Italy: Staff Report for the 2002 Article IV Consultation

This 2002 Article IV Consultation highlights that the economic slowdown in Italy in 2001 has been followed by only a modest resumption of growth in the first half of 2002. As weaker external demand spilled over into domestic demand, economic growth stagnated in the last three quarters of 2001. GDP growth turned marginally positive in the first half of 2002, although final domestic demand remained weak, as did industrial production, notwithstanding a rebound in business confidence from its 2001 trough. Equity prices have fallen by more than 20 percent from end-2001 to mid-October 2002.


This 2002 Article IV Consultation highlights that the economic slowdown in Italy in 2001 has been followed by only a modest resumption of growth in the first half of 2002. As weaker external demand spilled over into domestic demand, economic growth stagnated in the last three quarters of 2001. GDP growth turned marginally positive in the first half of 2002, although final domestic demand remained weak, as did industrial production, notwithstanding a rebound in business confidence from its 2001 trough. Equity prices have fallen by more than 20 percent from end-2001 to mid-October 2002.

I. Key Issues

1. Italy faces two key economic challenges:

Fiscal consolidation: Italy’s public debt ratio, at 110 percent of GDP, is the highest in the EU, the deficit remains well above the Stability and Growth Pact’s (SGP) medium-term requirements, and aging-related spending (pensions and health care) will rise substantially over time.

Raising employment: though rising since the late 1990s, Italy’s employment rate remains the lowest among OECD countries—a critical factor behind Italy’s relatively low per capita income.

2. The government in power since June 2001 has formulated an ambitious program to address these challenges. The program focused on labor market reform and a retrenchment of the economic role of the state, including through further fiscal consolidation, tax cuts, and privatization—areas that have been at the center of previous Fund advice (Box 1). But progress on this difficult agenda has so far been limited, especially on fiscal consolidation and public expenditure reform.

II. Report on the Discussions

A. Short-Term Outlook

3. As elsewhere in the EU, the economic slowdown of 2001 has been followed by only a modest rekindling of growth:

Policy Recommendations and Implementation

Since Italy’s entry into the euro area, the Fund’s advice has focused on reducing the high public debt ratio through cutting primary expenditure (in relation to GDP); reforming the pension system, in anticipation of the impending demographic shock; reducing the tax burden, as well as structural rigidities in labor and product markets, so as to boost employment and growth.

Over this period, the pace of fiscal consolidation and of structural reform has fallen short of Fund advice, but good progress has been made on a number of fronts. Although the debt ratio has declined somewhat, fiscal consolidation has stalled, with primary spending rising (as a share of potential GDP) and the cyclically-adjusted fiscal deficit (net of asset sales) remaining above its level in 1999. After major reform steps earlier in the 1990s, no significant further savings were secured with respect to aging-related expenditures; and public sector employment reductions have also proven elusive. Limited progress was made in lowering some marginal tax rates in recent years, including on capital income.

More significant progress has been made on structural reforms in the labor and product markets, but Directors have noted ample scope for further steps. In the labor market, some important rigidities have been removed—especially through a relaxation of constraints on temporary and part-time jobs; but regional wage differentiation has not been secured, despite very large regional unemployment disparities. Significant progress has been made on privatization (notwithstanding a pause in 2001) and in the liberalization of some product markets. In the financial sector, in 2001 the Fund supported the authorities’ call to reverse the trend decline in banks’ capital ratios—and a turnaround appears to have started in late 2001.

• After a decade of growth below the euro-area average, Italy’s growth slowed in 2001 along with the euro area, with GDP rising by 1¾ percent (Figure 1; and Table 1). As weaker external demand spilled into domestic activity the economy stagnated during the last three quarters of 2001, notwithstanding a fiscal relaxation (Table 2). Slowing exports reflected foremost weak world demand; price and cost competitiveness remained broadly stable in the two years prior to the euro’s recent appreciation, with the external current account in broad balance (Figures 23).

Figure 1.
Figure 1.

Italy: International Comparisons of Macro economic Performance, 1997-2002

Citation: IMF Staff Country Reports 2002, 230; 10.5089/9781451819748.002.A001

Source: IMF, World Economic Outlook (October 2002, forthcoming); OECD Labor Market Statistics; and Fund staff estimates for 2002.
Figure 2.
Figure 2.

Italy: Effective Exchange Rates, Selected Interest Rates, and Monetary Conditions Index, 1997:1-2002:8

Citation: IMF Staff Country Reports 2002, 230; 10.5089/9781451819748.002.A001

Sources: IMF, International Financial Statistics; Bank of Italy, Bloomberg; and Fund staff calculations.1/ The index is defined as a weighted average of the real short-trem interest rate and the real effective exchange rate, using WEO weights.
Figure 3.
Figure 3.

Italy: External Performance, 1997-2002

Citation: IMF Staff Country Reports 2002, 230; 10.5089/9781451819748.002.A001

Sources: Bank of Italy; ISTAT; and IMF, World Economic Outlook.1/ As measured by real growth of exports of goods and nonfactor services less growth of import demand in partner countries.2/ Fund staff estimates for 2002.
Table 1.

Italy: Selected Economic Indicators, 1997-2003

(Percentage changes, except as otherwise indicated)

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Sources: Data provided by the Italian authorities; and Fund staff estimates and projections.

Staff estimates and projections, unless otherwise indicated.

Volumes and unit values are customs basis; trade balance and current account are balance of payments basis.

Based on unit labor costs.

For 2000, including UMTS receipts of 1.2 percent of GDP, for 2001, 2002, and 2003 including asset sales of 0.2, 0.8, and 0.7 percent of GDP, respectively, as a negative entry under capital expenditure; however, these receipts are removed for the purpose of calculating the structural balance. The fiscal balance projections for 2003 reflect the authorities’ targets as presented in the 2003-06 DPEF, adjusted for staff’s macroeconomic scenario.

End-of-period data; data for 2002 refer to July; data break in 1998, and 2002.

End-of-period data; data for 2002 refer to March; data break in 1998.

End-of-period data; data for 2002 refer to July.

Period average; data for 2002 are available up to July.

Table 2.

Italy: General Government Accounts, 1997–2002

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Sources: ISTAT; Ministry of Economy and Finance, Relazione Trimestrale di Cassa (April 2002) and Documento di Programmazione Economica e Finanziaria 2003-06 (July 2002); and Fund staff calculations.

Authorities’ revised budget estimate in the Relazione Trimestrale di Cassa (April 2002). Components (but not the overall balance) differ from the Stability Program targets shown in other tables.

