This paper focuses on selected aspects of Italy’s fiscal situation, its origins, and its pervasive economic consequences. The paper analyzes different aspects of regional duality and the unbalanced recovery. The paper highlights that regional duality is a salient feature of the Italian economy. In the south, average incomes and consumption are lower, unemployment rates higher, and the percentage of the population living in poverty larger than in the center and north. The paper also examines fiscal performance of Italy during 1986–95.

Abstract

This paper focuses on selected aspects of Italy’s fiscal situation, its origins, and its pervasive economic consequences. The paper analyzes different aspects of regional duality and the unbalanced recovery. The paper highlights that regional duality is a salient feature of the Italian economy. In the south, average incomes and consumption are lower, unemployment rates higher, and the percentage of the population living in poverty larger than in the center and north. The paper also examines fiscal performance of Italy during 1986–95.

II. Regional Duality and the Unbalanced Recovery 1/

Regional duality is a salient feature of the Italian economy. In the South, average incomes and consumption are lower, unemployment rates higher, and the percentage of the population are living in poverty larger than in the Center and North (Chart 1). This duality became even sharper in the past two years as the Italian economy recovered from the 1992–93 recession. This recovery has differed markedly from previous ones: it has been almost entirely driven by exports, mainly attributable to the revival of foreign demand and the deep depreciation of the lira, and against the backdrop of ongoing fiscal retrenchment. Meanwhile, domestic demand responded more slowly than usual; in particular, consumption remained flaccid well into the expansion. Investment was held back by flagging construction, but due to some special factors the pickup in machinery and equipment investment was unusually brisk.

Chart 1
Chart 1

ITALY Regional Disparities

Citation: IMF Staff Country Reports 1996, 035; 10.5089/9781451819694.002.A002

Sources: Bank of Italy; ISTAT (1995); and SVIMEZ (1992).

These macroeconomic developments have had regionally differentiated effects, due to the structures of the regions’ economies: in particular, the Center-North has benefitted much more from the export boom? as well as from the surge in investment in machinery and equipment. The South, on the other hand, suffered relatively more from the sluggishness of consumption and from cutbacks in government primary spending. This differential regional impact, amplified by the segmentation of factor markets, has widened regional disparities. As a result, in the Center-North unemployment rates had declined to about 7 1/2 percent in October 1995, and labor market pressures were reported for some skill categories; at the same time, unemployment in the South was over 21 percent.

The resulting exacerbation of regional disparity gives several reasons for concern. First, there is the risk that inflationary pressures may emerge long before unemployment in the South has reached acceptable levels--and there is evidence that conditions in the Center-North dominate the national wage formation process. This lends additional weight to the usual concern over an undervalued exchange rate: that the real effective exchange rate may adjust to equilibrium through higher inflation rather than nominal appreciation. A nominal appreciation would have the beneficial effects of rebalancing the composition of demand, alleviating some of the regional imbalances. In contrast, higher price inflation could further exacerbate wage pressures in the North; in the context of renegotiation of wage contracts at the national level, this would likely lead to larger wage increases, possibly leading back into a wage-price-exchange rate spiral.

Another concern with an unbalanced recovery in an already unbalanced economy is that the regionally differentiated effects of macroeconomic conditions may heighten political pressures on economic policymaking, stiffening resistance to fiscal adjustment. However, fiscal adjustment is not the problem, but part of the solution: fiscal measures adequate to enhance confidence would help bring about the exchange rate adjustment needed to alleviate imbalances. More generally, since regional imbalances have been perpetuated by labor market institutions and by government involvement which has created dependence in the South, a central policy implication is the need to rectify these underlying distortions, including through greater wage differentiation and labor mobility.

This chapter will set the stage by examining regional differences in economic structure, and then go on to discuss how the unbalanced economic recovery worsened the regional disparities associated with these structural differences.

1. Structural differences among regions

Regional differences in the Italian economy are striking. The South is relatively poorer and more dependent on government transfers than the Center and North, with unemployment substantially higher and of much longer duration. There are also important differences in economic structures: the South has a more traditional productive base and tends to produce more for local consumption. The North-South cleavage has several aspects: the failure of income levels in the South to converge, interregional differences in economic structure, productivity differentials, segmentation of factor markets, and differences in the structure of household income and in the role of government. Each of these dimensions will be discussed in turn.

