Statement by Pier Carlo Padoan, Executive Director for Italy

Economic activity stagnated in the first half of 2003, but recent indicators point to a gradual recovery. On product markets, there was agreement that progress had been secured over recent years, but also that Italy continued to suffer from insufficient competition in a number of protected sectors. Consolidation, privatization, and improvements in risk management in recent years have helped the banking system weather the current economic slowdown. The authority for telecommunications has recently revised downward the price cap in the retail market.

Abstract

Economic activity stagnated in the first half of 2003, but recent indicators point to a gradual recovery. On product markets, there was agreement that progress had been secured over recent years, but also that Italy continued to suffer from insufficient competition in a number of protected sectors. Consolidation, privatization, and improvements in risk management in recent years have helped the banking system weather the current economic slowdown. The authority for telecommunications has recently revised downward the price cap in the retail market.

November 7, 2003

As for other EU countries Italy’s growth over the recent past has been constrained by an unfavorable international environment. Prospects for the next year are more encouraging as the global recovery hopefully gains momentum. Notwithstanding short-term improvements in growth perspectives, we concur with staff that medium-term growth performance has been disappointing, reflecting structural weaknesses.

Structural reforms are beginning to bear fruit and additional structural measures are being introduced

On a more positive side, as also described in the staff report, measures adopted in the second half of the nineties to reform the labor market, as well as the new policy approach to tackle the long standing issue of lagging growth in the Mezzogiorno, are beginning to bear fruit. Such developments confirm that structural reforms are needed to revamp the economy but also that it takes time for these reforms to produce tangible results, especially in a low growth environment.

The authorities are encouraged by these results and significant actions have been taken to reinforce them. Additional labor market reform measures have been introduced early in 2003 and they are being complemented with measures to curb spending in aging related items as a new pension reform bill has been submitted to Parliament and is about to be introduced. These structural measures, in addition to sustaining long-term growth, will strengthen fiscal consolidation in the framework of the EU integration process.

The short-term outlook remains favorable

My authorities share with staff the view that a pick-up is expected in 2004. Private consumption, supported by the favorable employment performance, has so far underpinned domestic demand. However, this has not been enough to compensate for the negative contribution of external demand to growth. My authorities expect, for 2004, a significant rebound in private investment, supported by a stronger business confidence, the level of which in October was well above the average of the previous nine months. In addition, the external component of demand, while still negative, should improve with respect to 2003.

Long-term growth is disappointing, and it partly reflects weakening international competitiveness

In spite of improvements in the short term, longer-term growth prospects continue to be less than satisfactory. Over the past decade Italy’s growth rate has remained below the EU average. It is not reassuring to note that the trend of decelerating growth can be traced back to the previous decade and that it follows a pattern that is partly shared by other EU countries. Over the recent past, and especially since the last Art. IV consultation, the debate over the causes of such performance in my country has been very lively. Views differ on the causes of such performance. But there is hardly any disagreement that no single factor can be held accountable for the overall slowdown and that these causes lie mostly with supply side impediments.

Lower long-term growth is partially related to weakening external competitiveness, itself the result of a number of factors that, in many cases, overlap. The erosion of competitiveness, which has become more visible recently, reflects the still insufficient adjustment of the economic system to the changes in the distribution of comparative advantages that have taken place, and continue to take place, in the international economy.

Real appreciation is putting pressures on firms. But past experience shows that firms have the capacity to react

There is broad agreement in my country that, notwithstanding the strong performance of highly competitive industry segments, Italy’s production mix should be strengthened in high value-added and high growth-of-demand sectors. Over the past decade, and before that, real depreciations have periodically provided some breathing space to exporting firms. The strengthening of the euro and the perspective of further real appreciation due to price level convergence, as suggested in the staff report, have now changed the picture. While these developments add to short-term pressures they should also stimulate the capacity of firms to react. Indeed during previous episodes of sustained real appreciation, firms have responded to pressures by increasing productivity in a number of ways, including through higher capital investment, and similar reactions should be expected in the current phase, especially once the growth environment improves. My authorities believe that, in the current circumstances, the way forward is to increase the pace of innovation activities and, to this purpose, they have included measures in the budget law for 2004 to support innovation efforts.

