil lia ic B o at a lza To n o C sca am n a Lo pa m nia ba rd Pu ia gl Si i a Em ci ilia L lia -R igu om r ia ag M na ol ise

0%

Note: Lazio not included because of insufficient financial data.

Decline in Projected Revenues due to Transfer Cuts1 Re gion Ca m pa nia V ene to P ie m on te Abruzzo Ma rc he E m ilia -R om a gna Um bria La zio P uglia Tos ca na Ca labria Liguria Lom b ardia Ba silic at a Mo lis e S ic ilia S arde gna Friuli-V e ne zia G iulia Tren to Bolza no V alle d'Aos ta Ita lia n Re gion s ( all)

2 0 12 3 .59 % 3 .21 % 3 .00 % 2 .98 % 2 .97 % 3 .00 % 2 .94 % 2 .99 % 2 .92 % 2 .92 % 2 .82 % 2 .72 % 2 .70 % 2 .43 % 2 .42 % 2 .00 % 1 .67 % 1 .42 % 0 .83 % 0 .77 % 0 .61 % 2 .64 %

2 0 13 6 .53 % 5 .81 % 5 .42 % 5 .39 % 5 .37 % 5 .41 % 5 .32 % 5 .40 % 5 .28 % 5 .27 % 5 .09 % 4 .91 % 4 .84 % 4 .37 % 4 .36 % 3 .58 % 2 .99 % 2 .52 % 1 .47 % 1 .36 % 1 .08 % 4 .76 %

2 0 14 7 .18 % 6 .32 % 5 .90 % 5 .85 % 5 .83 % 5 .79 % 5 .78 % 5 .77 % 5 .74 % 5 .71 % 5 .53 % 5 .30 % 5 .15 % 4 .71 % 4 .69 % 3 .79 % 3 .19 % 2 .67 % 1 .55 % 1 .42 % 1 .13 % 5 .11 %

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. 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. 1Cuts are derived from Decree Law No. 98/2011, Decree Law No. 138/2011, and Decree Law 95/2012 (Spending Review Plan). 2IMF Public Financial Management Division.

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

31


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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

Debt Affordability Should Weaken Slightly Cuts in the revenue base due to slow growth and austerity appear to be manageable given debt expectations Region Abruzzo Lazio Umbria Campania Piemonte Liguria Sicilia Puglia Marche Basilicata Calabria Friuli-Venezia Giulia Toscana Sardegna Molise Emilia-Romagna Veneto Lombardia Valle d'Aos ta Bolz ano Trento Italian Regions (all)

Debt Service as a % of Revenues 2011 2012 2013 5.81% 5.98% 6.31% 5.43% 5.58% 5.87% 4.30% 4.43% 4.67% 3.17% 3.29% 3.51% 3.96% 4.07% 4.30% 3.60% 3.70% 3.88% 6.03% 6.13% 6.34% 2.26% 2.32% 2.45% 2.21% 2.28% 2.40% 2.68% 2.74% 2.87% 2.20% 2.26% 2.38% 5.03% 5.10% 5.22% 2.17% 2.23% 2.35% 3.50% 3.56% 3.66% 1.93% 1.98% 2.07% 1.46% 1.50% 1.58% 0.78% 0.81% 0.85% 1.12% 1.15% 1.20% 4.61% 4.64% 4.69% 0.60% 0.61% 0.61% 0.14% 0.14% 0.14% 2.96% 3.04% 3.18%

2014 6.64% 6.07% 4.91% 3.74% 4.53% 4.06% 6.48% 2.57% 2.52% 2.99% 2.50% 5.33% 2.47% 3.77% 2.15% 1.64% 0.90% 1.23% 4.72% 0.62% 0.15% 3.30%

'11-'14 Change 0.83% 0.64% 0.61% 0.57% 0.57% 0.45% 0.45% 0.32% 0.31% 0.31% 0.30% 0.30% 0.30% 0.27% 0.22% 0.17% 0.12% 0.11% 0.11% 0.02% 0.00% 0.34%

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.