Convergence. Economic development over the past 40 years has led to increasing economic integration of Center and North, narrowing differences between the North and Center in income levels, productive structure, international trade links, and, to a lesser extent, labor market conditions. But the South has failed to converge. A recent study by Cosci and Mattesini (1995), for instance, examined evidence on economic convergence. The authors found that, while for Italy as a whole it is possible to find evidence of convergence of incomes to a steady state path, there are significant differences in the paths to which incomes are converging in different regions, and the estimated rate of convergence is faster when Southern provinces are excluded from the estimation sample. In addition, this study shows a substantial decrease in the dispersion in per capita income among the various provinces of the North and (to a lesser extent) Center, but none at all within the South. 1/

Economic structure. Differences in the economic structure of the Center-North and the South are reflected in the composition of final demand in the two regions. The Center-North is export-oriented and the South import-dependent, as reflected in the substantial positive contribution of net exports to demand for goods and services in the North, while the contribution in the South was negative (Chart 2, top panel). A recent study confirmed the specialization of the Center-North in production of exports, and found that exports from that region had systematically out-performed those from the South (Viesti (1995)). The share of investment was similar in the two regions, but the public component was larger in the South. Moreover, much of the machinery and equipment installed in the South was either produced in the North or imported. Demand in the South came much more heavily from household and government consumption.

Chart 2
Chart 2

ITALY Structural Comparison

Citation: IMF Staff Country Reports 1996, 035; 10.5089/9781451819694.002.A002

Source: SVIMEZ(1995).

The regions also differ considerably in the sectoral composition of value added (Chart 2, bottom panel). The share of manufacturing, mainly involving the production of tradable goods, is over twice as large in the Center-North as in the South. The South relies more heavily on production of services, particularly non-market (mainly government) services. Construction was of slightly greater relative importance to the economy of the South in 1994--but this understates its normal share, given that construction in the South has had a large public component which was stalled in recent years by investigations of corruption and criminal involvement. The share of agriculture, although small in both regions, is larger in the South than in the Center-North; given the crop mix in the South and the prevalence of small farms, Southern agriculture was particularly adversely affected by recent reforms in the EU’s Common Agricultural Policy (ISTAT (1995)).

Productivity. Labor productivity in the South is lower than in the Center-North in all sectors, as shown in Chart 3. Of particular interest is manufacturing, where labor in the South is more than 20 percent less productive than in the Center-North. There may be several reasons for productivity gaps, including educational and skill levels, agglomeration economies, infrastructure, capital stock, and social structure.

Chart 3
Chart 3

ITALY Productivity Indices

(ITALY=100)

Citation: IMF Staff Country Reports 1996, 035; 10.5089/9781451819694.002.A002

Sources: Staff calculations based on data from SVIMEZ (1995) and ISTAT (1995).

If labor markets were flexible, these regional differentials in productivity would result in wage differentials that would give incentives for employers to locate in the South and for workers to migrate northward. Instead, national wage bargaining has maintained a uniform level of wages across regions, pricing Southern workers out of work. Southern Italy thus has higher unemployment rates; it also has lower participation rates (Chart 4), partly reflecting a discouraged-worker effect. Italy had the highest regional dispersion of unemployment rates in the OECD and the lowest degree of inter-industry wage differentiation (OECD (1990)). The July 1993 wage agreement provides that, beginning with 1996, wage agreements at the industry level can differentiate based on productivity, but these differentials are likely initially to be rather contained; moreover, they are to pertain to different rates of change of productivity rather than different initial levels.

Chart 4
Chart 4

ITALY Employment and Participation Rate 1/

Citation: IMF Staff Country Reports 1996, 035; 10.5089/9781451819694.002.A002

Source: Bank of Italy1/ Break in all series 1992q2-q4 due to change in methodology for labor force survey.2/ Labor force as percent of entire population in region.

Wage dynamics respond most strongly to labor developments in the Center-North, as confirmed in a study by Bodo and Sestito (1991). This creates the danger that, if a shock results in a further tilting of the interregional balance, a perverse cycle could be initiated, going from economic expansion in the North to higher national wages and, ultimately, higher unemployment in the South. Other work by Sestito (1991) suggests that regional mismatches between labor supply and demand have played an increasing role in unemployment in Italy since the late 1980s. This work adds to concerns that regional bifurcation could impede a reduction in unemployment despite economic growth.