Authorities’ estimate in the Documento di Programmazione Economica e Finanziaria 2003-06 (July 2002). Estimates of the structural balance are based on the authorities’ output gap and cyclical adjustment method. In mid September, the authorities revised the 2002 deficit estimate from 1.1 percent to close to 2 percent of GDP. The revenue and expenditure details for this revised estimate are not yet available (see forthcoming supplement to this report).

Selected Economic Indicators, 2001-03

(Real growth rates, in percent, unless otherwise noted)

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Sources: ISTAT; and Fund staff estimates and projections.

In percent of potential GDP.

• GDP growth turned marginally positive in the first half of 2002 (0.7 percent, annualized)—although final domestic demand (notably for consumer durables and investment) remained weak, as did industrial production, notwithstanding a rebound in business confidence from its 2001 trough.



(Index, 1998Q1=100)

Citation: IMF Staff Country Reports 2002, 230; 10.5089/9781451819748.002.A001

4. The authorities conceded that the marked growth acceleration envisaged in the 2002 budget was no longer feasible—and they and staff expect now an only moderate rebound in 2002/03. In mid-September, the government revised further downward its growth projections and, at ½ percent for 2002 and 2¼ percent for 2003, these are now in line with staff’s (and similar to the latest Consensus Forecasts).1 They reflect the persistent weakness in leading indicators of economic activity (including electricity consumption) over the summer, and additional declines in consumer confidence. Moreover, export markets did not recover as earlier envisaged, and equity prices have fallen some 27 percent from end-2001 to late September 2002 (following a 25 percent drop during 2001), adding to sizable emerging market losses (retail losses on Argentinean bonds alone were about 1 percent of GDP).



Citation: IMF Staff Country Reports 2002, 230; 10.5089/9781451819748.002.A001




Citation: IMF Staff Country Reports 2002, 230; 10.5089/9781451819748.002.A001

5. While some rebound of economic growth remains the most likely scenario, the outlook is subject to sizable downside risks. Staff agreed that several factors were likely to underpin stronger growth in the period ahead, including supportive monetary conditions and tax incentives for investment (set to expire at end-2002). At the same time, downside risks have intensified, concerning the robustness of the projected recovery in external activity, including in other major European countries; additional spillovers from international equity markets—though the demand impact should be less than in most industrial countries, given Italy’s lower market capitalization; and the euro’s potential to appreciate further. As to domestic risks, the investment response to temporary tax incentives in 2002 remains especially uncertain, also in light of weakening business sentiment over the summer. The authorities noted also upside risks, relating to the supply impact of fiscal reform, and to prospects for employment and monetary policy. While employment growth decelerated to less than ½ percent in the third quarter of 2002 (quarter-on-quarter, annualized), the authorities saw their labor market reforms as possibly supporting faster employment growth than staff. Moreover, a euro appreciation would reduce inflationary pressures and could delay monetary tightening.

6. Inflation is still somewhat above the EU average (Figure 4). With steady, albeit moderate, wage growth, and cyclically declining productivity, unit labor costs have accelerated, contributing to underlying inflation above 2½ percent since late 2001. Key labor market contracts are expiring in the fall, and the authorities agreed that continued wage moderation was critical to lower inflation and sustain employment growth. After the mission, the authorities indicated that “programmed inflation” (the inflation rate used as a reference for wage discussions in both the private and public sectors) would be 1½ percent in 2003. While this target is somewhat below the staff’s projections on current policies 1¾ percent), its achievement would be facilitated not only by wage moderation but also by increased competition in sheltered sectors (Section D). However, to help contain inflation, in late August the authorities froze electricity, gas, water, and postal services tariffs for three months.

Figure 4.
Figure 4.

Italy: Indicators of Inflation, 1997:1-2002:08

(In percent)

Citation: IMF Staff Country Reports 2002, 230; 10.5089/9781451819748.002.A001

Sources: Bank of Italy; ISTAT; and EUROSTAT.1/ Excluding energy, and seasonal food.2/ Data for 1998, which suggest a decline of 1.5 percent in unit labor costs, reflect the removal of various contributions in the context of the introduction of IRAP. If the portion of IRAP revenues attributable to labor is added to wages, labor costs effectively borne by firms increased 2.3 percent in 1998.

B. Fiscal Challenges

7. Discussions on fiscal issues focused on three aspects: (i) the appropriate medium-term fiscal balances and the speed of fiscal adjustment; (ii) tax and expenditure reform; and (iii) fiscal transparency. The need to proceed with fiscal consolidation was not in dispute—but staff regretted the lack of progress so far, including in 2002, and called for more ambitious medium-term targets, absent further aging-related spending reform. Within the context of their overall strategy, the authorities stressed the pivotal role of tax reductions, starting in 2003—an area where staff cautioned against moving ahead before durable expenditure reductions had been secured.

Fiscal policy: medium-term targets

8. The authorities considered broad budget balance an appropriate medium-term objective, gradually reducing the high public debt They concurred that fiscal consolidation was far from complete: the public debt ratio exceeded those in other EU countries, and pension expenditures (in relation to GDP) were among the highest in the OECD, even ahead of the most adverse impact of population aging. In the authorities view, these constraints were adequately addressed by achieving medium-term budget balance (and some entitlement reforms were also under consideration; see below). They noted that the public debt-to-GDP ratio would gradually decline under their program, reaching 94 percent by 2006 (from almost 110 percent at present), with considerable further declines in subsequent years.

9. Staff argued, however, for more ambitious medium-term balance targets—absent further substantial reforms of aging-related spending—reflecting a stronger weighing of concerns related to Italy’s high public debt and pending demographic shock. Underlying these concerns was the view that government debt should act as an intertemporal buffer, rising in relatively “bad” times but falling in “good” times (or, in the case of a high-debt country, falling faster in good times than in bad times). This principle argued against entering the “bad” period of rapid population aging with the debt ratio still very high by international comparisons. Maintaining a balanced budget after 2004 would, in the staff’s view, not be sufficient to meet these requirements: the public debt ratio would still be above 75 percent early in the next decade (assuming potential growth of 2 percent, and privatization receipts of some 5 percent of GDP over the next five years, the ambitious government target).2 This is when the most adverse fiscal impact of population aging would set in: notwithstanding earlier reforms—which would limit pension spending increases to below those expected for most industrial countries—staff projected aging-related outlays to increase by some 3½ percentage points of GDP during 2011-30.3 The discussions also covered concerns related to the Stability and Growth Pact’s (SGP) requirement that the debt ratio had to fall at a sufficient pace if it exceeded 60 percent. Under the authorities’ public debt and deficit scenario, the obligation to continue to lower the debt ratio could force a substantial rise in taxation from an already high level, once the aging-related spending pressures set in.

