Statement by Pier Carlo Padoan, Executive Director for Italy

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.

Abstract

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.

At the outset, on behalf of my authorities, I would like to thank staff for their very useful and highly professional work during this consultation, which is reflected in the high quality of the reports.

I. Consolidation continues, in spite of the heavy slowdown.

As is the case of other EU countries the Italian economy has been hit by a sequence of adverse shocks that have worsened the global slowdown and have depressed expectations of both households and firms. Prospects for recovery in the coming months remain optimistic although the pick up might be weaker than previously expected. Early indications suggest that business expectations are improving as activity starts to pick up.

In spite of the deterioration in the cycle budget consolidation continues, in line with the requirements of the EU agreements. At the same time, as a first step to a more comprehensive tax reform, tax cuts are being undertaken to support low income households and boost consumption. Structural measures are being introduced to enhance control of spending procedures, and new initiatives to extract value from state owned assets are being implemented.

In spite of encouraging employment growth, reflecting progress in labor market reforms, employment creation remains a key policy priority, given the overall low employment levels. These, however, largely reflect long-lasting regional imbalances that are being addressed by a comprehensive strategy.

II. The Cycle. International and country specific factors.

Growth is hit by weaker global activity, wealth losses, and deteriorating expectations.

A number of EU-wide and country specific shocks have led, over the current year, to downward revisions of growth prospects. During the first half of 2002 GDP growth has remained flat on a yearly basis. The second half of the year promises to be more encouraging, leaving, however, overall growth for 2002 well below 1 percent. Authorities’ forecasts are in line with staff projections. Disappointing demand growth is the result of reduced activity as well as sizable wealth losses. Estimates of the Ministry of the Economy indicate that, had the stock market index remain unchanged with respect to 2001, GDP in 2002 would have been higher by 0.4 percent. International and domestic shocks have hurt confidence and increased uncertainty both in corporations and households, as indicated in the decrease in the propensity to consume.

International and country specific factors account for the slowdown.

Recent developments reflect both international and country specific factors. Among the latter are the, still to be clearly identified, consequences of the crisis in Latin America, and in Argentina in particular, given that Italian investors have acquired Argentinean assets for a value of about 1 percent of Italy’s GDP.

In addition, Italy has suffered from the geographic and sectoral characteristics of its export structure. Germany and other major EU countries account for a very large part of Italy’s exports, which have been negatively affected by the slowdown in these countries. Also, as Italy’s share of high-tech production is limited, export performance has not benefited from the acceleration of world demand for high tech goods. As a consequence Italy’s exports have increased less than those of other EU member states.

Possibly, other sector-specific events, such as those that have hit the largest auto producer, may contribute to downside risks.

On the positive side. Confidence is improving, and employment is growing.

There are however, signs that business confidence is beginning to recover, as orders pick up, driven by foreign demand, and the degree of capacity utilization increases. Household confidence remains weak, but it is expected to recover as the one-off price effects of the introduction of euro notes and coins vanish and lower-income households begin to benefit from tax cuts included in the budget law.

Prospects for recovery will also be enhanced by the contribution to infrastructure and public works that the new company—Infrastrutture SpA—will provide.

In spite of the slowdown employment continues to increase, although at a lower pace. This will lead to a further fall of the unemployment rate—in contrast to the overall EU trend—that should be just above 9 percent in 2002.

III. The Budget and Fiscal Consolidation.

Fiscal consolidation continues, in spite of the slowdown. Expenditure control is being strengthened.

The intensity of the slowdown has made it necessary to revise budget projections for 2002 and 2003 in line with lower expected growth, and the consequent drop in revenues. The revenue shortfall is, in part, the consequence of reimbursements on personal income tax, and, to a larger extent, the consequence of lower tax revenues from large firms that have benefited from tax reductions introduced in previous legislation as well.

To cope also with the consequences of the slowdown on the budget and to strengthen the budget, a decree, presented by the Government in early September, introduces more rigorous rules in expenditure control, including: the prohibition to implement spending decisions without the appropriate financing, the mandate for Government to return to Parliament if previously approved expenditure decisions require new funds, a shortening of the time period that funds can be left idle in the budget (“residui di stanziamento”). The new measures will significantly increase transparency in expenditure procedures and lead to the elimination of discrepancies in the budget in terms of cash and accrual.

