Can Berlusconi renew the nation?

To his horror, Italian entrepreneur Savino Rizzio discovered last year that Chinese rivals were flooding the global market with counterfeits of his brass plumbing valves--at prices 50% less than what he charged. Gazing at the well-made Chinese fake on his desk, VIR founder and President Rizzio concedes that the quality of the counterfeits has improved rapidly. And it's impossible for Italy's valve industry to compete with Chinese labor costs, which amount to $100 a month per worker, compared with $2,500 a month in Italy. Facing a steady decline in orders, Rizzio must rapidly develop sophisticated products that are more difficult to knock off, or move production totally out of Italy. "We are really facing hard competition from emerging countries. And we've lost our flexibility," he laments.

Rizzio and hundreds of thousands of other anxious entrepreneurs voted on May 13 for media baron Silvio Berlusconi in the hope the new Prime Minister will carry out his promise to reverse Italy's declining competitiveness. Across the long-prosperous northern industrial zone, from the foothills of the Alps to the flat plains of the Veneto, Italy's vaunted small and midsize exporters are being hammered by rivals from emerging markets that are making the same products for cut-rate prices. The threat is doubly potent since at home, these Italian businesses are being throttled by high labor costs, overregulation, an antiquated infrastructure, and an inept public administration.

Of course, Italian businesses have always suffered from the effects of a stifling bureaucracy, overregulation, high taxes, and venal public officials. But the country's entrepreneurs survived and even thrived by remaining small and nimble. In the northern industrial districts, manufacturers of the same products, such as textiles or shoes, clustered together like virtual keiretsu, purchasing supplies jointly, for example, but skirting inflexible labor laws by employing fewer than 15 workers each. With next to no research spending, they constantly tweaked production processes to keep the number of workers low. They bridged the gaps in skills or education with extensive in-house training. And many simply evaded an oppressive public administration, crushing payroll levies, and high taxes by operating underground--fueling a black market that makes up an estimated 28% of gross national product. The result has been an army of small and midsize companies that boast global strength in fashion, industrial design, machinery, and other niche sectors. Their companies, like VIR, aren't household names, but they have delivered prosperity to Italy for decades, however chaotic the country has seemed.

But now, Italy's stalwart exporters face a series of obstacles that is proving insurmountable for many of them. "We are caught in the middle" of two new forces, says valvemaker Rizzio. Cheap Asian goods of steadily improving quality are flooding global markets, posing competition Italians have never experienced. At the same time, the rest of Europe is leaping ahead into the digital economy, with companies producing some of the most sophisticated software and telecom products in the world. And Italy? Its businesses, by and large, simply lack the size and research muscle to go against bigger competitors in these technology-driven industries.

FALLEN IDOLS. Meanwhile, in Italy, taxes, labor costs, and labor-market regulation have become even more burdensome and restrictive over the past 15 years. Aging roads and railroads are obstacles to growth. Half-hearted liberalization has left markets in the grip of former monopolies. Worst of all is a serious deterioration in the quality of education at every level, the power of courts to function properly, and the ability of hospitals to deliver decent health care.

The price paid for inaction now will be nothing less than the country's economic vitality. Small and midsize companies such as VIR produce more than 80% of Italy's GDP. A weak euro has helped pump exports for the past two years, and forecasts for GDP growth this year are 2.3%. But the fundamental erosion continues apace. In those two years, for example, some 200 textile makers and suppliers around Lake Como have gone out of business, victims of global competition.

At the same time, Italy's few large industrial players have ceded ground dramatically or sold out to foreign interests. Fiat, which once dominated European small-car production, is now virtually a unit of General Motors Corp. Olivetti, once Europe's largest personal-computer maker, is a mere holding company for Telecom Italia. Without large industry to buffer the assaults of outside forces, Italy's economy is all the more vulnerable.