10. Against this background, discussions focused on possible strategies to address the demographic shock: securing sizable fiscal surpluses, or further reforming aging-related spending. Staff noted that relying entirely on large surpluses would require a major fiscal effort: budget surpluses would have to average about 1½ percent of GDP during this decade, to bring the debt ratio to below 60 percent (for further details on alternative scenarios, see last year’s Country Report No. 01/207; the Annex covers standard public debt sustainability issues). Achieving such surpluses would be a daunting task, particularly if, at the same time, the government’s ambitious tax-reduction agenda was to be implemented. The need for large surpluses could be alleviated, however, by substantial further progress on entitlement reform. The room in this area remained considerable, as illustrated by Italy’s low effective retirement age and its high replacement rate. In any case, in the staff’s view, it was important not to procrastinate and to aim at sizable medium-term surpluses until further aging-related spending reforms had been secured. The authorities concurred that containing aging-related spending was of importance: indeed, it would be difficult to raise sizable surpluses without containing these expenditures. They thought, however, that the need for sizable surpluses could be reevaluated at a later stage, focusing first on balancing the budget over the medium term. They also counted on some entitlement reforms, introducing moderate—and in the staff’s view insufficiently ambitious—incentives to encourage people to retire later.4

Fiscal targets: recent developments and the speed of Fiscal adjustment

11. Progress toward medium-term budget balance has so far proved elusive. In 2001, the SGP-relevant deficit widened to 2¼ percent of GDP, well above target (see text table), reflecting not only weaker-than-anticipated growth, but also overly optimistic revenue projections by the previous government and insufficient progress in containing spending (including on health care and wages). Developments in 2002 are clouded by lack of direct data on the SGP-deficit. But various indicators including the sizable government borrowing requirement (fabbisogno), suggest that the deficit will be around 2 percent of GDP—a view broadly shared by the authorities in revised estimates presented in mid-September. The substantial overruns vis-à-vis the original target of ½ percent of GDP (and the 1.1 percent in the July DPEF) reflect revenue shortfalls (only partly due to cyclical developments) and some primary expenditure overruns. Moreover, the deficit estimate for 2002 includes sizable—and still unrealized—one-off revenues from asset sales (¾ percent of GDP).5 The cyclically-adjusted deficit net of asset sales would be around 1¾ percent of GDP—essentially unchanged from 2001, and well above the level at the outset of monetary union in 1999. This lack of progress reflects difficulties in containing primary spending—which indeed has risen in relation to GDP (see text figure)—and risks interrupting in 2002 the trend decline in the public debt-to-GDP ratio (Table 1).6

General Government Balance: Outcome and Staff Projections, 1999 02

(In percent of GDP)

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In percent of potential GDP.


PRIMARY SPENDING, 1990-2002 1/

(In percent of potential GDP)

Citation: IMF Staff Country Reports 2002, 230; 10.5089/9781451819748.002.A001

1/ Primary expenditure is calculated net of asset sales. Data for 2002 are staff estimates.

12. At the time of the mission, the authorities planned to balance the budget in 2003—a view supported by staff. This implied a cyclically-adjusted deficit net of asset sales of ¼ percent of GDP (given the staff’s GDP projections). The required effort with respect to 2001 was sizable—a cumulative 1½ percentage points of GDP over 2002-03. But this effort was seen as consistent with cyclical considerations, given the expected pick up in output. And, after the lack of progress during the past few years in approaching the medium-term targets, further delays in fiscal consolidation were seen as inappropriate. Moreover, a stronger fiscal effort early in the legislature was justified by political economy considerations. Staff also argued that the adjustment should have started already in the second half of 2002, limiting the slippage from this year’s target and avoiding an abrupt squeeze next year.

13. Following the mission, however, the authorities opted for a slower pace of fiscal consolidation. The July DPEF revised the 2003 deficit target to ¾ percent of GDP, against the original balanced budget objective (see Table 3). In discussions following the publication of these new targets, the authorities explained that the revision reflected the more uncertain cyclical outlook: balancing the 2003 budget could have jeopardized the recovery. Indeed, with the further downward revision of growth made in mid-September, the authorities’ 2003 deficit target may be further revised (a supplement to this report will provide information on the 2003 budget, to be finalized by end-September). Staff conceded that balancing the budget in 2003 was no longer appropriate—in view of the large fiscal slippage expected for 2002, which had not been reined-in as argued at the time of the mission, and of weaker growth. With no progress on fiscal consolidation now likely in 2002, this argued for shifting the structural adjustment of 1½ percentage point of GDP, previously envisaged for 2002-03, to 2003-04. Equally spacing the improvement called for reducing the cyclically-adjusted deficit by ¾ percent of GDP in 2003. Measures in the 2003 budget would not only have to cover the structural improvement in the deficit, but also a planed reduction of the tax pressure, targeted in the DPEF at ½ percent of GDP with respect to 2002.

Table 3.

Italy’s Stability Program, 2001–05 and Medium-Term Program, 2003-06

(In percent of GDP, except as otherwise indicated)

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Sources: Ministry of Economy and Finance, Italy’s Stability Program (December 2001), and Documento di Programmazione Economica e Finanziaria 2003-06 (July 2002); and Fund staff projections.

Financing tax cuts while proceeding with fiscal consolidation

14. Reducing the tax burden, while proceeding with fiscal consolidation, is a central element of the government’s reform agenda. The tax reform aims at lowering the tax burden and simplifying the tax system (Box 2). Tax levels remain comparatively high in Italy and, provided sufficient expenditure savings are secured, staff supported the intention to reduce them over time to complement other employment-enhancing policies. The reform is to be implemented gradually, starting in 2003—and while its broad goals have been decided, many important aspects still remain to be determined.

Tax Reform

The government’s tax reform focuses on four areas (see Chapter IV of the Selected Issues Paper):

Personal income tax: The number of tax brackets will be reduced from six to two, with the lowest marginal rate to decline from 23 percent to 18 percent, and the highest from 44 percent to 33 percent. The authorities also intend to replace the extensive range of tax credits with income-related allowances-—but concurred that this would achieve little if the latter merely replicated the former.

Corporate tax: The average tax rate is expected to stay roughly constant, in spite of a number of changes including: (i) the abolition of the “Dual Income Tax”—under which reduced rates applied on imputed returns to equity; (ii) changes in the tax treatment of dividends; (iii) provisions for the consolidated tax treatment of company groups; and (iv) cuts in the statutory rate from 36 percent to 33 percent. The new system will reintroduce a bias toward debt financing, but, the authorities noted, will be closely aligned with regulations in several other EU countries.