The Budget.

The budget law, recently presented to Parliament is based on the following guiding principles: a) structural spending cuts; b) measures to improve the efficiency and transparency of public spending, including centralization of procurement (which will improve the terms of trade for the administration) and an increase in the utilization of flexible contracts for public employment; c) tax cuts, especially targeted at low income and representing a first step towards a comprehensive fiscal reform. These tax cuts will boost household demand and strengthen incentives to labor participation; d) tax amnesties, which are not seen by Authorities as alternative to spending cuts, aim at increasing revenues and, especially, at obtaining permanent increases in the tax base. Historical experience of past amnesties shows that up to one quarter of additional revenue is permanent as a result of emersion of previously submerged activities; e) reinforced social safety nets, as agreed with social partners (“Patto per l’Italia”); and f) two new agencies to improve the management of public real estate assets and obtain additional resources (Patrimonio SpA), and to finance infrastructure investment in cooperation with the private sector through project financing (Infrastrutture SpA).

These measures will lead to a continuation of structural adjustment in the budget and debt reduction, which will also benefit from an improvement in the structure of debt.

Privatization will progress.

The Ministry of Economy and Finance holds stakes in 20 industrial corporations and companies. The total value of these holdings is estimated at about 80 billion euro. Central and local governments also hold assets and real estate, the latter estimated between 23 billion and 30 billion euro. Other public bodies, such as municipalized firms, also have holdings.

In 2000 and 2001, the privatization process slowed down as a consequence of the fall in equity markets. The privatization strategy in the new, less favorable circumstances in financial markets, will be based on the following steps: a) postponement of global offerings, b) unbundling of networks in regulated utilities before their sale, c) strengthening of institutional investors. Intermediate steps include: a) restructuring of state-owned enterprises in view of future privatization; b) market liberalization (liberalization in electricity, natural gas, telecom, is quite advanced with respect to other European countries. Municipal utilities will be liberalized and privatized following the separation between infrastructure and service provision); c) improvement of corporate governance by fostering the development of pension funds, improving protection for minority shareholders and fostering equity culture.

The Government plans to complete sale of all remaining stakes by the end of 2003 (including Telecom Italia, Seat, ETI, Mediocredito Friuli Venezia Giulia, Coopercredito, Tirrenia, and Fincantieri) with the exception of ENEL, Terna, Gestore della Rete di Trasmissione, and Alitalia. For the latter it will reduce its holdings to a 30 percent ceiling. The total amount of shares to be sold by end 2003 is worth 20 billion euro. This includes 37.58 percent of ENEL, if market conditions allow.

The Postal Service Company, Poste Italiane SpA, which was transformed into a joint-stock company in February 1998, is progressing in financial consolidation, restructuring of postal services, and development of new financial services. It could achieve market listing in 2003.

Ferrovie dello Stato (the railroad corporation) has been restructured. It now holds 100 percent participation in two new companies, Trenitalia (operating medium- and long-distance trains) and Rete Ferroviaria Italiana (operating the track network). Sale of Trenitalia is being considered.

The overall privatization program will amount to around 60 billion euros between 2002 and 2006 and it will have a significant debt-reduction impact leaving public debt at about 94 pecent of GDP at the end of 2006.

Securitization.

In 2002 and 2003, if market conditions allow, the Government will carry out securitizations of real estate assets expected to yield proceeds of 14-15 billion euro. In December 2001 the first securitization of residential real estate assets belonging to the Enti Previdenziali was launched, covering 27,292 residential homes and 262 commercial units, amounting to a market value of 5.4 billion euro. The securitization operation amounted to a bond issuance worth 2.3 billion euro. A second operation will be launched before the end of the current year, including 54,000 homes belonging to the Enti Previdenziali, for a market value of about 20 billion euro. In 2003, via securitization, residential houses will be sold belonging to the Ferrovie dello Stato, Poste Italiane, Ministry of Defense, and Demanio (State Property). Assets are worth about 3-3.5 billion euro.

Less favorable conditions impose lower speed. But the direction towards budget adjustment remains unchanged.

