Italy: 2006 Article IV Consultation—Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Italy

This 2006 Article IV Consultation highlights that Italy’s economy is enjoying a broad-based, if comparatively modest, cyclical upswing. Output is estimated to have grown by 1¾ percent in 2006—the strongest pace since the beginning of the decade. Inflation is close to that of the euro area, financial conditions are favorable, unemployment is falling, and the current account deficit is moderate. Some progress has been made on broad-based structural reform. Recent initiatives in labor contracting envision a partial rollback of earlier liberalizing reforms.


This 2006 Article IV Consultation highlights that Italy’s economy is enjoying a broad-based, if comparatively modest, cyclical upswing. Output is estimated to have grown by 1¾ percent in 2006—the strongest pace since the beginning of the decade. Inflation is close to that of the euro area, financial conditions are favorable, unemployment is falling, and the current account deficit is moderate. Some progress has been made on broad-based structural reform. Recent initiatives in labor contracting envision a partial rollback of earlier liberalizing reforms.

I. Background: A Propitious Setting for Adjustment and Reform

1. A cyclical upswing is underway. After four sluggish years, growth recuperated to about 2¼ percent during the first three quarters of 2006 (annualized), as exports finally got some lift from the global expansion, feeding a recovery in fixed investment and employment, and underpinning continued moderate consumption growth. The current pick-up is notably more broad-based and balanced between domestic and foreign sources than the previous aborted recoveries of 2003–04.

2. But the recovery masks Italy’s longer-term low-growth malaise. Potential growth rates have declined from around 4 percent in the early 1970s to about 1¼ percent currently. Extensive product market regulation and protection, a slow legal system, and a heavy tax burden have all combined to discourage innovation and inhibit restructuring, especially in industry, where the productivity gap relative to France and Germany is striking. Recent reforms of labor contracts have led to a significant increase in employment, but have not translated into higher output due to declining productivity growth. As a result, Italy continues to lose competitiveness. Economic rigidities, along with Italy’s historic specialization in products with relatively low value added, contributed to a steady erosion of competitiveness, reflected in a substantial loss of export market share (Box 1).

Annual Labor Productivity Growth by Sector, 2002-05

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excludes construction

3. Earlier labor market reforms have led to significant increases in employment. Employment under new flexible contracts, fostered by the 2003 “Biagi” and earlier laws, has grown briskly, outpacing traditional employment growth and accounting for the bulk of new hires; regularization of immigrants also sustained employment growth. The cheaper flexible contracts helped contain growth of real wage and labor costs, especially in services.1 The unemployment rate fell to 7 percent by 2006:Q2, but the share of long-term unemployment (half) has remained unchanged, unemployment among the old and young is still high, and the participation rate has remained at 63 percent since 2003.

Italy: The Growing Importance of Flexible Employment, 2004-2006

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Source: Istat

Data for 2006 refer to Q2.

Permanent part-time and all fixed-term contracts.


Italian Experience: “Job-rich” Stagnation

Citation: IMF Staff Country Reports 2007, 064; 10.5089/9781451819991.002.A001

Source: Eurostat, ISTAT, WEO projections.

Low Productivity Growth is a Key Problem

Citation: IMF Staff Country Reports 2007, 064; 10.5089/9781451819991.002.A001

Source: Istat, OECD.

Italy’s Dwindling Competitiveness1

Italy has steadily lost export market share since the early 1990s. Based on national accounts data for real exports of goods and services, Italy’s market share declined some 38 percent since 1993, versus 2 percent for the euro area as a whole.2 Constant market share analysis suggests the bulk of Italy’s market loss has been due to deteriorating price competitiveness.

Italy: CMS Analysis of Export Changes 1/

(In percent)

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Source: IMF staff estimates.

Constant market share analysis based on the commodity composition of exports as of 1994.

A range of indicators points to an appreciable, albeit not large, competitiveness gap versus other euro-area members. Italy’s unit labor cost-based real effective exchange rate has appreciated by some 20 percent since 1998—generally considered a benchmark year—and 2005. However, establishing a benchmark year is not without problems and staff used complementary (CPI-based) methodologies to estimate Italy’s competitiveness gap at end-2005, including a current account (macroeconomic balance) approach, a reduced-form equilibrium real exchange rate approach using determinants drawn from cross-country panel data analyses (net foreign assets relative to exports, terms of trade, labor productivity, and government consumption), and an external sustainability approach. Though such methodologies have known shortcomings with the results contingent on the assumptions and subject to estimation errors, they suggest a competitiveness gap in the range of 5 to 8 percent.


A Selected Issues Paper explores measures of the competitiveness gap.


In value terms, Italy’s market share declined by 23 percent in the same period.