A lost decade may have already cost Italy--still the world's fifth-richest economy--its chance to bid for a stake in high-growth technology industries. Graduates and specialists with top information-technology or scientific skills are scarce, family-owned companies have little access to the capital they need for foreign investment or research, and technology transfer between universities and industry is nearly nonexistent. "Italy has waited until the last possible moment to change. It now has 24 to 36 months maximum to achieve a new positive direction" or completely lose its competitiveness, says Roberto Crapelli, managing director of A.T. Kearney's Mediterranean unit.

It will be hard for tycoon Berlusconi to reverse this decline anytime soon--especially since the fragmented and unstable political system is part of the problem, not the solution. Berlusconi has promised sweeping tax cuts, investment in infrastructure, an end to red tape, and reform of the schools and courts. But his agenda will face resistance from union leaders, bureaucrats, and most likely, his own coalition members.

Previous governments began the uphill struggle of remaking Italy a decade ago, when most state-owned industry was bankrupt, the national debt was out of control, and political parties were imploding in the wake of investigations that revealed massive corruption. Prime Minister Giuliano Amato drastically cut public spending in 1992, helping Italy make the grade as a founding member of monetary union. Later governments carried out large-scale privatizations and market reforms.

But the convalescence was far from complete. In 1998, Italy's reform effort stalled again, exacerbating the country's competitiveness gap with rivals. As a result, its share of global exports is steadily shrinking. Italy ranks last in Europe in foreign direct investment. Economic growth underperforms its neighbors, while unemployment remains among the highest in the EU, at 10.5%. Without faster change, Italy is bound to fall further behind, becoming a potential drag on the already-depressed euro while former laggards such as Spain, Ireland, and Finland surge ahead. "Italy is starting from a third-world situation," says Eric Chaney, chief European economist for Morgan Stanley Dean Witter & Co.

That's a bitter pill for Italians, who in the mid-1990s believed the promises of politicians that Italy could become the California of Europe--an entrepreneurial economy, attracting talent and capital from the whole world. Instead, many midsize businesses, family-owned and lacking capital, have already saturated their small market niches globally and must move into more sophisticated products to grow. Others are racing to shift production of low-tech goods to eastern Europe and Asia. Geox, an Italian shoemaker with a patent on soles featuring a breathable lining, has outsourced manufacturing to Romania, Hungary, and other cheap locales. With $190 million in sales, the company employs 6,000 directly and indirectly in low-wage markets and only 300 designers and engineers at headquarters in Montebelluna, near Venice. "Competition [in Italy] will be harder and harder," says Geox boss Mario Moretti Polegato.

Yet even while traditional industry hollows itself out, Italy seems incapable of producing a new generation of startup companies in cutting-edge industries. Rules governing startups remain hostile, and labor-market rigidities stifle investment. Stock-option regulations have changed four times since the late 1990s. "There has been not a single action to make it easier to develop startups in Italy," says Michele Appendino, co-founder and managing director of Net Partners, a venture capital company with offices in Brussels, London, and Milan.

Even many Italians with capital tend to invest outside Italy. "We'd rather invest in Switzerland. Unfortunately, there is not enough innovation in Italy," says Gian Lucca Braggiotti, founding partner at Milan-based seed fund MyQube. The fund has made only 5 of its 14 investments in Italy and is expanding an office in Geneva to be close to the researchers at CERN, the birthplace of the Worldwide Web. "If you really want to start a venture-capital fund in Italy, it's a mess," agrees Appendino, who has made 20 investments in Europe but only 4 in his homeland.

Many Italian tech grads and researchers flee to more hospitable countries. Project scientist Francesco Paresce bolted in 1995 for the European Southern Observatory near Munich. He was fed up with the lack of professionalism and accountability in Italian research. The reality he left behind: Italy spends only 1% of GDP on research, less than half the level spent by other industrial countries. It produces the lowest number of patents in Europe, pays professors and researchers dismally, and fails to reward performance. "Practically nothing is based on real and measurable merit. It's who you know, not what you know, that counts," says 61-year-old Paresce.