Capital income tax: A single flat rate of 12½ percent will apply, with the previous, innovative system for the taxation of capital gains removed. Staff pointed to tax arbitrage possibilities created by the wide gap between tax rates on corporations and financial incomes—a feature already present, but amplified by the reform—and the authorities were reviewing ways for more closely aligning these rates.

Regional tax on value added (IRAP): IRAP, the main source of finance for the regions, will be phased out. Alternative regional funding sources have still to be identified.

The implementation of the reform will start in 2003, with tax reductions amounting to ½ percent of GDP—mostly consisting of personal income tax cuts for lower-income individuals, as well as a 2 percentage point reduction in the corporate income tax and the exclusion of some labor costs from the IRAP tax base. Other features of the tax reform remain to be decided, including the amount and structure of personal income tax deductions and the basic tax exemption.

15. While supporting the goal of lowering the tax burden, staff noted that the plans for lowering spending had not yet been spelled out in equal detail, and that, in their absence, spending was increasing. The July 2001 DPEF envisaged a decline of public spending of some 7 percentage points of GDP during 2002-06, the bulk of which would consist of cuts in primary spending. A later update to the DPEF postponed the beginning of the spending cuts to 2003, but still envisaged a fall in total spending by some one percentage point of GDP per year during 2003-06. Against these targets, primary spending is now projected to rise significantly in 2002 (see above), primarily reflecting increased spending for health and lack of progress in containing other spending items, such as public wages, following wage increases well above inflation granted in 2001 to part of the public sector. Moreover, the July 2002 DPEF was not very specific on expenditure reform plans, did not specify a target for the reduction in public spending for the general government over the medium term, and envisaged only a modest decline in primary spending of the central government in 2003 (0.3 percent of GDP).

16. The authorities acknowledged that more needed to be done and were taking steps to proceed more speedily. They noted that expenditure pressures in 2002 partly reflected decisions taken by the previous government, such as the cut in co-payment for pharmaceuticals. Others reflected difficulties in ensuring fiscal discipline at subnational levels. For example, the 2001 DPEF’s goal of cutting public employment by 1 percent per annum was undermined by hiring at the subnational level (as well as other exceptions). Moreover, they acknowledged that the agreements with regions on health expenditure (the latest one in August 2001) had yielded mixed results.7 Looking ahead, procedures were being put in place to monitor regional health expenditure monthly, and, during the summer, the government took some steps to contain health spending (amounting, however, to less than 0.1 percent of GDP). In September, the government also strengthened the Treasury’s powers to regulate public spending. More generally, in June 2002, parliament adopted a resolution calling for clearer rules and better information to ensure the consistency between fiscal discipline and devolution.8 As to plans for the 2003 budget, the authorities expected substantial expenditure savings by extending the centralization and standardization for the procurement of goods and services. The program had already yielded significant savings in 2001 for the few expenditure categories to which it had been applied. Staff welcomed this step, but noted that goods and services represented only a small share of total spending, and that more broad-based measures were needed, including strict discipline in the forthcoming public wage negotiations, and more determination in pursuing the goal, set forth in the 2001 DPEF, of reducing enterprise subsidies and containing social spending.

17. Staff also expressed concern about the increased attention that the government seemed to pay to temporary or less reliable alternatives to expenditure cuts. These included, in addition to the revenues from asset sales mentioned above: (i) the expectation of a strong reform dividend in terms of higher GDP and tax revenue growth; (ii) tax amnesties; (iii) increased yield from government assets; and (iv) a decentralization of public investment through public-private partnerships. Staff saw severe risks in relying on these alternatives. More specifically:

The authorities’ medium-term fiscal plan assumed a considerable increase in potential growth. Their reform agenda, including the tax cuts and labor market reforms, was expected to gradually raise potential output growth over time to close to 3 percent.9 Staff acknowledged that, in principle, this could have sizable implications for fiscal balances—provided that the growth-related revenue “dividend” were applied to strengthening the fiscal balance. But staff also stressed that the amount and timing of the growth effects were uncertain. Moreover, these effects would materialize only if the tax cuts were seen as sustainable: proceeding with the tax cuts without expenditure reform, in the expectation that those cuts would be self-financing, was very risky. Altogether, it would be prudent to base the medium-term fiscal plan on the assumption of broadly unchanged potential output growth, until there was firm evidence to the contrary.

After a hiatus of several years, new tax amnesties had been introduced in 2001. A first involved the cancellation of all tax liabilities related to assets held abroad, as long as they were repatriated or declared and a penalty equal to 2½ percent of capital was paid. Some €60 billion had emerged, resulting in 0.1 percent of GDP in budget revenues. A second amnesty concerned the “emersion” of enterprises from the underground economy, facilitated by favorable tax treatments. But few enterprises seized this opportunity. The authorities explained that the purpose of these amnesties had not been to raise revenues, but, respectively, to boost the supply of resources for investment, and to reduce the underground economy. Staff cautioned that regardless of their purpose, these amnesties risked weakening tax compliance, especially with Italy’s history of repeated amnesties—a factor that, in combination with repeated rumors about new amnesties, may partly explain recent revenue weakness.

A new agency—Patrimonio S.p.A.—was charged with managing state properties. The authorities noted even a modest yield on these properties (which they estimated to be worth some 40-70 percent of GDP) could provide permanent savings. Staff cautioned against budgeting large revenue increases from this source before they materialized, as previous attempts in this direction had generated only modest results.

Another new agency—Infrastrutture S.p.A.—was set up to finance infrastructure investment in cooperation with the private sector. Financing from this agency was not expected to be included in the SGP deficit definition, in line with the experience of similar agencies in the EU (such as the German KfW). It was agreed that public-private partnerships in infrastructural investment might yield useful synergies, but that safeguards were needed to avoid quasi-fiscal deficits and contingent liabilities arising from these operations.

Fiscal transparency

18. While fiscal transparency has significantly improved in recent years, further progress is needed in several areas. As described in a separate fiscal Report on the Observance of Standards and Codes (ROSC), Italy meets the standards of the fiscal transparency code in many respects, but the quality of fiscal data falls short of code requirements. A large discrepancy between the cash deficit (fabbisogno)—the only indicator of fiscal developments available at a monthly frequency and with short lags—and the accruals-based SGP deficit (indebitamento netto), hampered the monitoring of fiscal developments. Progress has been made in reconciling these two items ex post (a reconciliation that was accompanied by substantial upward revisions in the SGP-deficit), but staff noted that, as in other countries, more needed to be done to make SGP-based figures available at a higher frequency. The ROSC also recommended: (i) increasing the influence of the initial budget by limiting the carry-forward of unspent appropriations; (ii) strengthening the procedures for budget preparation, execution, and control; and (iii) improving the quality, timeliness, and transparency of fiscal information—by adopting common accounting and reporting procedures across all levels of government. The authorities are reviewing several specific recommendations, including for a systematic and timely reconciliation of different fiscal aggregates; more detailed analysis of fiscal risks; and the completion of an integrated financial management information system for the general government.