Regions w/ Higher Industrial Concentrations May Relatively Outperform on Credit Quality Employment by Sector per Region Region Marche Veneto Friuli-Venezia Giulia Emilia-Romagna Lombardia Piemonte Umbria Abruzzo Molise Toscana Trentino-Alto Adige Basilicata Puglia Campania Liguria Lazio Valle d'Aos ta Sardegna Sicilia Calabria Italy

Agriculture 2.74% 3.22% 2.56% 4.08% 1.64% 4.07% 3.53% 3.85% 7.34% 3.60% 5.32% 8.11% 8.91% 4.23% 2.19% 1.82% 3.51% 5.05% 7.50% 10.65% 3.90%

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

Industry NonConstruction construction 31.20% 7.91% 27.89% 8.29% 27.22% 7.30% 26.81% 6.87% 26.47% 7.82% 25.65% 7.54% 20.92% 9.78% 20.08% 9.13% 19.27% 11.01% 18.98% 8.94% 16.81% 8.72% 15.14% 11.35% 14.79% 9.07% 12.49% 9.97% 12.23% 7.99% 10.82% 8.91% 10.53% 12.28% 9.93% 9.43% 8.40% 8.47% 7.50% 10.30% 20.03% 8.44%

Services 58.14% 60.61% 62.92% 62.24% 64.07% 62.74% 65.76% 66.94% 62.39% 68.47% 69.15% 65.41% 67.24% 73.31% 77.59% 78.46% 73.68% 75.59% 75.63% 71.55% 67.64%

32


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Credit Impact | Expect Current Relative Credit Rankings, Market Opportunities, to Hold Spreads vs. Total Debt/Total Revenue (%) 600

Conclusions: Lombardia • 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.

500 Spread to Bunds (bp)

Liguria

Umbria

400

Abruzzo Sardegna

300

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

200 100 0 0%

10%

20%

30%

40%

50%

60%

Total Debt/Total Revenue (%)

Spreads vs. Operating Margin (%) 600

Liguria

Spread to Bunds (bps)

500

Umbria

400

Sardegna

Lombardia

Abruzzo

300 200 100 0

-5%

0%

5%

10%

15%

• 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.

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

33


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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.

34


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Politics – An Often Overlooked Channel of Contagion Decreasing Confidence in Government and No Clear Political Majority Voting Intentions (% of Total) 30

PD

PdL

UdC

LN

M5S

IdV

SEL

Other

- 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 runup to the election, which has to happen by April 2013, might well result in less willingness or ability to maintain a sound reform path.

25 20 15

- 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.

10 5 0 Jan-12

70

Feb-12

Mar-12

Apr-12

May-12

Jun-12

Jul-12

- 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.

% of Voters with Confidence in...

65

...Prime minister Monti

- 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.

...Monti's government

60 55 50

- 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.

45 40 35 N/A

30 Jan

Feb

Mar

Apr

Jun

Jul

Sep

Source: DataMonitor, IPR Marketing & La Repubblica, Morgan Stanley Research

Conclusions: A still unresolved political situation might well turn into a further channel of contagion. Support for the current government has diminished.

35


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

On the Return of the Political Risk Premium… Political Events Have Exerted a Significant Impact on Italian Markets in Recent Decades 50

Asset Prices Before / After Gov't Changes*

40

39

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

30

24 20

20 10

10

8 3.0

0.6

0 -2.6

-4.1

-5.0

-10

2 weeks before Same day and Period between 2 weeks before Same day and end of old 2 weeks after end of old and start of new 2 weeks after end of old start of new start of new

15

- 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 shortterm interest rates is about 24bp – controlling for other factors. Similarly, equity markets fall by around 5% over the same period.

Asset Prices Before / After External Events*

- 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.

11

10

8

5 3 0.2

0 -0.4

Short-term interest rates (bp)

-0.4

Equity returns (%)

-5 1 week before event

1 week after event

2 weeks after event

*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

- 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.