The inflation differential should decline as reforms produce their effects

Weakening competitiveness is also the result of a persistence of an inflation differential. The causes of this divergence have to do, in part, with the structural determinants indicated in the staff report, including low productivity growth, price level convergence, lagging benefits of energy sector liberalization and a much tighter output gap effect once regional segmentation effects are taken into account. The relevance of several of these factors should diminish substantially once measures to address structural impediments in the energy sectors and in the Mezzogiorno fully produce their effects.

There are also some additional explanatory factors whose effects on inflation should be temporary: a) the increase in housing prices over the last several years, accelerated after the stock market crisis of 2000, has been more substantial than in other EU countries, especially in large cities. Such increase has progressively slipped into increases in rents and in higher costs for the retail system and has been carried on to consumer prices. The long-term increase in house prices has now largely subsided and there are indications that it is coming to an end. Nonetheless, substantial lags due to the duration of rental contracts could sustain such effect for some time; b) because of the heat wave and the drought very substantial price increases have affected the food industry, particularly fruits and vegetables. Tensions have been easing after the summer and food prices are now coming down. Preliminary October data for consumer prices (Istat, non harmonised) point to a reduction of the inflation rate to 2.6% from 2.8%. Furthermore, the industrial price core inflation rate remains under control (0.9%).

Service sector liberalization

We concur with staff that progress in liberalization will further support a decline in inflation differentials and improve competitiveness. The government moved in this direction in a number of sectors, including railways and postal services where further liberalization has been scheduled through the implementation of EU Directives in 2003.

In the telecommunication sector, prices have decreased in 2002 by 5.4%. The Authority for Telecommunications has recently revised downward the price cap in the retail market. Furthermore, recently introduced measures will result in further reductions in prices, likely to be in the order of 15%.

With reference to the electricity sector, some competition enhancing measures have recently been implemented and others are being developed. By July 2004 final users—except households—will be able to choose their own provider, while households will be able to do so by July 2007. The establishment of the Electric Exchange, which will start its operations early in 2004, is expected to increase the transparency of prices in this sector.

It should be noted, however, that the level of energy prices mainly reflects the lack of lowcost energy sources in Italy, differently from other European countries. A number of initiatives recently undertaken by the authorities address this issue by providing incentives to develop renewable energy sources. With the aim of increasing the productive capacity, a recently-introduced law considerably streamlines the procedures for building new electric plants and for connecting the domestic electric system with those of other countries. However, while these measures have a favorable impact on prices in the long-run, they may induce temporary upward pressures in the short-run, given the need for financing extensive investment plans.

Labor market. Encouraging results and new measures

Higher growth will require higher employment. For the first time since the release of new Istat data on employment (end 1992), the Italian unemployment rate is as low as 8.7%, slightly below the EU12 average. The employment level has surpassed 22 million people in 2003 (marking an increase of 231,000 units with respect to the previous year). The employment rate and the activity rate are also rising. As emphasized also in the staff report these results are encouraging, the more so given the low growth environment, and they are largely the result of reform measures introduced during the second half of the nineties. Such results are likely to be reinforced once the new labor market reform, approved by parliament in February 2003, produces its full effects.

The ‘Biagi’1 reform, represents a major step in the implementation of the Pact for Italy, signed in July 2002 between the government and the majority of social partners, aiming at raising employment rates in line with the EU Lisbon strategy. It includes a number of major institutional innovations in line with the approach of increasing ‘flexibility at the margin’. The implementing measures have entered into force in October 2003. They focus on improving job matching services and introducing/redefining different types of contracts. The intervention of a plurality of agents in an integrated network (private-public) should improve transparency and efficiency of job matching services, facilitating employment. A complete monitoring system will be instrumental in improving statistical information and especially in the evaluation of policies.

The second pillar of the reform includes measures to improve the legislative framework to better interpret the needs of a modern economy. It envisages flexible schemes to increase the opportunities for regular employment, according to workers and employers’ preferences: the introduction of job sharing, temporary jobs, a redefinition of part-time, incentives for training young people entering the job market, workers over 50 and women in areas with high unemployment.

Wage differentiation

Given the large regional disparities staff suggests that more pronounced wage differentiation would improve employment opportunities. As we reiterated in last year’s discussion such initiatives are for the social partners to decide. With respect to staff’s advice that the public sector should play a leading role in introducing wage differentiation through differentiated cost of living allowances for public employees, my authorities believe that public salary differentiation should reflect different productivity levels, as already is the case for the private sector. A first step in this direction has already been taken for the salary of top management in the Public Administration, which is partially related to performance.