4. There are initial signs of structural transformation. A recent pickup in exports in value terms, including in some traditional sectors and in highly competitive emerging markets, suggests that the initial stages of transformation to higher value-added goods may be unfolding. And anecdotal evidence suggests that Italian firms have begun to outsource to enhance their competitiveness, although they remain behind regional competitors in this process.


Initial Signs of Recovery in Some Traditional “Made in Italy” Sectors

Export volume by sector, six-month growth averages (in percent) 1/

Citation: IMF Staff Country Reports 2007, 064; 10.5089/9781451819991.002.A001

1/ Normalised by the growth rate of total exports in goods.Source: ISTAT

The Anatomy of Recovery: More Balance Among Growth Components 1/

Citation: IMF Staff Country Reports 2007, 064; 10.5089/9781451819991.002.A001

1/ The timing of the quarter “zero” corresponds to the respective troughs of the cyclical upswing episodes, as follows: 2002 - Q1; 2003 - Q3; 2005 - Q1.Sources: Istat, IMF Staff estimates.

5. Remarkably strong budget revenues translated into appreciable fiscal overperformance (net of one-offs) in 2006, despite substantial spending overruns. While the determinants of the revenue buoyancy — observed also in several other EU countries — remain to be fully explained, the increase is broad based and a substantial part seems structural. The authorities speculate that the new government’s commitment to eschew tax amnesties and combat tax evasion is enhancing compliance, including on the part of those that have “emerged” as a result of previous pardons.2 Spending however exceeded the budget target, driven by a persistent upward drift in primary outlays (Box 2).3 Still, the general government deficit, net of two large one-off operations,4 is estimated by staff to have declined to 3.0 percent of GDP in 2006 (versus an original budget target of 3½ percent of GDP), implying an appreciable withdrawal of fiscal impulse. The headline deficit, however, is estimated to have risen to 5.0 percent of GDP.


Nominal year-on-year revenue growth and elasticity to GDP Q1-Q3 2006

Citation: IMF Staff Country Reports 2007, 064; 10.5089/9781451819991.002.A001

6. The 2007 budget seems likely to meet the thrust of Italy’s EDP obligations. The budget targets a headline deficit of 2.8 percent of GDP and, in official calculations, a cumulative underlying adjustment of 1½ percent of GDP in 2006–07. In staff’s view, even discounting the yield of certain measures, the more favorable base given by the 2006 overperformance should ensure that the headline target is met, although staff’s estimate of underlying adjustment is less (some 1 percent of GDP). After rising in both 2005 and 2006 (partly due to the VAT repayments), the public debt/GDP ratio is projected by staff to remain broadly unchanged in 2007, at around 107 percent.

The Relentless Growth of Primary Spending

Italy’s primary spending ratio grew by 2½ percentage points of GDP in 1995–2005, in marked contrast to other large euro-area countries.


Change in Primary Spending: 1995-05

Citation: IMF Staff Country Reports 2007, 064; 10.5089/9781451819991.002.A001

Part of the spending growth appears to stem from euro-area wide convergence in current primary expenditure/GDP ratios, of which there is some evidence. In Italy the initial level of such spending was lower than the euro-area average, though health care spending has now caught up, and the pension and public wage bills are significantly above those of the euro area. Also, the pronounced decline in long-term interest rates over the past decade cut the cost of capital (especially for high-debt countries) and facilitated investment spending.

But the rise in primary spending also reflects missed opportunities from the lower interest bill, combined with Italy-specific policy slippages.

  • The large fall in the interest bill in high-debt countries was ultimately used for new spending, rather than deficit reduction.

  • Italy incurred significant overruns relative to own-spending targets, explaining much of the deficit slippages in 2001–05.

  • With social spending growth contained by pension reforms, other current spending (notably on wages and goods and services) rose rapidly since the late 1990s, partly reflecting the lack of a comprehensive expenditure framework.

7. Financial conditions remain sound. Bank profits have edged up and the quality of their loan portfolio has improved. Household balance sheets remain robust despite double-digit consumer credit growth over the past few years. Household debt, at 34 percent of GDP, is well below the euro-area average. Despite the recent up-tick in servicing costs, delinquency rates are low. Corporate leverage also increased as corporations locked in low interest rates. The October 2006 downgrading of Italian sovereign debt had a minimal impact on long-term spreads, which remain—at about 30 basis points relative to German Bunds—somewhat lower than during the period surrounding the April 2006 elections. Continued lengthening in the average public debt maturity has further reduced the sensitivity of debt service to upward interest rate movements.


Fiscal Imbalances Persist

Citation: IMF Staff Country Reports 2007, 064; 10.5089/9781451819991.002.A001

Source: Eurostat and ISTAT

Monetary and Financial Indicators Remain Favorable

Citation: IMF Staff Country Reports 2007, 064; 10.5089/9781451819991.002.A001

Sources: Eurostat, Istat.