C. Raising Employment

19. Government, employer, and trade union representatives concurred that Italy’s low employment ratio was probably the most critical structural factor behind its relatively low per capita income (Box 3; and Table 4).

Table 4.

Labor Market Characteristics in Italy and Other Selected Economies, 1998 1/

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Sources: OECD, Labour Market Statistics (2001); Eurostat (2002); and IMF, WEO (2002).

Data are for 1998, except where indicated otherwise.

Excluding Luxembourg.

The rank decreases as the value of each variable increases. For example, Italy has the lowest labor force participation rate in the Euro area and is ranked as eleventh, while it has the highest coefficient of variation of regional unemployment rates and is ranked as first.



Employment, Productivity, and Per Capita Income

• In 2000, Italy ranked only eighteenth in terms of (purchasing-power-parity adjusted) income per capita among OECD countries. This does not reflect low per capita productivity, but rather the low level of employment: the Italian worker is highly productive, but few people work (see figure below).

• Only 54 out of 100 Italians of working age have a job; this is the lowest employment ratio in the OECD, reflecting both low labor force participation and high unemployment: labor force participation (61 percent in 2001) is the lowest in the EU; and, at 9 percent, the unemployment rate is the third highest in the EU.

• Labor market performance is particularly weak in the South, where the unemployment rate is close to 20 percent, and even higher among the young (Figure 5). This, coupled with levels of productivity below the Italian average, results in a per capita income lower than in the poorest EU countries. The North benefits from higher productivity and virtually full employment, but even there the employment rate is below the EU average.

Figure 5.
Figure 5.

Italy: Unemployment in Italy and the Euro Area, 1997-2002

(In percent, seasonally adjusted)

Citation: IMF Staff Country Reports 2002, 230; 10.5089/9781451819748.002.A001

Sources: ISTAT and EUROSTAT.

GDP per worker

(In thousands of PPP adjusted $)

Citation: IMF Staff Country Reports 2002, 230; 10.5089/9781451819748.002.A001

The combination of high productivity and low employment, while possibly influenced by the size of the underground economy and related measurement problems, reflects at least partly labor market rigidities that since the 1960s encouraged labor-saving investments (the capital-labor ratio is among the highest in the OECD, raising labor productivity).

20. The experience since the late 1990s shows, however, that wage moderation and the removal of labor market rigidities can have a large payoff. Staff’s previous analysis pointed at the important role of wage moderation, which began later in Italy than in most large EU countries, in stimulating employment growth.10 Moreover, far-reaching constraints on temporary and part-time jobs (“atypical contracts”) were relaxed in the late 1990s, a process that culminated in late 2001 with the adoption of the principle that temporary labor contracts are permitted, except when explicitly prohibited. The authorities and the social partners stressed that these reforms had been critical in boosting employment in the late 1990s, when its elasticity with respect to output had far exceeded the historical average. Employment growth, initially limited to “atypical” contracts, had extended to open-ended contracts in 2000 and 2001, following modest tax incentives that facilitated the conversion.




Citation: IMF Staff Country Reports 2002, 230; 10.5089/9781451819748.002.A001



(Over previous 5 years)

Citation: IMF Staff Country Reports 2002, 230; 10.5089/9781451819748.002.A001

21. Against this background, staff pointed at five causes of continued labor market weakness:

• Insufficient regional wage differentiation: regional wage variation was the second lowest in the EU, even though the variation of regional unemployment was the highest, as wage setting in Italy tended to be dominated by lower unemployment regions (in the North). This reflected excessively centralized wage bargaining structures.11

• Notwithstanding recent reforms, employment protection legislation (EPL) was among the strictest in the OECD, with more adverse effects in the South (Box 4).

• The tax wedge on labor income—primarily reflecting differences between firms’ labor costs and workers’ after-tax income—was the sixth highest in the OECD.

• Spending on active labor market policies (as a percentage of GDP) was the second lowest in the euro area, and mainly benefiting workers in the North.

• Product market impediments, were also likely to have important adverse effects on employment (Section D).



(In percent)

Citation: IMF Staff Country Reports 2002, 230; 10.5089/9781451819748.002.A001



Citation: IMF Staff Country Reports 2002, 230; 10.5089/9781451819748.002.A001

Source: OECD.1/ Index ranges from 0 to 6, with higher numbers indicating more restrictive legislation.

Why Does Strict Employment Protection Hamper Labor Market Performance More in the South?

While EPL is the same across regions, labor market outcomes exhibit vast regional differences. Three factors explain why the same EPLs may have more adverse effects in the South:

  • The cost of losing a dismissal case for an employer in the South is higher than in the North. This is because legal proceedings last on average longer in the South; and a worker that is wrongly dismissed will eventually receive payments for the whole period of the duration of the trial. There are also additional penalties for late payments of social security contributions.

  • EPL rules may be more strictly applied in the South. Empirical evidence indicates that higher unemployment rates in the South influence the courts’ decisions: the same misconduct by the worker may be considered sufficient for separations in the tight labor market of the North, but insufficient in the high unemployment regions of the South.1

  • Strict EPL slows labor market adjustments following adverse shocks and can extend periods of higher unemployment.2 This problem may be particularly relevant for the South, which has been subject to larger idiosyncratic shocks (see Chapter III of the Selected Issues paper), including sizable public expenditure cuts in the early 1990s.

1 See A. Ichino, M. Polo, and E. Rettore, “Are Judges Biased by Labor Market Conditions?”, European Economic Review, forthcoming.2 See O. Blanchard and J. Wolfers, 2000, “The Role of Shocks and Institutions in the Rise of European Unemployment: the Aggregate Evidence,” The Economic Journal 110, 1-33; and T. Boeri, G. Nicoletti, and S. Scarpetta, 2000, “Regulation and Labour Market Performance,” Centre for Economic Policy Research, Discussion Paper No. 2420.

22. These arguments elicited different responses from the various interlocutors:

• The authorities broadly concurred with the staff’s analysis. Indeed, it was consistent with their multi-pronged labor market strategy as formulated in the employment program presented to the EU that aimed at raising the employment rate from 54½ percent in 2001 to 58½ percent by 2005. The authorities noted, however, that the degree of centralization of wage bargaining was up to the social partners: no regulation prevented the latter from agreeing on more flexible wage contracts. In this respect, staff suggested that wage differentiation in the private sector could be encouraged by introducing regional wage differentiation in the public sector, for example, through cost-of-living allowances. It was also time that the central statistical office (ISTAT) started producing regional cost-of-living data, so as to facilitate wage agreements that reflected differences in the cost of living.12 The authorities agreed with the latter suggestion, noting that work was underway, but considered it politically difficult to break with a tradition of equal pay for equal work in the public sector.