The Mezzogiorno. Breaking with a long tradition of ineffective policies

As we had already noted during the 2002 Art. IV consultation there is no doubt that Italy’s long-term growth would be significantly increased if the Mezzogiorno could complete its catching-up process. The chapter on the Mezzogiorno included in the selected issues offers a quick, yet comprehensive, description of the evolution of the policy approach to this deep rooted problem. It also highlights how the new approach adopted by authorities since the mid nineties is now beginning to bear fruits.

The new approach is based on a shift away from sectoral interventions towards integrated regional policies that are based on concentrating funds on selected targets to increase competitiveness rather than on broad redistribution measures, provision of public goods (especially, physical and immaterial infrastructure) rather than state aids. Moreover, it introduces a reform of the implementation practices, including stronger monitoring and evaluation, increased transparency and accountability. Special emphasis is put on coordination in the provision of public goods and incentives for institution building and empowerment of regional administrations.

In this context, the performance reserve system introduces incentives for local administrators to accelerate the implementation of administrative reforms and pursue high quality projects. In Southern Italy, the modernization of regional administrations takes on special relevance, given that they are responsible for selecting projects for nearly two thirds of all capital resources available. The national performance reserve system of the Community Support Framework 2000-2006 allocates nearly five billion euro (10 per cent of total funds, the highest percentage among all EU Member States) to high performing administrations. The reward system is based on clearly identified indicators, approved by central and regional administrations. The system has led to significant results, although with variations across regions, including: the implementation of administrative reforms (for example delegation of managerial responsibilities to public officials; setting up of public investment evaluation and verification units, etc), administrative innovations (promotion of the information society in public administration; setting up of one-stop shop for enterprises, etc.) and the implementation of structural reforms in key sectors (integrated water resource systems and urban waste collection etc.).

This approach will take time to show its results. However, it is encouraging to observe that regional output and unemployment disparities have declined since 1999. The latest available information show that the southern regions are performing above national average. Improved confidence in the private sector goes hand in hand with the positive results in the labor market, where unemployment has further been reduced to 16.8% (in July 2003). The contribution to growth of infrastructure investment since the second half of the nineties is also a positive sign, indicating a stronger effectiveness of public investment.

The Italian EU Presidency, considers cohesion policy a fundamental pillar in the process of EU integration and has recently promoted an initiative to evaluate the reform prospects in the context of EU enlargement. The guiding principle is that cohesion policy, by reducing social and economic disparities, can strongly contribute to the Lisbon and Gothenburg agendas, to boost competitiveness in employment and growth.

Fiscal consolidation. Increased emphasis on structural measures to reduce spending and support growth

The low growth environment and the high stock of debt continue to put severe pressure on the budget. The financial law for 2004, now under discussion in Parliament, amounting to approximately 16 billion euros is based on the following principles: continued consolidation of public finances, gradual elimination of one-off measures and their replacement with structural measures aimed at reducing spending, additional measures to support growth and competitiveness.

Eight billion euros will be targeted to the South to increase physical and immaterial infrastructure. In this area, projects have already come a long way: from July 2001 through June 2002 infrastructural projects have been launched for a total of 32 billion euros; between July 2002 and June 2003 projects for an additional 19 billion euros have been allocated.

A significant amount of resources will be committed to support innovation activities. Measures include the tax abatement of profits reinvested in innovation and research activities and fiscal incentives to Italian researchers working abroad to return home. A new Institute for Technological Innovation will be established, aiming at creating a more effective interaction between R&D activities carried out in universities and applied R&D performed by the private sector, also through reinforcing monitoring and dissemination of results.

On privatization, a few days ago, the authorities have divested shares from ENEL for an amount equivalent to 6.6% of its capital, with a view to further reduce their holding in the future.

The 2003 deficit will be close to 2.5% of GDP, 0.2 percentage point higher than in 2002. The cyclical adjusted deficit, however, amounts to 1.9% of GDP, 0.3 percentage points lower than in 2002. The output gap2 will be significantly higher in 2003 than in 2002, given the prolonged slowdown. This has resulted in an increase in the cyclical component of the deficit amounting to 0.7% of GDP.

Looking ahead, the cyclically-adjusted budget deficit in 2004 should fall to 1.6% of GDP, thus decreasing by a further 0.3% with respect to 2003 and the trend should continue in the following years, with a 0.5% reduction each year, implying to significant fiscal consolidation effort in 2005-07.