Factor market segmentation. Italy’s labor markets are characterized by a low degree of geographical mobility. This can in part be explained by social and cultural factors. However, the recent situation stands in striking contrast to the period up until the 1960s, when Southern Italians emigrated in large numbers, not only to Northern Italy, but all over the world. Since the cultural factors cannot have intensified since that time, the obvious inference is that economic policies over the past 2-3 decades--including a wide array of subsidies and transfers--have diminished the economic incentives for migration, resulting in a significant degree of segmentation of labor markets between the Center-North and South.

Some degree of regional segmentation is also present in capital markets. To a great extent, this is a legacy of the 1936 banking law, on which the Italian banking system was based up until the 1990 reform. Aside from a few national banks that provided credit to medium-large firms nationwide, most banks were confined to a particular geographical area. This limited banks’ ability to channel funds into productive investments and made Southern banks more vulnerable to credit risks associated with the region’s economy. The 1990 banking law, together with a more liberal approach toward branch expansion by the Bank of Italy, eliminated legal barriers to regional bank expansion. Nevertheless, the South remains serviced to a greater extent by weak banks with poor management capabilities and regionally under-diversified credit exposures.

Structure of income. The differentiation and segmentation of the regions’ economies is reflected in the structure of household income--which in turn influences household demand. Apart from the fact that average household income is about 40 percent higher in the Center-North than the South, its composition is different (Table 1). In particular, transfer payments account for 24 percent of income in the South compared with 21 percent in the Center-North; interest payments account for 18 percent of income in the South as against 22 percent in the Center-North.

Table 1.

Structure of Household Income in 1993

(In thousands of lire)

article image
Source: Bank of Italy (1995).

Impact of government. Inter-regional differences in the structure of household income correspond to differences in the role of government. The regional incidence of government spending and taxation has been the subject of considerable debate, both academic and political. Due to the lack of detailed fiscal accounts, most studies of the regional incidence of fiscal policy and its evolution through time have necessarily relied on the authors’ estimates (using different methodologies) to assign many categories of spending and revenues to particular regions. There have traditionally been two opposite views about the net incidence of taxation on the regional balance of resources (Svimez (1993)); one is that the North pays a disproportionately high level of taxes and effectively finances large transfers to the South; an opposing view is that tax incidence is at least as high in the South as in other regions, if due account is taken of the fact that taxes levied in one region may have their incidence in another as a result of their effects on prices.

Despite these disagreements, there seems to be some consensus that government spending per capita is similar across regions while tax payments are more closely related to the regions’ income levels--consistent with a net redistribution of resources from the North and Center to the South. A study by Padoa-Schioppa (1990) finds important regional differences in the structure of spending: per capita spending on transfers to households is similar in the two regions, with higher personal transfers in the South and higher pension payments in the North. 1/ Public investment spending in the South was also large, some 67 percent of the total in 1990. Transfers to local government were slightly larger to the South on a per capita basis. Other direct spending (which includes, for instance, salaries of civil servants) was much higher in the Center-North on a per capita basis--reflecting, in large part, the fact that Rome is classified in the Center-North. Per capita transfers to enterprises correspond to 3.2 percent of value added in the South, compared with 2.2 percent of value added in the Center-North.

The foregoing discussion of the role of government pertains only to the state sector. Another important element is the state enterprises, especially those owned by state holding companies such as IRI and EFIM, which transferred resources to loss-making companies, including those in the South. During the 1990s, this involvement of state enterprises was scaled back. The 1992 bankruptcy of holding company EFIM forced the sale of its component companies. In the case of IRI, the component parts are being privatized in a more systematic way, in fulfillment of an agreement with the European Commission to reduce the holding company’s debt to a level appropriate for a private company, thus reducing the state aid implicit in the government guarantee of this debt. The need to comply with EU rules on state aid has also had an impact on particular industries: notably the steel industry, concentrated in the South, has been restructured--with the closure of some large steel mills and mass layoffs at others--in accordance with EU agreements as well as in conjunction with the government’s privatization plan. Subsidies to other state-owned industries with an important presence in the South, such as chemicals and shipbuilding, have also been cut in compliance with EU regulations.