36


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

…the Issue of Political Stability… - 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 Italy’s Governments (1972 – Present) Government Andreotti II Rumor IV Rumor V Moro IV Moro V Andreotti III Andreotti IV Andreotti V Cossiga Cossiga II Forlani Spadolini Spadolini II Fanfani V Craxi Craxi II Fanfani VI

Start 26-Jun-72 07-Jul-73 14-Mar-74 23-Nov-74 12-Feb-76 29-Jul-76 11-Mar-78 20-Mar-79 04-Aug-79 04-Apr-80 18-Oct-80 28-Jun-81 23-Aug-82 01-Dec-82 04-Aug-83 01-Aug-86 17-Apr-87

End 02-Jun-73 03-Mar-74 03-Oct-74 07-Jan-76 30-Apr-76 16-Jan-78 31-Jan-79 31-Mar-79 19-Mar-80 27-Sep-80 26-May-81 06-Aug-82 13-Nov-82 29-Apr-83 07-Jun-86 03-Mar-87 28-Apr-87

Government Goria De Mita Andreotti VI Andreotti VII Amato Ciampi Berlusconi Dini Prodi D'Alema D'Alema II Amato II Berlusconi II Berlusconi III Prodi II Berlusconi IV Monti

Start 27-Jun-87 13-Apr-88 22-Jul-89 12-Apr-91 28-Jun-92 28-Apr-93 10-May-94 17-Jan-95 17-May-96 21-Oct-98 22-Dec-99 25-Apr-00 11-Jun-01 23-Apr-05 16-May-06 08-May-08 16-Nov-11

End 11-Mar-88 19-May-89 29-Mar-91 24-Apr-92 22-Apr-93 16-Apr-94 22-Dec-94 17-May-96 09-Oct-98 18-Dec-99 19-Apr-00 31-May-01 20-Apr-05 16-May-06 07-May-08 12-Nov-11 Incumbent

The end indicates the actual collapse of the government coalition or the resignation of the Prime Minister. Source: News agencies, Morgan Stanley Research

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. 37


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

…and Attitudes Towards the Euro - 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.

- 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.

What People Think About Europe Do You Think We Should Keep € or Return to National Currencies? Keep €

Return to national currencies

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

Don't know

Favour

100%

100%

80%

80%

60%

60%

40%

40%

20%

20%

0%

Oppose

Don't know

0% Greece

France

Germany

Spain

Italy

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

France

Italy

Spain

Germany Poland

Czech

Greece

UK

38


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Not Really Peripheral… at the Core of the Next Leg of the Crisis - 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.

- Our bear case encompasses a much deeper recession in both years, with GDP contracting by around 3% next year (20% probability).

- 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.

- 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.

- 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.

- 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.

- 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.

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.

A More Severe Downturn in Italy Might Significantly Impact the Eurozone 10

Eurozone GDP (% of Total) 6.5

1.7

Exports to Italy (% of Exporter Total)

2.1

OTH

1.9

8.3

GRE

IRE

8.3

ITA

6

GDP Growth (% Y/Y)

4

7.8

8 16.6

9.5

2

6.2

6

POR

28.5

SPA

4.6

1.8

AUT 11.1

3.1 3.8 21.0

2.0

BEL

4

3.4

4.8

0

3.7

EMU Base

-2 2.4

FIN

FRA

GER

NLD

EMU Base & ITA Bear Cases

2

EMU Base & Periphery Bear Cases

-4

EMU Bear Case -6

0 FIN

IRE

POR

BEL

NET

GER

AUT

FRA

SPA

GRE

1996

1998

2000

2002

2004

2006

2008

2010

2012

Source: Eurostat, IMF, Morgan Stanley Research

39


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Size Matters Italian Gov’t Debt Now Becoming More Domestic, but a Significant Amount is Still Held by Foreigners General Gov't Debt by Holder (%) Non-Resident

Resident non-financial

Resident financial

100%

- 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.

80% 60% 40% 20% 0% BEL

100

GER

IRE

SPA

FRA

ITA

NET

AUT

POR

FIN

Gov't Marketable Debt, Foreign Holders (% of Total)

60

40 Italy

Spain

Portugal

Greece

Ireland

Germany

France

Other Core

0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Source: Eurostat, Morgan Stanley Research

- 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.