The revised budget figures reflect the growth revision due to the slowdown. However, structural adjustment continues in 2002, showing clear progress. The cyclically-adjusted deficit shrinks over the current year. The table reports the evolution of the budget balance from 1999 to 2003 both in nominal and cyclically-adjusted terms. The output gap figures are those included in the EC Commission 2002 Spring Forecasts. Figures for 2001 are presented before and after Eurostat decisions not to include revenues from lottery and housing sales in the computation of the financing requirement.

The table indicates that, starting from 2000 and neglecting the effects of Eurostat decisions, the cyclically-adjusted balance shows a steady improvement. Furthermore, starting in 2001, the cyclic ally-adjusted balance shows a declining path of at least 0.5 percent, in line with the recent Commission recommendation. My authorities consider the potential output values used to compute the cyclically-adjusted budget balance in line with those of the EC Commission (confirmed in a recently-published Report) to be conservative, and therefore leading to conservative cyclically-adjusted balance figures.

Budget Balance In Italy, 1999-2003

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Based on the last official series on output Gap provided by the Commission

After the Eurostat decision

Before the Eurostat decision

Output gap estimation

The selected issues paper presents new, and lower, potential output estimates and compares the results with those of the EC, the OECD, and the Italian Authorities. Much of the difference is accounted for by the different treatment of employment figures in staff estimates. Both the Authorities’ and staff estimates do not include the effects of future labor market reforms. However, staff estimates also neglect the impact of recent labor market reforms, the effects of which are beginning to be felt on employment growth, and which show a comparatively better performance in Italy with respect to the rest of the Euro area. As a consequence staff suggest that, once the impact of cyclical factors is completed, employment will converge to past trends.

In addition, while we recognize the difficulty of providing satisfactory TFP estimates having to rely on a limited number of observations and hence on the need to use growth forecasts to 2007, we would caution against excessive reliance on such estimates. Overall, my authorities remain unconvinced of the extent to which the new estimates presented by staff can offer a robust alternative to existing estimates, and look forward to further refinements of the analysis.

Tax reform.

My Authorities stress the pivotal role of tax reductions for fiscal consolidation. As mentioned, tax cuts included in the Budget Law, concentrated on low-income families, represent the first step towards a comprehensive tax reform. The guiding principle of the reform is a change in tax progressivity that will move from the current system, based on several tax rates, to a system based on tax allowances, which will be inversely related to income brackets. The new structure will generate a lower marginal tax rate that will boost labor supply, reduce the underground economy and tax evasion, and improve transparency.

The proposed tax amnesty (concordato) should be considered in this perspective. It differs from traditional tax amnesties as it does not envisage penalties on the tax due in previous periods but it focuses on tax due in the current period. My authorities believe that such an approach will improve the relationship between taxpayers and the administration, and the increase in revenue will be, for a significant amount, permanent.

Finally, as for corporate taxation, the overall goal is to eliminate the bias against small and medium firms while softening the relative advantage large firms have so far benefited from. The average tax rate on firms will remain unchanged.

Pension reform.

Over the nineties, Italy has been one of the few EU Member States to implement a wide ranging reform of the pension system, that will guarantee the long-term financial sustainability of public pension expenditure. The BEPG 2001 Implementation Report presented by the European Commission recognized the positive impact of the Italian pension strategy stating that “… the reforms of the pension system of the 1990s have helped contain the growth of ageing-related expenditure as a percentage of GDP and recent projections suggest that the budget can absorb such pressures without imbalances…”.

Long term projections carried out by the Governement show that, given current legislation, pension spending over GDP would rise from 13.8 percent in 2000 to 16 percent in 2033 and, subsequently, decline to 13.6 percent by 2050.

On international comparison this is one of the smallest increases, in spite of the substantial increase in the dependence ratio that is due to reach 60 percent by 2050. In fact, the replacement ratio will decline substantially after 2010, and the ratio between average pension and labor productivity will decline in the central part of the projection period, as the system shifts to a defined contribution mechanism.

Debt sustainability analysis in the staff report considers the impact of population ageing on public finances. The assessment is in line with the Authorities’ projections that show that Italy’s long term pension position is among the most robust in the EU.