• Employers’ representatives largely agreed with the staff’s analysis, but saw a risk that increased decentralization in the wage bargaining system could raise labor costs in the North, where labor conditions were tighter.

• Trade union representatives concurred with some aspects of the staff’s analysis (notably the need to reduce the tax wedge and to strengthen active labor market policies). They noted, however, that much had been done to liberalize the labor market (including through atypical contracts) and feared that further major steps, in particular major revisions in EPL, would violate workers’ basic rights. Moreover, they thought that any labor market reform would have to include a strengthening of unemployment benefit, which staff acknowledged was underdeveloped in Italy.13 As to regional wage differentiation, the trade unions did not oppose a close link between future wage and productivity increases (including any arising from regional differences), but were against revising wage levels to reflect regional differences in the cost of living or local labor market conditions. They noted that what prevented growth in the South was not so much the cost of labor, but the lack of infrastructure, and relatively poor law enforcement and governance.

23. Following the mission, a labor market accord was reached between the authorities, two of the three main trade unions, and the employers’ association. The agreement included:

• Labor market reforms to: (i) ease some dismissal restrictions; (ii) facilitate job matching, including through measures to strengthen public employment agencies and improve their cooperation with private-sector agencies; and (iii) improve employability, through job-oriented education.14 These measures—included in enabling legislation to be approved by parliament—are in addition to steps further liberalizing part-time contracts, fully implementing the EU directives.

• The government’s commitment to reduce the tax wedge on lower incomes, through personal income tax reductions.

• A government pledge for continued initiatives supporting the South, including for infrastructure.

• An expansion of the unemployment insurance system: benefits will be increased, applied more uniformly across sectors, and extended to cover up to one year, with declining replacement rates (60 percent in the first semester, falling to 30 percent by the last quarter). Ahead of the specific regulations, budgetary costs were difficult to project—but were put at below 0.1 percent of GDP for 2003 in government estimates.

D. Boosting Productivity and Other Issues

24. Stronger employment growth in recent years has been associated with a decline in productivity growth (see text chart). The authorities intend to boost productivity not only through a retrenchment of the public sector, but also through more competitive product markets, regional policies supporting the South, and maintaining a vigorous yet stable financial system.15 Benefits in these areas depend also on enforcing the rule of law.



(In percent)

Citation: IMF Staff Country Reports 2002, 230; 10.5089/9781451819748.002.A001

Source: ISTAT and staff calculations (see Chapter II of the Selected Issues paper).

25. Discussions focused first on ways to reinvigorate product market reforms.

• With the reconstitution of a privatization committee, the privatization process is to be revived. After stalling during the past year, the government has targeted receipts of €20 billion in 2002-03. Limited progress was expected at the local level, although local governments controlled a sizable share of public properties. And equity market developments have accentuated risks to the government’s revenue target.

• To enhance competition in the energy sector, plans call for separating the ownership of transmission from production assets. However, regulators noted that incumbents would still enjoy dominant positions in production, while prices typically remained among the highest in the EU.

• For the provision of local public services, central guidelines have been issued to increase competitive pressures through private sector tendering, although local governments will set operating guidelines and own the infrastructure.

• Little progress has been achieved toward increased competition in retail trade, and the Anti-Trust Authority noted that its limited sanctioning powers hampered efforts to foster competition in professional services.

26. Building on recent progress, new initiatives aim at accelerating real convergence of the South. Recent initiatives are beginning to bear fruit, and growth rates in the South have exceeded those in the North since the mid-1990s, with important contributions from private investment. The authorities expected that their labor market reforms would have particularly beneficial effects for the South, as would the envisaged private-public sector cofinancing of infrastructure projects. Further steps were also underway to improve law enforcement and judicial efficiency and to reduce bureaucratic procedures for investment—measures that should also facilitate the “emersion” of the large underground economy. Other steps aimed to improve the quality of public investment, including through performance-based pay and extensive monitoring.

27. Discussions on banking centered on the recent decline in profitability, and on moves to raise capital ratios and reduce control of banks by nonprofit foundations. Bank profitability was lowered by sizeable domestic and international shocks in 2001, including the downturn in equity markets (Table 5)—reducing asset-management income significantly—and problems arising from a number of sizable exposures, including in Latin America. Despite this, the banking system’s capital ratio rose in 2001, reversing a trend that had left Italy below many of its peers. This turnaround was fostered by the Bank of Italy establishing capital-ratio targets above minimum international standards, and was apparently achieved without a significant impact on credit growth—which has slowed in line with weaker economic activity. The share of nonperforming loans to total loans—still high relative to partner countries, reflecting earlier loan losses and a slow resolution process—bad fallen further, though the Bank concurred that credit losses typically emerge with a considerable lag following economic slowdowns. Even so, both supervisors and market participants thought that losses would not be substantial, pointing to relatively low household indebtedness and robust corporate profitability. New legislation aimed at improving governance of financial institutions will force nonprofit foundations to place their holdings with asset management companies by June 2003, and relinquish control of financial institutions by 2006.

Table 5.

Italy: Indicators of External and Financial Vulnerability 1/

(In percent of GDP, unless otherwise indicated)

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Sources: Bank of Italy, Economic Bulletin and Statistical Bulletin; data provided by the authorities; IMF’, International Financial Statistics and Balance of Payments Statistics Yearbook; and Fund staff estimates and projections.

The interpretation of some indicators is affected by the launch of monetary union in 1999.

Reserves and foreign liabilities refer to the Bank of Italy, both before and after EMU; excluding gold.

Definition of M3 changes January 2002, to exclude currency held by the public.

Data refer to banks, including cooperative and mutual banks.

28. Discussions also covered corporate governance issues more generally. Legislative changes in 1998 had improved the rights of minority shareholders, and were conducive to the decline in the market share of major shareholders and the increased role of institutional investors. The securities market regulator stressed, however, that more could be done in this area, including improving disclosure, especially for unusual and related party transactions. A reform of the bankruptcy law, before parliament, is aimed at better protecting the value of firms in difficulty and reducing resolution costs.

29. A new coordinating body has been established to assist in combating the financing of terrorism (CFT). The recent EU directive to extend anti-money laundering (AML) and CFT efforts to nonfinancial entities is expected to be transposed into Italian law by mid-2003. Italy continues to provide both finance and personnel for technical assistance on AML to other countries, and is a signatory to the OECD anti-bribery convention.

