Meeting EMU criteria and facing the demographic challenge on pensions are the big issues as far as investors are concerned. John Lappin reports

There are two great spurs to economic change in Italy: EMU and demography.

For many in Italy, not making the EMU core would raise concerns about the post-war identity of the state, though most Italian analysts to support this political imperative point to macro-economic figures that are at least moving in the right direction.

As for demographics, current levels of state pensions provision will prove untenable by the second decade of the next century, prompting reform.

Hugo Doyle, economist at Banca Commerciale Italiana, says that demographics is the ultimate macro issue. This reform is intended to put pension flows back into order at a macro-economic level. It should see improving opportunities for pension fund investments," he says.

Reforms to the first pillar of pension provision should see significant cutbacks with a planned second pillar taking the strain.

Success in meeting EMU and resolving welfare issues could create a virtuous circle for investors with lower inflation, convergence on German bond rates pushing liquidity into the equity market which itself has plans to privatise. Domestic institutional demand from pension funds should mitigate the traditional volatility of the Italian stock market medium term, while providing buyers for the shares of newly privatised companies. Perhaps even more important greater numbers of the traditionally strong medium-sized companies will come to the market.

Italy remains far from this scenario and a gap has opened between political intent and practice. The pensions law was passed two years ago but funds cannot commence operation as details about the board composition have not been finalised in a dispute over the qualifications of trade union representatives and the regulatory body is reportedly understaffed. By way of contrast, the Prodi government has recently announced a similar defined contribution system of pensions reforms for public sector workers.

Political concerns centre on the unreformed communist party, upon which the Olive Tree coalition is dependent. Some go further. Attilio Pellero, managing director at William Mercer in Milan, believes that the economy needs another spur, a government that truly believes in the profit motive. His greatest bugbear is corporation tax, officially 52% but according to him nearer 60%.

More optimistically Pellero and most though not all commentators believe that Italy will make the EMU first tranche. However, domestic analysts and foreign investors remain cautious about the equity market.

Summing up the market, Carlo Parisi, a broker at Intermobiliare Securities, says: "Interest rates should stay low and the good liquidity picture should continue. We have a lot of privatisations and a lot of new placements so we give a potential upside of between 5 and 7%."

He believes that telecoms offer value compared to the rest of Europe and that banks should see some growth but cyclicals must wait for a European recovery next year and he is wary of Italian blue chips.

Alfredo Granata, head of research at Banca di Roma, expects growth this year to be slightly less than official projections of 1.5%. It should be export-led but with a small increase in domestic demand leading to a slight increase in inflation towards year-end. He expects two interest rate cuts, one in the near future and another towards the end of the year.

"Equity, in particular, will be positively affected by this, and this combines with slightly higher profits in 1997," he says. He continues: "Much of the bond market will depend on EMU," adding, "I am quite optimistic because the decision is mainly political. Italy will arrive at the end of the year with positive economic figures while the political scenario should not worsen."

Doyle at BCI agrees with this combination, with the fundamentally political nature of the project reinforced by economic figures which meet or are moving towards the convergence criteria securing Italy's first round involvement.

Doyle says: "On a political level German and French companies would not want Italian companies to possess the advantage of a devalued lire."

"In deficit performance, apart from some accounting procedures - shared by other countries - the movement is significant, and the treaty is flexible enough to be impressed by something that is rapidly approaching the 3% target."

Even the more cautious Parisi, who does not think that Italy will make the first round, does not believe that this will herald a major crisis. Doyle, however, expresses fears about a possible fall into recession, if a non-EMU core Italy was forced to accept overly stringent restrictions on fiscal and monetary policy.

There is no perfect fit between EMU moves, a revamped investment climate and welfare and pensions reform. Overall pensions reform may help to reduce debt, but there have been suggestions that the government is delaying funds until 1998 because it cannot afford to lose tax revenue pre-Maastricht. More definitely, funds have only limited tax incentives for this reason.

Pellero is the most cynical. "My view was much better before the law. I think the real objective of the government was not to create private pension funds but to wipe out an area of tax effectiveness," he says.

According to his calculations, many workers will receive a pension of 100% final salary and the new system is only useful in discouraging early retirement. He is particularly concerned at the failure to allow companies to adequately reward senior management. "In our view this legislation reinforces the first pillar and reduces the second pillar."