80

20

- 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.

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.

40


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

A European Programme for Sovereign Support: Pros, Cons, and Catalysts PROS: Use ESM to buy / insure gov’t bonds + ECB intervention

CONS: Don’t 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 maintain some areas of economic policy within the national boundaries, thus determining the pace and extent of reform.

- 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.

- 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.

CATALYSTS: What Could Trigger / Delay Sovereign Support - 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.

Contagion

- 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- Limited or no extra conditionality, perhaps tightening that will have to happen anyway, might make it respecting the fiscal and reform commitments of the Negotiation difficult for the government to muster domestic Stability Programme, might probably help limit the consensus, and perhaps trigger a political crisis. 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.

Seniority

- 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.

41


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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

- 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.

42


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

…and What Investors Think About It 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) No programme will be required, as Italy will benefit "in kind" from Spain's participation

- 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.

22%

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

45%

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

20%

Soon after Spain, as the benefits of doing so quickly become apparent

- 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.

13%

0

10

20

30

40

50

When Will Spain Apply for Sovereign Support? (Full Bailout / Precautionary Credit Line) No programme will be required due to the combo of implied ECB support and structural progress

- 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.

3%

Only following serious and prolonged external pressure (e.g., after sovereign ratings junked)

41%

Soon, due to either rising market or domestic funding pressures

49%

7%

Immediately

0

10

20

Source: Morgan Stanley Research

30

40

- 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.

50

60

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. 43


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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%.

44


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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 - We think that deteriorating asset quality is a growing issue for Italian banks, especially as capital levels and internal capital by 140% since 4Q 2008 to €207bn with a 40% coverage generation do not provide a sufficient buffer. Impaired

250

Substandard

Restructured

Past due 207

+140% since 4Q 2008

87

- 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.

4Q08

200

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

- 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”.

150 100 50

1Q12

4Q11

3Q11

2Q11

1Q11

4Q10

3Q10

2Q10

1Q10

4Q09

3Q09

2Q09

1Q09

0

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 Gross NPL ratio (rhs)

18%

Coverage ratio (lhs)

65%

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

15%

60%

12%

55%

Household producers

Household consumer

other

200 4 4 40

160

38 3

9%

50%

6%

45%

3%

40%

0%

35%

3 27

120 80

2 20 10

40

31

17

17

14

12

80

117

126

Q411

Q112

92

50

2002

2004

2006

2008

2010

2Q12

2013e

0 Q408

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

Q409

Q410

Note: Includes impaired, substandard and past due (excl. restructured)

45


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Net NPLs Absorb a Large Amount of Our Universe Tangible Equity and Are Growing Net NPLs absorb a large amount of, or even exceed, NAV for most of the banks in our universe Net NPLs / NAV 238%

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

Post collateral NPLs / NAV 2Q 2012

- 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.

157%

104%

97%

91% 71%

67% 44%

45%

39% 28%

MPS

BP

UBI

UCG

BPM

25%

ISP

24%

17%

MB

Asset quality for our coverage as of 2Q 2012 Reserves

Collateral for NPLs

Coverage

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

Uncovered

BP

ISP

MPS

UBI

Total Italy

UCG

1.6%

Cov. + Collateral

100 80

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

100% 85% 80%

81%

85% 74%

80%

79%

60

60% 47%

49% 42%

40

29%

31%

36%

47% 40%

1.2%

0.8%

40%

0.57%

0.4%

20

20%

0

0% UCG

ISP

MPS

BP

UBI

Source: Company data, Morgan Stanley Research

PMI

MB

0.25%

0.0% 1Q11

2Q11

3Q11

4Q11

1Q12

2Q12

46


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Running the Numbers on Increasing Provisioning Levels on Current NPLs Stock A 20% increase in reserve coverage (just above 2007 peak) indicates €22bn capital erosion for our universe UCG group Gross NPLs Q2 Gross NPLs ratio

ISP

MB

MPS

UBI

BP

PMI

MS cov.

