Italy: The Euro Zone's Sickest Patient

Giacomo Capogreco moved to Turin from Calabria 17 years ago to take a factory job at Itca, one of the area's many parts suppliers for auto makers Fiat and Ferrari. Now Itca is closing three out of its four Turin-area factories -- and labor leaders fear most of the 59 automobile suppliers in the region are doomed to extinction by Fiat's woes. Half of the suppliers' 15,600 workers have either been fired or furloughed since 2000. "We want a future -- we don't want to watch this area decline to a wasteland," says 37-year-old Capogreco.

That bleak vision is haunting Italy as its industry falters in the face of global competition. First-quarter data released this month reveal that the euro zone's third-largest economy is officially in recession. That news, coupled with Brussels' upward revision of estimates for Italy's budget deficits in the past two years, has stoked fears that the country is in worse condition than previously thought. With autos, textiles, clothing, furniture, and footwear companies increasingly unable to compete with cheap Asian products, a crisis seems to be looming. In the worst-case scenario, the shuttering of Italy's uncompetitive industry could send unemployment soaring and trigger a long recession. "The risk is a European version of the Argentinian crisis," warns Francesco Giavazzi, professor of economics at Boconi University in Milan.

Italy, once an export power in its own right, has become Europe's sickest economy. A sharp recession in a country that contributes 16% of Europe's gross domestic product could shave as much as 0.4% a year from the European Union's output, economists warn. The Organization for Economic Cooperation and Development expects Italy's GDP to contract by 0.6% this year. But what has many really worried is the prospect of a prolonged downturn. Four or five years of recession could lead Italy to abandon the euro and revert to the lira, says Morgan Stanley economist Eric Chaney. That in turn would trigger a default on domestic debt and a currency devaluation of as much as 20%. "It's a very remote possibility, but you can't exclude it," Chaney says. He thinks that could also torpedo the entire monetary union.

In the past, Italy relied on repeated currency devaluations to revive its industries. But with the country locked into the euro, the only alternative is to introduce painful, overdue reforms such as making labor markets more flexible and overhauling the country's weak banking sector. Such measures would help revive investment and spur a shift to more innovative, technology-based products and services.

Even if policymakers launch reforms soon, Italy faces 5 to 10 years of wrenching dislocation. As industry shifts low-cost production offshore and migrates into more competitive sectors, thousands of manufacturing jobs will disappear permanently. "Italian industry needs to adapt," says Finance and Economy Minister Domenico Siniscalco.

The process is already unfolding in Italy's textile and apparel industries. Sistema Moda Italia, a fashion and textiles association, estimates that Chinese textile and apparel imports shot up 128% in the first two months of this year, compared with the same period in 2004. To blunt competition from China and other low-wage countries, Italian companies like apparel giant Benetton Group (BNG ) have begun shifting production abroad. Even fashion houses such as Prada and Giorgio Armani -- known for exquisite Italian workmanship -- are considering making less exclusive items, such as leisure wear and jeans, in China. "We are at a point where we need to make major choices about the structure of our economy," says Paolo Garonna, chief economist of the Italian Employers Association.

Amid the gloom, a few companies stand out as a beacon. Exports make up 80% of revenues at Technogym, a $285 million maker of high-tech fitness equipment that grew 14% percent last year. "If you have innovative products, the [strong] euro and the Asians are not a problem," says Nerio Alessandri, Technogym's founder and president. Italy's uncompetitive companies must either "change or die," he adds. Maybe that message will finally sink in as the economic indicators blink red.

By Gail Edmondson in Frankfurt, with Maureen Kline in Milan

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