Italy's schools, meanwhile, are turning out few graduates with 21st century skills. In a survey by the International Institute for Management Development in Lausanne, Italy ranked 45th out of 49 countries in delivering the kind of education that "meets the needs of a competitive economy." From elementary school through college, computers are often scarce in many classrooms. "The state of Italian universities is hopeless. You can't teach an advanced finance course the way you want because no one knows how to use a computer," says a Milan professor. He advised his nephew to "get out of the country and stay out."

LOTS OF DROPOUTS. Many students just give up. "The resources I had in England amazed me," says a former architecture student at the University of Naples who quit after two years to complete her education at the University of London. She was fed up with the complicated scheduling, overcrowded lecture halls, nonexistent technical support, and professors who "simply didn't show up for class." Such conditions contribute to a dropout rate of 65%, the highest in Europe.

Italian companies are hard-pressed to compensate for the scarcity of workers with top engineering degrees and other computer, telecom, or technical skills. Appendino's Net Partners, for example, has difficulty recruiting good accountants, Web masters, or networking managers in Italy. These glaring weaknesses, combined with sagging research efforts, could well exclude Italy from next-generation growth. "There is no question that technology drives growth. If Italy misses the next wave, it will stagnate or fall back over the next 10 years," says Enzo Torresi, a Catania-born serial entrepreneur and venture capitalist who has spent his career in Silicon Valley.

Torresi, who left Italy to head Olivetti's advanced-research lab in Cupertino, Calif., for years imported Italy's brightest engineers to the U.S. Of the 60 he hired, 50 remained in the U.S. to start companies. Although previous governments have asked Torresi what it would take to lure him back to Italy, he says politicians still fail to comprehend what's needed: "Resources are spread so thin that they are ineffective. This country needs a chief scientist."

In an effort to make up for the glaring research deficit, Italy's few remaining large companies are starting their own initiatives. Cable- and tiremaker Pirelli recently funded a new $30 million research-and-development foundation to support worthy projects by independent scientists. It also boosted in-house research by 68%, pumping $135 million into advanced research in photonics, fiber optics, and superconductivity.

The slow pace of liberalization has helped stunt Italy's chances in new technology and related services. Delays in deregulating the country's telecommunications market, for example, have limited the ability of new players to compete on cost. Netscaliber, a Milan Internet service provider, has given up on offering broadband services because of a lack of clear rules for entering the market. "Italy is taking substantially longer than other countries to open up its infrastructure to new players," says Netscaliber CEO Francesco Caio.

To keep pace with Italy's wealthy neighbors, Berlusconi will have to devise urgent shortcuts to get capital pumping into new technologies--including boosting foreign investment. "The life span of a product is becoming shorter and shorter, but we don't have the technical possibility to improve the product. There are not enough resources to reinvest," says Franco Platini, export manager for $65 million Zucchetti Rubinetteria, Italy's second-largest maker of water taps, which is also feeling heat from Chinese competitors.

Platini and others insist that Italy Inc. needs more effective state spending on R&D and tax incentives to help increase corporate investment in research. Donatella Ratti, president of Como-based Ratti, a maker of designer fabrics and ties with $136 million in sales, is battling to revive revenue growth by developing two new high-quality fabric lines. "If I survive, it will be by inventing new designs and new fabrics," says Ratti, who would like to triple his current R&D spending to as much as 10% of sales. "We need a new law on research and development."

A new government that can cut the chains weighing down the country's entrepreneurs will have a chance to reverse Italy's decline. "There is entrepreneurial capacity to overcome the gap," says Marco Tronchetti Provera, chairman and chief executive of Pirelli. "We make major changes when our back is to the wall, and we really perceive risk."

The risk is real. If Berlusconi fails to deliver, the cost to Italy will be a generation of lost wealth.

By Gail Edmondson in Valduggia, Kate Carlisle in Forli, and Sheila Pierce in Rome

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