78

46

2

26

9

15

4

180

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%

16

9

0.5

5

2

3

1

36

67%

69%

60%

62%

51%

49%

56%

64%

-9

-5

-0.3

-3

-1

-2

-0.4

-22

Additional 20% reserve Cov. after 20% increase post-tax capital erosion

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

- 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). Cap ratios (2Q 2012, B3 CT1) for our universe after increase in reserve coverage - some low numbers (ex. gov’t hybrids) 8.4% 7.5%

7.5%

7.4%

21.6

7.2% 6.5%

6.4%

9.3 5.5

2.3%

MS universe

MPS

BP

PMI

UCG

MB

MB

UBI

0.3 ISP

0.4

MS universe

1.1

PMI

BP

MPS

ISP

UCG group

1.8

UBI

3.2

Source: Company data, Morgan Stanley Research estimates

47


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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 300bp 200bp

Post-tax capital erosion, bp

Capital relief from NPL sale

Net impact

- 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.

100bp 0bp -30bp

-100bp

-40bp

-78bp

-105bp

-200bp

-34bp -69bp

-90bp

-172bp

-300bp -400bp

UCG

ISP

MB*

MPS

UBI

BP

PMI

Total

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

8.4

recap 10%

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

6.2

- 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 €2040bn, 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 €2241bn as of 2Q12). The ultimate capital hit will depend on the earnings path.

5.3

3.6 2.2 1.3 0.8

1.3 0.3

UCG

MPS

1.1

0.9

ISP

MB*

PMI

0.8 0.2

UBI

Source: Company data, Morgan Stanley Research estimates

BP

48


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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

Benefits

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

 Banks balance sheet quality and transparency is improved

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

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

 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

Source: Morgan Stanley Research

 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)

49


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Funding Requires Some Rebalancing – Thus Credit Flows Remain Constrained Ratios of loan / deposit and loan / retail funding L/D ratio 2Q12

Deposits are still growing but savings rate in Italy has declined significantly and is now below the eurozone 20

L/D (just deposits) 2Q12

Savings Rate (% of Disposable Income)

312%

Eurozone

18 238%

Italy

230% 204%

130%

191% 150%

109%

103%

99%

193%

16

144% 97%

96%

102%

93%

14 12

MB

MPS

ISP

UCG Italy

BPM

BP

UBI

MS universe

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

37

2H 12012

45

41

2013

2014

10 1999

2003

2005

2007

2009

2011

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

121

ISP UCG Italy UBI MPS BAPO MB BPM Total total 2012-14

2001

funding 2012-14 at risk Loans Deleveraging 374,953 28,000 8,400 -2.2% 223,000 21,061 6,318 -2.8% 95,333 8,230 8,230 -8.6% 144,461 12,050 12,050 -8.3% 91,028 9,300 9,300 -10.2% 35,268 9,400 2,820 -8.0% 34,948 3,300 3,300 -9.4% 998,991 91,341 50,418 -5.0%

total LTRO amount

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

50


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Funding Requires Some Rebalancing – Thus Credit Flows Remain Constrained (cont’d) Customer loan trends: Worst six months in last 30 years 18% 15%

GDP

- Assuming:

Loans

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

12%

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

9% 6%

- 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.

3% 0% -3% -6% 1988

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

1992

1996

2000

2004

2008

1H12

Customer loans down -3.2%Y on average for our universe of banks Loan Growth 2Q11 - 2Q12

1%

-3%

-3%

MB

BPM

- 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 midcap 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.

-4% -6% -7% -8% MPS

UBI

BP

UCG Italy

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

ISP

51


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

With Low Profitability, Reducing Capex Remains Key, as Macro Remains Difficult - Returns have declined significantly over the years and without significant intervention on restructuring will see little improvement, on our estimates.

RoNAV remains depressed over time… 40%

BP MB

BMPS PMI

UCG UBI

ISP

30% 20% 10%

- 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.