III. Staff Appraisal

30. The authorities have laid out a bold agenda, targeted at addressing Italy’s key economic weaknesses—but it needs to be complemented by comparably bold fiscal consolidation in both the short- and longer-term. The agenda’s key elements—labor and product market reform, cuts in taxes and public spending, and further fiscal consolidation—have long been at the core of Article IV recommendations, and remain critical for achieving major inroads in spurring growth and raising Italy’s low employment rate. Progress is being made in reforming the labor market and plans have been formulated for lowering the tax burden, with implementation starting in 2003. But no progress will be made in 2002 in lowering primary government spending and the cyclically-adjusted deficit net of asset sales. Moreover, for the first time in several years, the public debt ratio may not decline.

31. The July labor market accord presents an important step toward broad-based reform. As low employment in Italy reflects a host of factors, reforms are rightly based on a broad-based strategy, involving improvements in job matching and education, cuts in the tax wedge on labor, and increased labor market liberalization. However, as unemployment is distributed very unevenly, progress in raising employment also requires wage structures that reflect more closely regional differences in labor market conditions and the cost of living. Social partners should work toward this end. In the public sector, consideration could be given to regional cost-of-living allowances, once comparable regional price level data are collected.

32. Fiscal developments have been disappointing. In 2002, the deficit will exceed the original target by a wide margin. This reflects not only cyclical developments, but also structural revenue shortfalls and overruns on some primary current expenditures. The recent decree aimed at avoiding expenditure overruns is useful, as a stop-gap measure, but its effectiveness remains to be seen. The interpretation of fiscal developments in 2002 has been made difficult, once again, by the lack of higher-frequency deficit estimates on an accruals basis, and of a timely reconciliation between cash-based and accruals-based deficit estimates. Progress in this area is needed, in line with the recommendations in the fiscal Review of Standards and Codes (ROSC).

33. Delays in introducing corrective measures during 2002 make it now inevitable to delay the pace of fiscal consolidation. Italy’s fiscal consolidation process is far from complete, as highlighted by the highest public debt ratio in the EU, medium-term spending pressures arising from the forthcoming demographic shock, and the increase in the cyclically-adjusted deficit net of asset sales since the beginning of monetary union. Against this background, it would have been preferable to initiate adjustment steps already in 2002 and approach a balanced budget (cyclically adjusted and net of asset sales) in 2003. But the latter is no longer feasible in view of the lack of progress in addressing the 2002 slippages, and also in light of weaker growth. It is now imperative that structural adjustment in 2003 does not, again, fall short of the requirements for substantially strengthening the fiscal position. Thus, the 2003 budget should contain sufficient measures to reduce the cyclically-adjusted deficit (excluding asset sales) by at least ¾ percentage points of GDP, with a similar improvement for 2004. Around these targets, the automatic stabilizers should operate fully and symmetrically.

34. As to the medium term, further reform of aging-related entitlements are critical to achieving the government’s growth and employment targets; absent such reforms, sizable budget surpluses will be required, so as to rapidly reduce the public debt ratio during this decade, ahead of the most adverse impact of population aging. In light of the uncertainty about the magnitude and the timing of any structural reform dividend, medium-term fiscal plans should be based on prudent growth assumptions and not count on steady gains in potential output growth, as in the government’s current program.

35. The immediate fiscal challenge is to implement long-delayed expenditure cuts. Such cuts—which are now expected to be initiated in the 2003 budget—are needed not only to proceed with fiscal consolidation, but also to allow for the planned tax cuts and the loss of the sizable one-off revenue measures of the last few years. Specific measures are required in all areas identified in the government’s reform agenda, including steps to contain the wage bill through public employment cuts and moderate wage increases, and health care costs by strengthening the enforcement of regional spending ceilings. On pensions, the government’s plan to develop a second, fully funded and private pillar is welcome, but consideration should be given to raise the effective retirement age substantially and shorten the transition to the contribution-based pension regime. Some expenditure savings are also expected from the creation of the new public entity aimed at financing private-public sector partnerships for infrastructure projects. This partnerships could yield efficiency gains in public spending, benefiting in particular the South; at the same time, careful monitoring and full transparency in the operation of these entities is critical to ensure that future public sector liabilities are avoided.

36. Durable expenditure cuts would allow a gradual reduction of Italy’s high tax burden. The authorities’ personal income tax reform rightly targets initial relief at lower income groups, which should help employment growth in the most disadvantaged segments. For the corporate income tax, care needs to be taken to limit distortions between alternative financing sources. The recent recourse to new tax amnesties—which risk weakening the efforts to enhance tax administration—is regrettable, and should be avoided in the future. The implementation of the tax reform, particularly of those components that involve a reduction in the overall tax burden, should, however, advance only in tandem with expenditure cuts, so as to proceed speedily on the road of fiscal consolidation.

37. Recent steps to reinvigorate the privatization process and expand product market reforms are welcome, and could underpin stronger productivity growth. After stalling for some time, the privatization process should proceed both at the central and local level. The plan to split the ownership of transmission and production assets in energy markets is a positive step, but strong competition requires greater divestiture by incumbents of production assets. Raising competition in local public service provision depends on better coordination between different levels of government—a need illustrated by insufficient progress in achieving more competition in retail trade. Giving additional sanctioning powers to the Anti-Trust Authority could foster competition in professional services. The recent temporary freeze of some utility prices is regrettable: it risks undermining market-oriented reforms more generally, and it goes against the need to increase competitive pressures under the guidance of independent and transparent regulators.

38. The Bank of Italy rightly undertook efforts to boost banks’ capital. Flexible use of target capital ratios should help to align Italian banks with their international peers without unduly restricting the supply of credit. Changes to prevent foundations from controlling financial institutions could enhance governance, but implementation details will need to be carefully considered, especially to ensure that the relationship between foundations and asset management companies is truly at arms’ length. Governance of all corporations could improve by further increasing minority shareholder rights. The pending bankruptcy law reform is long overdue.

39. Italy remains a strong supporter of abolishing trade barriers for exports from the least developed countries, but efforts are needed to further increase its relatively paltry official development assistance.

40. Italy’s economic data are adequate for surveillance. Statistical and fiscal ROSCs identified, however, weaknesses related in particular to general government data (Appendix II), and the authorities’ intention to quickly address these weaknesses is welcome.

41. It is proposed that the next Article IV consultation take place on the standard 12-month cycle.

APPENDIX I Italy: Fund Relations

(As of August 31, 2002)

I. Membership Status: Joined 3/27/47; Article VIII.

II General Resources Account:

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III SDR Department:

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IV. Outstanding Purchases and Loans: None

V. Financial Arrangements: None

VI. Projected Obligations to Fund: None

VII. Exchange Rate Arrangement:

• Italy entered the final stage of European Economic and Monetary Union on January 1, 1999, at a rate of 1,936.27 Italian lire per 1 euro.