Pension reform

The proposed pension reform, which is currently being discussed, builds on the 1995 reform (“Dini”). The overall aim is to prolong working life, rising the retirement age to 60 for women and to 65 for men, - a measure staff has advocated several times in the past–and extend the contributions period needed to access the pension benefits to 40 years (from 35). This strategy, which requires a significant investment of political capital by authorities, alleviates pressure on financing requirements over the coming years due to the rise of aging population and contributes to rising the employment rate and will ultimately support long term growth. These last results will be enhanced by some provisions of the Biagi law which encourage firms to hire workers over 50 through fiscal bonuses similar to those previously granted for the exclusive hiring of young people. In the same fashion, actions will be taken to encourage continuous learning during the workers life cycle so as to facilitate job transition for senior workers.

Staff has produced a remarkable job in carefully reviewing the Italian pension system and exploring its future evolution under different assumptions and policy options. Staff and authorities however (RGS, Ministry of Finance) adopt different assumptions on both the macroeconomic outlook (GDP and labour productivity) and on the size of the deficit for their long-run projections. In particular, authorities’ assumptions foresee an average annual growth rate of Gdp of 1.4 – 1.5%, in line with both the European Union and the OECD long-term scenarios for Italy. Staff assume a growth rate slightly below 1%, with a difference of about 0.5 percentage point per year. Similarly different assumptions are made with respect to labour productivity which my authorities place at 1.7-1.8% on average for the overall simulation period, with a peak of 2.0% from 2026 to 2050, while staff numbers are respectively 1.2-1.3% and 1.5%.

The combined effect of different macroeconomic assumptions and different hypotheses on the deficit level leads to quite different results. Staff project an explosive growth of the debt/GDP ratio to over 200% in 2050 while the EU projections, which my authorities take as reference, indicate a final debt ratio ranging from approximately 90% to zero according to the assumptions on net borrowing requirements

The Banking System

The position of the banking system is sound. Capital adequacy ratios have increased during 2002, the ratio of nonperforming loans to total gross loans has decreased in the course of 2002 to 6.5 percent, and large exposures in relation to capital have fallen.

With regard to the cost structure and the profitability of the banking system, structural improvements in cost ratios have been achieved as a result of the reorganization of the banking system that began in the mid-1990s. The increase in operating costs in the most recent period is mainly due to investments in the field of information technology and to early severance incentives. As a result, between 1995 and 2002 the stock of IT capital rose roughly fourfold, and the number of employees decreased by 4.5 per cent. In the years 2000 and 2001, the profit performance of the Italian banking system was heavily affected by the financial difficulties in some Latin America countries and a few large foreign corporations. In fact, the operating profits of Italian banks turned out higher than the EU average.

Looking ahead, the authorities welcome any further action aimed at strengthening the profitability of the system. It should be, however, noted that policies directed to enhance the efficiency of individual institutions are up to bank managers, who can choose among a wide range of options. MAs made it possible to improve the efficiency in the production and distribution of banking services in Italy starting from a situation in which the banking system was highly fragmented, with a large number of small and medium-sized banks engaging mainly in deposit-taking and lending in local markets.

Official Development Assistance

Italy has subscribed to the EU commitment to pursue the 0.39 percent objective (as a collective average) as an intermediate objective in view of the attainment of the UN target of 0.7 percent.

Within this framework, Italy is committed to make every effort to reach the 0.33 percent target by 2006 and the Italian government has defined a roadmap for a gradual increase in ODA from 2002 to 2006.

Some progress is already visible. In 2002 and 2003 the Italian percentage of ODA in relation to the Gni went up to 0.20 and 0.21 percent respectively after a sharp decline in the Nineties (from 0.41 percent of Gdp in 1989 to 0.15 in 2001). ODA increased also very substantially in real terms (by 31.5% in 2002) reflecting a major increase in bilateral aid, including debt relief operations in the context of the HIPC initiative, as well as contributions to the EC and Global Funds.

In addition, the Italian Government is in the process of devising alternative mechanisms of development financing, such as the de-tax, which was approved by the Parliament in March 2003, and is expected to become operational within one year. This mechanism is based on the involvement of private sector in the financing of development and would free additional resources with respect to ODA.

1

The law takes its name after its original proponent Marco Biagi, a Professor of Law and consultant to the Minister of Welfare, assassinated by the Red Brigades in March, 2002

2

Computed according to EU methodology