My Authorities, however, recognize that the overall cost of the system, also in comparison with other EU cases, imposes a heavy burden on the budget and on the economy, and represents an obstacle to higher growth. They remain committed to tackling the issue in the near future. As a matter of fact a “Legge Delega,” currently under review in the Parliament, strongly focuses on the appropriate incentives to increase the retirement age. However they note that the adverse cyclical conditions do not allow for enough space in the current year, given a possible negative short-term impact on income and demand as well.

IV. Employment, growth, and regional disparities.

In spite of recent progress, employment remains disappointingly low…

As mentioned, employment is increasing at non-negligible rates and unemployment continues to decline—in spite of the adverse cyclical conditions and the overall Euro area evolution—thanks to employment reforms and wage moderation.

The slowdown has, nonetheless, weakened the favorable dynamics of the recent past. Growth in permanent employment contracts, which had accelerated until recently, also supported by tax incentives, is slowing down, while employment through flexible contracts (atypical) is increasing at a faster pace.

Employment rates remain low in terms of EU averages and targets set at the Lisbon EU Council. Impediments to stronger employment growth include elements of employment protection legislation, product market regulation, and the tax wedge.

The “Patto per l’ltalia,” agreed on with trade unions and business representatives, aims at increasing labor market participation and employment rates. The agreement is based on four pillars: a) tax reform, b) improvement in private and public job placement systems, c) reform of income support measures towards active measures, aimed at encouraging job search, d) measures in support of new employment and targeted at increasing employment levels in small firms.

…but it reflects largely a regional problem.

Differences in employment and unemployment rates are wide on a regional basis. The rate of unemployment stands at less than three percent in the north-east, and slightly above four percent in the north-west, virtually full employment and well below the Euro area average. It is slightly above six percent in the center, and close to 18 percent in the south. Employment rates vary from close (or even above) 70 percent in the northeast to around 45 percent in the south. Such differences reflect long standing structural impediments (accumulated idiosyncratic shocks) that involve diverse regional aspects, including the way employment protection legislation is applied in the south by the judiciary, the dramatic lack of infrastructure, higher law enforcement costs, and specialization in low growth sectors.

Mezzogiorno is growing faster than the rest of the country…

Notwithstanding these long lasting structural differences, which make Italy a highly differentiated economy, it is encouraging to note that, over the recent past, the growth rate of the Mezzogiorno has exceeded that of the rest of the country. Growth has been driven by private investment, in the non agricultural sector in particular, and by exports, both of which have grown faster than in the north, and should continue to do so, given the healthier state of business confidence in the south with respect to the rest of the country. On the other hand, consumer confidence, traditionally more buoyant in the south, is now converging to lower levels, in line with the rest of the country.

Over the current year private investment has substantially benefited from tax incentives that have been further streamlined and strengthened.

Employment growth has significantly picked up since 1997 and has exceeded that in the rest of the country. In addition, over the past decade, the share of employment in manufacturing has significantly increased, improving the composition as well as the amount of employment.

…but an acceleration of catching up will require additional effort and resources.

The medium-term strategy of the Government aims at achieving a growth rate that, in a few years, should be well above that of the rest of the country and the EU average. This target, while ambitious, is not out of line with recent experiences of catching up of backward EU regions, and will require both new financial resources and a better implementation of spending procedures. This, together with an acceleration of the use of EU funds, aims at allocating to the Mezzogiorno 45 percent of total capital account spending.

Measures to improve employment perspectives in the south should also include wage differentiation to better reflect productivity differentials. The selected issues papers suggest that insufficient wage differentiation may be due to excessive wage centralization, implying that wage setting in the south is determined by labor market conditions in the north. To this respect it is worth recalling that, according to both official and non official sources, wage differentials have widened over the past decade.

This not withstanding, enhancing regional differentiation in wage formation (but productivity differentials also carry a firm specific dimension, which is already accounted for in the Italian bargaining system), is up to social partners to decide. However, future work should concentrate on the effective impact of wage differentiation on employment, and on the interaction of appropriate wage negotiation mechanism with other factors affecting growth and employment creation.

It should be kept in mind that, as far as employment and potential growth are concerned, the dualistic nature of the Italian economy has to be duly taken into account in order to derive appropriate policy prescriptions, and that dualism is not just the consequence of the wage-bargaining mechanism.

Italy: Staff Report for the 2002 Article IV Consultation
Author: International Monetary Fund