• Italy retains restrictions vis-à-vis Iraq pursuant to UN resolutions, notified under Decision No. 144 (EBD/90/244, 8/13/90 and EBD/92/187, 8/28/92).

VIII. Article IV Consultations:

Italy is on the standard 12-month consultation cycle. The previous consultation discussions took place during July 2001 and the staff report (SM/01/207, 10/17/01) was discussed on November 5, 2001 (EBM/01/112).

APPENDIX II Italy: Statistical Information

Italy’s economic database is comprehensive and of generally high quality. Italy has subscribed to the Special Data Dissemination Standard (SDDS) and has posted the metadata for the Bulletin Board. Data are provided to the Fund in a comprehensive manner (see attached table), and the authorities regularly publish a full range of economic and financial data, as well as a calendar of dates for the main statistical releases. Italy is also subject to the statistical requirements and timeliness and reporting standards of Eurostat and the European Central Bank (ECB), and has adopted the European System of Integrated Economic Accounts 1995 (ESA95).

Notwithstanding these strengths, weaknesses are evident in a number of areas. First, in the national accounts, inventory accumulation is derived as a residual and lumped together with the statistical discrepancy: this hampers an analysis of the business cycle. Second, no quarterly data are available for the general government balance, expenditure, and revenue on an accruals basis (that is, in line with ESA95): as a result, it is difficult to precisely assess fiscal developments and policies during the year. And third, as highlighted by a recent fiscal transparency Report on Observance of Standards and Codes (ROSC) mission, the quality and timeliness of some fiscal data, particularly on expenditure by local governments, falls short of the code’s requirements, notwithstanding some improvements of late.

A recent data dissemination ROSC mission found Italy’s macroeconomic statistics to be of generally high quality, but also identified some shortcomings that hindered an accurate and timely analysis of economic and financial developments: (i) no statistical agency had the responsibility to compile and disseminate an integrated, comprehensive statement of government finances, and a large difference had emerged between the several distinct measures of government deficit/financing; (ii) source data and/or statistical techniques could be strengthened in several areas, most importantly, by raising response rates on the enterprise surveys used in the national accounts and producer price index (PPI), making price collection for the CPI more efficient, improving the coverage of cross-border financial transactions that do not go through domestic banks, and widening the use of revision studies to shed light on sources of errors in provisional estimates; and (hi) monetary, balance of payments, and the existing portions of government finance statistics could come closer to the internationally accepted methodological guidelines on concepts and definitions, scope, classification and sectorization, and/or valuation. The mission also noted that resources were under pressure in some parts of the National Institute of Statistics in the face of the statistical requirements of the European Union and the euro area.

Italy: Core Statistical Indicators

(As of September 11, 2002)

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Central government on a cash basis. Overall government accounts are published once a year in February/March; the latest figure is for 2001 and was published March 1, 2002.

Provisional estimate.

ANNEX Public Debt Sustainability1

1. This annex compares the staff’s baseline projection for Italy’s public debt against scenarios based on historical averages for the key underlying variables. The sensitivity of the debt dynamics to a number of shocks is also considered. The shocks are applied as temporary deviations from the baseline, without consideration of feed-back effects, and with magnitudes based on historical developments over the past 10 years.

2. The baseline scenario envisages a gradual reduction in Italy’s high public debt—and the staff’s policy advice calls for a more rapid reduction (as discussed in the main report). The baseline scenario is premised, from 2002 onward, on the authorities’ medium-term economic program (as presented in the July 2002 Documento di Programmazione Economico-Finanziaria, DPEF), adjusted for deviations from the staff’s macroeconomic scenario. In particular, it builds on the authorities’ targets for the fiscal balance, but adjusts these for the staff’s (somewhat lower) growth projections (the staff’s growth projections for 2002-06 are on average about ½ percentage point per annum lower than those in the DPEF; see also Chapter II of the forthcoming Selected Issues paper). The public debt ratio would decline gradually to about 93 percent of GDP by 2007. In view of Italy’s high public debt and pending demographic shock, the staff has advised a more rapid decline in the public debt ratio—until further reforms of aging-related expenditure have been implemented.

3. The analysis of shocks to the baseline underlines the sensitivity of the debt dynamics to a sharp deterioration in the economic environment—although some of the risks have clearly been attenuated by Italy’s membership in monetary union. In view of the size of the public debt, its dynamics would be particularly affected by sharp increases in the real interest rate (stress tests 1, 2, and 5). However, risks of returning, for example, to the interest rate levels associated with the ERM crises of the 1990s seem remote in view of Italy’s membership in the euro area. A sharp deterioration in near-term growth prospects (scenario 3) would leave the debt ratio some 7 percentage points above the baseline scenario in 2007. By contrast, the small size of Italy’s non-euro denominated debt makes it relatively resilient to exchange rate fluctuations, with public debt ending only 1 percentage point of GDP above the baseline projection for a 30 percent real depreciation (stress test 6).

4. Italy’s debt dynamics is obviously sensitive to progress on fiscal adjustment—but no major deviations from the baseline scenario would be expected, provided that the Stability and Growth Pact commitments are met. While the debt dynamics would deteriorate vis-à-vis the baseline with a sharp worsening of the primary balance (scenarios 1 and 4), risks in this regard are severely limited by the authorities’ commitments under the Stability and Growth Pact (SGP). For example, if the primary deficit in 2003 and 2004 were 2 standard deviations (i.e., some 3 percentage points of GDP) below the historical averages, the fiscal deficit in those years would be far above the SGP’s 3 percent deficit ceiling (stress test 4).

5. While this Annex reports standardized stress tests, these do not encompass some important considerations for assessing Italy’s public debt dynamics. As noted in the main report, of particular importance is the potential impact of population aging on the public finances: absent further reforms, aging-related expenditures may rise by some 3½ percent of GDP over the next decades. Further details, including longer-run simulations under alternative assumptions for productivity, were reported in earlier staff papers (see, for example, the last two Country Reports, No. 01/207 and No. 00/71).

Italy: Public Sector Debt Sustainability Framework, 1997–2007

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Sources: Ministry of Finance, Documento di Programmazione Economica e Finanziaria (July 2002); and Fund staff calculations and projections.

Indicate coverage of public sector.

Defined as: r = interest rate; p = GDP deflator, growth rate; g = real GDP growth rate.

Real appreciation is approximated by nominal appreciation against U.S. dollar plus increase in domestic GDP deflator.

A negative deficit indicates a surplus.