2. An unbalanced recovery

The recovery of the Italian economy that started in February 1994 was unusual in its composition. The recovery was export-led to an exceptional extent: exports began to grow considerably before the recovery, dampening the effects of the severe contraction of domestic demand in 1993, and their growth rate has remained well above that of domestic demand throughout the first two years of expansion (Chart 5). The growth of exports reflected the expansion of foreign demand as well gains in market share; export volume increased by a cumulative 21 percent during the first seven quarters of the recovery (Chart 6). Imports grew by a cumulative 24 percent during the same period, with imports of inputs and capital goods experiencing even faster growth.

CHART 5
CHART 5

ITALY Macroeconomic Performance

Citation: IMF Staff Country Reports 1996, 035; 10.5089/9781451819694.002.A002

Sources: IMF, World Economic Outlook; ISTAT; and International Financial Statistics.1/ Period average = 100.
CHART 6
CHART 6

ITALY Trade Performance

Citation: IMF Staff Country Reports 1996, 035; 10.5089/9781451819694.002.A002

Sources: IMF, World Economic Outlook; and Bank of Italy.

The reliance on export expansion and the lack of response from domestic consumption expenditure were exceptional compared with past cyclical experience in Italy. It was not unique in recent European experience, though: in particular, Sweden, whose currency had also depreciated significantly over the period, concomitant with strong fiscal adjustment, witnessed a strong export-led recovery together with weak domestic demand (Chart 7). What is distinctive about the Italian case is the interaction of the unbalanced recovery with existing regional imbalances.

CHART 7
CHART 7

ITALY REER, Exports and Imports, GDP & Houshold Consumption, Selected Countries

Citation: IMF Staff Country Reports 1996, 035; 10.5089/9781451819694.002.A002

Source: ISTAT; World Economic Outlook; and IMF Research Department1/ Period average = 100.

The key reason for the unbalanced nature of the recovery is the weakness of the lira. This in turn can be traced to the lack of confidence in Italy’s political stability and the continuation of fiscal adjustment. These doubts kept the lira unusually weak by historical standards: at recent levels, the real effective exchange rate (based on consumer prices) was some 13 percent below its average level of the past 15 years, and the currency has widely been viewed as undervalued (see Annex). The competitiveness gains associated with this weakness of the lira contributed to the strengthening of exports and the trade balance.

Another key aspect of the unbalanced recovery was related to the behavior of real wages and therefore household incomes. During 1994-95, productivity increased for the usual cyclical reasons and also as a result of restructuring made possible, in part, by more flexible labor regulations, including those governing hiring and firing. At the same time, wages were restrained by the 1992 abolition of automatic indexation (scala mobile) and the July 1993 agreement on the cost of labor that established a system of national wage increases in line with official target inflation. 1/ In the event, actual inflation exceeded the target by a cumulative 3 ½ percent during 1994-95, resulting in compression of real wages. As real wages declined while productivity was rising, the share of profits soared (Chart 8).

CHART 8
CHART 8

ITALY Real Wages, Factor Shares, and Investment

Citation: IMF Staff Country Reports 1996, 035; 10.5089/9781451819694.002.A002

Sources: IMF, World Economic Outlook; and ISTAT.

The decline in real wages, together with continuing high unemployment, implied sluggish growth in household income (Chart 9). Household confidence failed to recover to pre-recession levels--due, in part, to uncertainty over income prospects associated with both high unemployment and the still unresolved fiscal quandary. The weakness of both household income and confidence combined to yield very slow growth in household consumption, which rose only a cumulative 2.8 percent from the beginning of 1994 through the third quarter of 1995. 2/

CHART 9
CHART 9

ITALY Employment, Household Income and Consumption

Citation: IMF Staff Country Reports 1996, 035; 10.5089/9781451819694.002.A002

Source: IMF, World Economic Outlook; and ISTAT.

Investment was slow to recover, but gathered strength in 1995 (Chart 9). There were two factors of particular importance in boosting investment, in addition to the usual accelerator effect of the recovery. The first factor was the strength of retained earnings--a particularly important determinant of investment in Italy, since neither the equity markets nor the banking system has the flexibility to provide adequate funds for investment. Second, the so-called Tremonti law offered tax incentives for investment financed by retained earnings in the form of a tax deduction for 50 percent of the amount by which investment exceeded a five-year moving average of previous levels. These incentives were initially confined to depressed areas, but the latter were defined quite liberally, to include extensive areas in the Center-North. The Tremonti law incentives appear to have had an important influence on the timing of investment.