The embryonic pensions industry is more optimistic. Stefano Grassi, the business manager of pension funds at Prime Investment Management, believes that the market will be worth IL120,000bn ($70bn), close to that of the mutual fund market which was set up in 1985 and is quoted as a benchmark by other analysts.

The current second pillar covers only 5% of the workforce, senior multinational staff and bank employees. Eighty-five per cent of this market - what Grassi describes as the start of the real second pillar - will be taken up by employed private sector workers in closed-end funds (with contributions up to 7.5% salary tax-free) while 15-20% will be self-employed (5% tax-free).

Grassi says that the closed-end funds for the employed will be dominated by the larger players (workers can migrate after five years, while open-ended funds - "basically mutual funds with fiscal incentivisation" - should see a role for smaller banks and insurers.But much depends on the depth of conservative investment attitudes.

Examining public opinion Grassi says that with EMU, the previously risk-free investment of Italian bonds will disappear. "There is uncertainty and many people are moving their savings into retirement products. Given the high savings rate this is positive for the second and third pillars," he says.

He also sees increased evidence of the move to equities in the fact that his company is offering mutual funds with a 40% equity investment and managing equities for life insurers.

But many institutions remain conservative and plan to offer insured retirement products. On the "buy-side", Fiat's planned fund has a conservative bond-centred strategy for its closed fund and it could influence others, while the chemical workers' industry-wide fund plans contributions of only 4% of salary.

Pro-equity institutions believe they must convince the public. Prime's open plans have three different investment strategies, conservative, balanced and aggressive. This structure has been followed by SimCoGeF, possibly the dream ticket among fund managers, a joint venture between BCI (known as Comit Bank in Italy), Generali and Flemings.

Hugh Twiss, seconded from Flemings, and in charge of investment strategy at SimCoGeF, believes that it will be a process of education. For their open funds, they offer four types of investment ranging from 100% bonds to 75% equities. "We anticipate more people will go conservative and then we can persuade them to be more aggressive." He has hopes of convincing groups such as professionals of the merits of equity investment.

Part of his argument will be to stress that any fund is only part of the pension. The largest proportion provided by the state is fundamentally conservative so taking a risk with the rest is justifiable.

Twiss also has reason for optimism in the lack of significant investment restrictions but it is unclear that pension funds will want to invest in Italy.

Grassi is enthusiastic about holding equity in Italian mid-caps. "A large number of medium sized companies are ready to quote their company to support investment in internationalisation and equipment investment," he says.

On privatisations, Grassi is more cautious, citing the mixed record of returns for investors and the difficulties of developing adequate competition for utilities. The veto-holding communist party favours a utility share sell-off but with the government retaining a majority holding, suggesting a complicated path to privatisation.

Broker Parisi has concerns that the wrong companies are being privatised. ENEL and Telecom, the planned sell-offs, are already efficient. It is the big loss-makers, Finmeccanica and Alitalia, that have most to gain. He adds: "It is not a question of public or private. Poor labour flexibility and little fiscal incentive for investing create the same problems for a private or public company."

Pellero is more scathing. He acknowledges that lower bond rates will promote some equity investment but he is ambivalent about what they can invest in. He does not, for example, share Grassi's benign view of the mid-caps. He says: "The Italian economy is strong in the north because of tax evasion. Small companies do not want to go public because it means somebody looking into the balance sheet. Yet with 60% corporate tax they cannot survive otherwise."

If anything, he is more critical of the larger companies. "Most recent scandals - Fiat, Olivetti, Montedison - all these groups have huge funds abroad used for purposes such as paying senior employees," he says.

"From the standpoint of institutional investors this is unacceptable but this is a very negative consequence of having a high level of taxes and a government that doesn't have the courage to face the problems."

Grassi's assessment is milder, yet he is not recommending Italian equity. He adds: "Pension plans could be an important tool in creating an economic democracy, but my advice is to invest overseas."

Twiss, while optimistic about the benefits of pension funds long term, says: "When the law first came, you would often read brokers reports saying 'Buy the market it is going up'. That is not going to happen."

More pointedly, he adds that the stock market, before it can gain the confidence of investors, must prove that its previously erratic behaviour and company neglect of shareholders are coming to an end.

Investors should be confident that Italy is moving in the right direction. Long term it has a chance to develop its stock market and dramatically increase its attractiveness, but those looking for virtuous circles may find these are not so easy to establish when many questions remain unanswered. IPE"