0% -10% -20% 2002

2004

2006

2008

2010

2012e

2014e

…and so does RoA (return on assets)

- 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

1.2%

ISP

UCG

BP

UBI

12%

PMI

BMPS

10%

0.8%

RoNAV 214e Bull

Base

Bear

8%

0.4%

6% 0.0%

4% 2%

-0.4% 2002

2004

2006

2008

2010

2012e

2014e

0% MB

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

ISP

UCG

MPS

UBI

BP

PMI

52


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

An Over-Branched Banking Sector Offers Ample Opportunities for Restructuring Branch penetration: Room for reduction in Italy Population ('000) / Branch 6

Netherlands

5

Sweden UK

4

Finland

- 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.

Ireland Germany

3 Belgium

Austria

2

Denmark

Italy Spain

1

France Greece Portugal

0 0

10

20

30

40

50

Employee / Branch

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 50000

Branches (lhs)

- 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.

Banks (rhs)

- 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. Spanish M&A has produced significant branch reduction

1000

50000

40000

900

40000

30000

800

30000

20000

700

20000

600

10000

10000 1996 1998 2000 2002

2004 2006 2008 2010

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

Branches in Spain

1995

1998

2001

2004

2007

2010

2013E

53


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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

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

Cost / Loans (2010-11) 3.0%

3.0%

UCG Italy

2.9% 2.6%

UBI

ISP

BP

BMPS

-520

-435

-352

PMI

MB

-115

-18

MS universe

2.5% 2.3%

2.3%

2.3%

2.2% 1.9%

-531 1.5% 1.3%

BBVA - Iberia Retail

Nordea Nordic Banking

Danske Bank

SAN - Spain Retail

Mediobanca

ISP Italy

UBI

MPS

BP

UCG Italy

BPM

BNP - French Retail

Socgen French Retail

1.3%

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

-906

-2877

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

Cost Reduction Required

-9%

-9%

ISP Italy

MB

-13% -15% -21%

-21%

UCG Italy

BP

-29% PMI

UBI

BMPS

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

2015e implied New RoNAV 2015e cost reduction RoNAV benefit RoNAV 2015e BPM 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)

54


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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. 55


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Italian Bank Equity: Low Profitability and Residual Credit Risk Cap Valuations, Downside Risk Outweighs Upside Potential in Our Bull / Bear Skew (Francesca Tondi) P/NAV/RoNAV for European banks 1.8

SHB

STAN

SWED

1.6 SEB HSBC

1.4

BARC

NOR BBVA

P/NAV 2012e

1.2

BCIV

DNB RBI 1.0

UBS

Danske

SAB

ERSTE CSGN

BNP RBSCABK KBC MB POP ISP NATIX SAN ING

BKT

0.8 0.6

UBI CBK PMI

0.4

BP

0.2

GLE

DBK LLOY ACA

UCG BTO

BMPS

0%

2%

4%

6%

8%

10%

12%

14%

16%

RoNAV 2014e

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

UCG UBI BMPS MB ISP BP PMI

- 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.

Price to earnings P/NAV RoTNAV MS Estimates MS Estimates MS Estimates 2012E 2013E 2014E 2012E 2013E 2014E 2012E 2013E 2014E 14.4x 14.6x 8.5x 0.5x 0.5x 0.5x 4.1% 4.0% 5.9% 17.5x 19.9x 7.9x 0.4x 0.4x 0.4x 2.6% 2.2% 5.5% 14.6x 15.2x 11.1x 0.5x 0.5x 0.5x 3.5% 3.3% 4.4% 22.0x 10.7x 6.4x 0.4x 0.4x 0.3x 2.0% 3.5% 5.3% 8.3x 7.1x 6.2x 0.6x 0.6x 0.5x 7.0% 8.4% 9.0% 11.4x 11.5x 9.3x 0.6x 0.6x 0.6x 5.6% 5.3% 6.4% 14.3x 13.8x 9.6x 0.3x 0.3x 0.3x 2.3% 2.3% 3.3% 13.0x 13.6x 10.3x 0.4x 0.4x 0.4x 3.4% 3.1% 4.0%

- 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 100% BULL

75% 50% 25% current price

BASE -1%

-7%

-25%

-15% -24%

-50%

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

PT

-23%

-25% -44% BEAR

-75% -100% ISP

UCG

MPS

Medio

UBI

BP

BPM

56


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Italian Bank Credit: Reviewing our Periphery Skew