Although overall investment strengthened during 1994-95, there were important differences in the performance of its components. Construction investment languished, declining by a cumulative 3 percent from the beginning of 1994 through the third quarter of 1995; this reflected a combination of soft real estate markets and the corruption scandals. Construction--especially public works--makes up a larger share of total investment in the South than in the Center-North. In contrast, machinery and equipment investment expanded quite rapidly, by a cumulative 21 percent over the period 1994 through third quarter 1995. The import composition of machinery investment is very high, and a substantial portion of increased investment was reflected in increased imports. Moreover, production of machinery is concentrated in the Center-North, particularly after the retrenchment of the steel and heavy machinery industries in the South. Therefore, the increase in investment did less to increase economic activity in the South than in the Center-North.

An additional feature of recent Italian experience is that the recovery was accompanied by fiscal consolidation. 1/ Unlike previous consolidation efforts, the adjustment of 1994 and 1995 involved a substantial real reduction in primary fiscal expenditure, including cuts in real government investment and consumption expenditure. Given the greater dependence of the South on government spending referred to earlier, fiscal retrenchment had a particularly strong impact on the South’s economy.

The unbalanced nature of the recovery had secondary effects through the financial system. Non-performing loans, which by November 1995 reached slightly above 10 percent of total loans nationwide, were particularly large in the South. This, combined with the competitive pressures that have reduced profitability throughout the banking system, has undermined the capital base of banks located in that region, inhibiting their lending activity. This may, in turn, have contributed to weakening the demand for goods and services in the South. The process of consolidation now under way in the Italian banking system will, in time, result in greater regional diversification, spreading the financial consequences of regionalized economic disturbances more evenly throughout the banking system. During 1990-94, 58 banks in difficulties (accounting for 11 percent of total lending nationwide), predominantly in the South, were acquired by other institutions, furthering this consolidation process. Some institutions based in the South--including two of Italy’s ten largest banks--have also received substantial infusions of funds from the Treasury and/or from other banks; this may dampen the economic consequences for the Southern economy of their difficulties--although perhaps at the same time delaying the long-overdue restructuring of these institutions.

3. Discussion and conclusions

The picture that emerges is the following. Italy’s recovery in 1994-95 was unbalanced because of the weak lira and the exceptionally depressed domestic demand. Consumption was weakened by the slow growth of household incomes and wage policy. Investment was stronger, but much of the investment spending was on machinery and equipment, which have a large imported component. And government spending was suppressed through fiscal consolidation efforts.

This pattern of the recovery was not, in itself, undesirable. It made possible a strong resurgence of economic growth alongside a significant strengthening of the external current account. It reflects, in part, the willingness of the Italian authorities to undertake much-needed fiscal adjustment, together with the wage moderation that helped subdue inflation despite the weakness of the lira. However, the lira’s weakness itself may reflect the markets’ perception that these fiscal and wage policies could unravel.

The reason the unbalanced recovery could create an economic problem is that it exacerbates the already unbalanced regional structure of the Italian economy. The recovery has had a differential impact across regions: exports and machinery and equipment investment, which have boomed, were disproportionately produced in the Center-North, while household consumption, construction, and government services, the components that flagged, are of greater relative importance to the Southern economy. Fiscal developments have also had a differential impact across regions, with adjustment of primary expenditures more than offsetting an increasing interest burden: the higher interest payments were to a disproportionate extent paid to households in the Center-North, while a greater share of primary expenditure had been done in the South. As a result of these differences, employment began to increase in the Center-North during 1995, while in the South it has continued to decline through the present (Chart 4). This unbalanced pattern translates into higher unemployment rates and lower household incomes in the South, thus widening regional disparities.

The unbalanced recovery, given the dominant influence of Northern labor market conditions on national wage bargaining, creates the risk of exacerbating inflationary pressures at an earlier stage of the recovery. This could lead the real exchange rate to adjust through inflation rather than through a nominal appreciation. A wage increase motivated by conditions in the North would also tend to worsen unemployment in the South. These developments could put additional pressure on macroeconomic policy as a result of the conflicting demands to counter inflationary pressures emerging in the North and combat still-high Southern unemployment.

The desirable policy response is two-pronged: first, fiscal consolidation has to reach a critical mass where it generates confidence effects that reverse the decline in the lira, and thus re-balance the recovery between domestic and foreign components. More fundamentally, there is a need for structural measures to alleviate the underlying imbalances between regions, including through greater wage differentiation, a more efficient public administration, and the removal of institutional barriers to labor mobility. These measures are needed to alleviate the disparities among the regions and integrate the South more fully into the national economy.

Table 2.

Regional Distribution of Government Spending

article image
Source: Padoa Schioppa (1990).

Refers to the total amount of spending that can be allocated to regions.

Value added at factor cost, including imputed banking services.

APPENDIX The Exchange Rate of the Italian Lira 1/

At the time of the last consultation, concluded on March 17, 1995, the staff took the view--also widespread in Italy--that the lira was undervalued, posing the risk of a resurgence in inflation (SM/95/32 and SM/95/48). The weakness of the Italian currency was perceived to reflect market uncertainties about the prospects for sustained fiscal adjustment, and expectations--reflected in forward interest rate differentials--that inflation in Italy would remain well above that in other partner countries. Such concerns and the related weakness of the lira persisted in 1995, with a further 3½ percent depreciation of the real effective exchange rate measured in terms of unit labor costs through end-1995, and a 2 percent year-on-year deterioration of the terms of trade by the end of the third quarter. Financial market developments reflected the uncertainty surrounding the political outlook, leading not only to chronic lira weakness but also to high exchange-rate volatility. This persistent weakness and volatility of the lira have thwarted re-entry into the exchange rate mechanism of the European Monetary System, an option contemplated by the Dini government in the early fall of 1995.

The behavior of the Italian currency since early 1995 clearly illustrates the link between the exchange rate and political developments. The lira fell by 13 percent in real effective terms between the beginning of 1995 and end-March, amid political turmoil and uncertainty about Parliamentary approval of the supplementary budget. Since then, the currency has risen substantially, and by late February 1996 stood at around its end-1994 level; this course has been marked by wide fluctuations reflecting changing political events as well as international market conditions.

Chart 10 shows the behavior of different measures of the lira’s real effective exchange rate during the past 15 years. The current exchange rate is some 20 percent below the average of the period. This is not necessarily an indication of exchange rate misalignment--it can be argued that the lira had been overvalued during the latter part of the ERM period, and historical averages do not necessarily reflect long-run equilibrium values. However, there is no apparent reason that the lira might have been so far above its equilibrium value for so much of the period, and there is also no obvious reason that this equilibrium might have changed by such a large amount. The difference in exchange rate behavior is larger with regard to EU partner countries as the lira often tended to rise and fall with the dollar against the deutsche mark: the lira appreciated more strongly against the latter in real effective terms during the 1980s, but this appreciation was unwound during 1992-94, with a sharp further depreciation in early 1995.

CHART 10
CHART 10

ITALY Real Effective Exchange Rates

(Period Average=100)

Citation: IMF Staff Country Reports 1996, 035; 10.5089/9781451819694.002.A002

Sources: IMF, Research Department; International Financial Statistics; Bank of Italy; and ISTAT.

Chart 11 depicts the path of real effective exchange rates, based on unit labor costs, for Italy, Spain, Sweden (upper panel) and the United Kingdom, France and Germany (lower panel). 2/ The path of Italy’s real effective exchange rate over the period 1988-95 has been similar to that of Sweden and Spain, but more extreme, with an initial real appreciation followed by a very sharp depreciation after 1992. The pound sterling’s appreciation and subsequent depreciation were less pronounced. As the chart shows, the lira is well outside the range of its typical experience, as shown by the shaded one-standard-deviation band.

CHART 11
CHART 11

SELECTED COUNTRIES Exchange Rates Based on ULC 1/

(Period average = 100))

Citation: IMF Staff Country Reports 1996, 035; 10.5089/9781451819694.002.A002

Source: IFS.1/ Shaded area denotes one-standard deviation band, calculated as average of standard deviation for each currency around its respective period average level.

The persistently depreciated level of the exchange rate has been reflected in the behavior of trade flows, shown in Chart 12. Exports have continued to grow strongly, with a further gain in market shares; they increased by nearly 40 percent in real terms since 1992. The growth rate of imports accelerated, in large reflecting higher demand for intermediate inputs and capital goods, coming in particular from the export sector. The current account surplus widened to 2½ percentage points of GDP in 1995 (Chart 13); as a result, net external indebtedness was reduced further, to around 5 percent of GDP. Staff projections show a further widening of the current account surplus to around 3½ percent of GDP by the end of the century, as the competitiveness effects of the depreciated real exchange rate are fully reflected in trade flows. It is questionable whether it would be appropriate for Italy to run current account surpluses of this magnitude into the medium term. Estimates of the level of the exchange rate consistent with a current account balance that stabilizes the net foreign asset to GDP ratio suggest that the lira is currently undervalued by around 10 percent. 1/