(Jackie Ineke)

- 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” banks B/O

Ticker

Coupon

Maturity

Issue (m)

Amt o/s (m)

12m high

12m low

Swap gains

B

Ccy

UCGIM

6.125

Next call

19-Apr-21

750

750

Steps

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

5.9

89.3

71.9

7

B

ISPIM

3.75

02-Mar-15

02-Mar-20

O

INTNED

6.125

29-May-18 29-May-23

B

ISPIM

5.15

O

INTNED

3.5

B

UCGIM

5.75

O

RBS

4.625

B

$

UCGIM

O

$

STANLN

L +95

Price

85.4

YTC

13.3

YTP/M

500

478

L + 89

87.0

9.9

5.3

88.5

71

7.8

1,000

1,000

L +255

103.0

5.5

5.5

103

86.9

19.7

16-Jul-20

1250

1203

6.0

99

73.5

9.4

16-Sep-20

1,000

1,000

5.4

4.3

94.9

80.9

7.4

26-Sep-17

1,000

1,000

6

101

72.2

17.5

22-Sep-21

1,000

1,000

7.9

5.8

89

61

13.1

6

31-Oct-17

750

750

93.5

7.6

94.5

73

20.5

6.4

26-Sep-17

1,000

1,000

114.9

3.2

114.9

102.1

21.1

16-Sep-15

22-Sep-16

94.7 L +136

94.9

L + 130

89

98.66

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

57


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Italian Gov’t Bond Market – Applying PCA to Sovereign Spreads

(Elaine Lin)

- 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. Systemic Sovereign Risk = Italy Sovereign Risk 600

100

4

500

50

3

0

2

-50

1

5yr Italy swap spread (bp, RHS)

1

400

0

300

-1

200

Spread (bp)

PC1 (systemic sovereign risk) 2

-100 -150

-2

100

-200

-3

0

-250

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

0 PCA weighting

Jun-10

-1

50:50 weighting

Systemic Risk (PC1)

3

Short France vs. Italy and Germany (20:80)

-2

Systemic risk - PC1 (RHS)

-3 Oct-10

Feb-11

Jun-11

Oct-11

Feb-12

Jun-12

Source: Morgan Stanley Research

58


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Morgan Stanley Bank International Limited, Milan Branch ("Morgan Stanley") is acting as financial advisor to Eni S.p.A. in relation to the proposed disposal of its stake in Snam S.p.A.. Eni has agreed to pay fees to Morgan Stanley for its financial services. Please refer to the notes at the end of the report.

59


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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Analyst Certification The following analysts hereby certify that their views about the companies and their securities discussed in this report are accurately expressed and that they have not received and will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this report: Jackie Ineke, Elaine Lin, Michael Zezas, Angela Wang, Francesca Tondi. Unless otherwise stated, the individuals listed on the cover page of this report are research analysts.

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MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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Overweight/Buy Equal-weight/Hold Not-Rated/Hold Underweight/Sell Total

Investment Banking Clients (IBC)

Count

% of Total

Count

% of Total IBC

% of Rating Category

1108 1283 109 469 2,969

37% 43% 4% 16%

445 499 34 115 1093

41% 46% 3% 11%

40% 39% 31% 25%

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.

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61


MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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Italy: Policy Options and Investment Implications September 24, 2012

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MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

Disclosure section (cont.) The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA. As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, nondeposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations. The trademarks and service marks contained in Morgan Stanley Research are the property of their respective owners. Third-party data providers make no warranties or representations relating to the accuracy, completeness, or timeliness of the data they provide and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request. Morgan Stanley has based its projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on publicly available information. MSCI has not reviewed, approved or endorsed the projections, opinions, forecasts and trading strategies contained herein. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research, or any portion thereof may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley Research is disseminated and available primarily electronically, and, in some cases, in printed form.

Additional information on recommended securities/instruments is available on request. Š2012 Morgan Stanley

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MORGAN STANLEY RESEARCH

Italy: Policy Options and Investment Implications September 24, 2012

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Asia/Pacific

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65


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