CHART 12
CHART 12

ITALY Recent Trade Performance

(Year–on–year percentage change)

Citation: IMF Staff Country Reports 1996, 035; 10.5089/9781451819694.002.A002

Source: Bank of Italy.
CHART 13
CHART 13

ITALY Current Account

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 035; 10.5089/9781451819694.002.A002

Sources: Bank of Italy; and IMF, World Economic Outlook.1/ Staff projections.

Notwithstanding the apparent undervaluation of the lira, market indicators such as interest differentials suggest that market participants may be anticipating further depreciation vis-à-vis the deutsche mark and other European currencies (Chart 14). Three-month eurocurrency interest rate differentials vis-à-vis Germany, equivalent to forward exchange rate premia, widened sharply during February/March 1995, and have remained above 6 percent since then. Italy’s long-term forward-rate differentials with respect to Germany are much smaller: at the beginning of February 1996, they were below three hundred basis points at the long (9-year forward) end.

CHART 14
CHART 14

ITALY Forward Rate Differentials and 3–Month Eurolira Differentials

Citation: IMF Staff Country Reports 1996, 035; 10.5089/9781451819694.002.A002

Source: IMF, Research Department.

This market evidence of expected further lira depreciation is not inconsistent with the notion that the lira’s real exchange rate is currently undervalued. It suggests that market participants fear that inflation differentials vis-à-vis partner countries, which widened during 1995 (Chart 15), could remain large and even, in case of continued political uncertainty and resulting policy drift, widen further.

CHART 15
CHART 15

SELECTED COUNTRIES Consumer Price Inflation

(Year–on–year percentage change)

Citation: IMF Staff Country Reports 1996, 035; 10.5089/9781451819694.002.A002

Source: IMF, World Economic Outlook.

References

Chapter II

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  • Associazione per lo Sviluppo dell’Industria nel Mezzogiorno (SVIMEZ) (1995), Rapporto sulla Distribuzione Nord-Sud della Spesa Pubblica, Bologna: Il Mulino.

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  • Banca d’Italia (1995), I Bilanci delle Famiglie Italiane nell’anno 1993, Supplement to the Statistical Bulletin (February).

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  • Bodo, G. and P. Sestito (1991), Le Vie dello Sviluppo, Bologna: Il Mulino.

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  • ISTAT (National Statistical Institute) (1995), The ISTAT Report on the State of the Country - Italy 1994, Rome: ISTAT.

  • OECD (1990), “The Role of Indicators in Structural Surveillance”, Working Paper No. 72.

  • Padoa Schioppa, F. (1990), L’Economia Sotto Tutela, Bologna: Il Mulino.

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  • Viesti, G. (1995), “La Geografia delle Esportazioni Italiane”, Rivista di Politica Economica, Vol. 85 No. 4 (April), pp. 69-97.

1/

Prepared by Timothy Lane and Javier Hamann.

1/

A paper by Barro and Sala-i-Martin, (1991) reported evidence of convergence in the South. However, the work of Cosci and Mattesini (1995) discussed above casts doubt on their results.

1/

Of the pension payments, the North was characterized by a larger number of old-age pensions. In the South, there were disproportionately many recipients of disability pensions--equivalent to 25 percent of the labor force in 1994, as against a (still high) 17.5 percent national average.

1/

The agreement provided for the possibility of some adjustment for productivity and catch-up of lost purchasing power to the extent that actual exceeded programmed inflation. However, such adjustment was to begin only with the 1996 wage bargaining round.

2/

The consumption statistics understate the weakness of Italian households’ consumption, since the national accounts include as consumption the expenditure of tourists--who may have been attracted to a considerable extent by the weakness of the exchange rate.

1/

The specifics are discussed in Chapter III below.

1/

Prepared by Gian Maria Milesi-Ferretti.

2/

The shaded area represents the average standard deviation.

1/

Other methods of calculating fundamental equilibrium exchange rates, relying on alternative judgements with regard to the equilibrium current account path, including an approach based on an assessment of Italy’s savings-investment balance, yield similar estimates.

Italy: Background Economic Issues
Author: International Monetary Fund