8. Staff expects growth to slow from 1.7 percent in 2006 to 1.4 percent in 2007. Continued moderate consumption growth would be supported by increased disposable income, employment gains, and healthy balance sheets. Investment growth seems set to decelerate but remain positive, sustained by domestic and foreign demand, increases in capacity utilization, and favorable financing conditions. The contribution of net exports would again be flat.

9. The risks to the outlook appear broadly balanced. The authorities saw slowing partner country growth, including a sharper than expected slowdown in the United States, and an unwinding of global imbalances that entailed euro appreciation as the main downside risks. Staff and other observers also noted the risk of adverse confidence effects provoked by the 2007 budget’s reliance on the revenue side. Upside risks stem from the ongoing economic restructuring, which some observers—while recognizing the lack of hard data—view as relatively advanced.

10. Inflation is set to hover slightly above 2 percent. Although headline CPI inflation recently edged down to 2 percent thanks to declines in oil prices and base effects, core inflation edged above that of the euro area, to 2 percent. The relatively high level of inflation in Italy suggests that the staff’s estimate of economic slack could be overstated, at least in the labor market. Thus, while staff projects wage growth of 3 percent in 2007, the possibility of generous wage increases in the public sector, with a demonstration effect on the private sector, could threaten this outlook.

11. The politics are difficult. The recently elected center-left government’s parliamentary majority is thin and the coalition comprises a broad spectrum of economic views, ranging from a committed reformist core to parties resistant to market-oriented reform. Although the government has overcome the budget hurdle, this has not been without concessions, and the outlook for fundamental fiscal adjustment and economic reform remains uncertain, with market concerns reflected in the credit ratings downgrades.


High-Frequency Indicators Bode Well for Continued Moderate Growth...

Citation: IMF Staff Country Reports 2007, 064; 10.5089/9781451819991.002.A001

Sources: Istat, ISAE.

12. Converting the current cyclical upswing into sustained growth and fiscal adjustment will require advancing on a broad front, stressed in previous Fund advice. Within this overarching theme, the Consultation discussions—the first with the new government—focused on using the start of the government’s term and the cyclical upswing to:

  • embark on and sustain expenditure-based fiscal consolidation;

  • return to growth by stepping up structural reforms;

  • further develop the financial system, while maintaining financial stability.

II. Policy Discussions

A. “If not now, when?”

13. The government has committed to strengthen the fiscal accounts and undertake competition-enhancing reforms, but deeds have not fully kept pace with words. In staff’s view, the 2007 budget puts too little emphasis on expenditure control and—after a promising start—the structural reform process still has to gain momentum and strategic coherence. The authorities contested this view, both in its substance (seeing the 2007 budget as an important first step on the medium-term consolidation path, and the structural reform process as being on track), and in its approach, arguing that the yardstick for assessing the government’s action should reflect a pragmatic, tempered balance between what is desirable and what is feasible, with critics (including staff) focusing unrealistically on the former

14. In staff’s view, the current environment is likely to prove “as good as it gets” for needed reforms. International experience indicates that structural reforms are best enacted early in a government’s mandate. Furthermore, a cyclical upturn marked by significant revenue overperformance constitutes a highly supportive setting for fiscal adjustment. While deferring on the assessment of the political constraints, staff shared the approach set out in the government’s ambitious medium-term economic program of July 2006—centered on expenditure control in key areas and competition-enhancing reforms—and argued for early action exploiting the window of opportunity now open.

Italy: Fund Policy Recommendations and Implementation

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B. Pursuing Sustained Fiscal Consolidation

The 2007 budget

15. While the likely observance of EDP commitments is a noteworthy achievement, views differed on the headway being made on fundamental expenditure control. Due to a range of new “pro-growth” and “pro-equity” spending initiatives, the 2007 budget promises no net reduction in spending, and the targeted adjustment comes entirely from an increase in the revenue ratio. While staff acknowledged that the budget contains some first steps to address medium-term spending pressures, it saw these as falling short of realizing the commitment in the government’s medium-term economic program of countering these pressures comprehensively in the key areas that account for the bulk of spending—public administration, local authorities, health care, and pensions.

Key Fiscal Indicators, 2005–07

(In percent of GDP) 1/

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Assumes staff’s GDP and output gap throughout.

Treats severance benefits contributions (0.4 percent of GDP) as one-off.

For 2006, net of two large one-off operations, which raise the deficit by 2 percent of GDP.

  • Public administration. The budget incorporates plans for reorganizing the public sector, reducing ministerial offices, eliminating duplication, regrouping agencies from a provincial to a regional level, and gradually reducing public employment. The authorities recognized that key to success lies in securing increased mobility in the civil service, which could not be legislated but would be pursued with the trade unions in early 2007. Staff noted that the resulting savings risked being largely offset by relatively generous wage renewals and large-scale conversions of temporary contracts to open-ended employment.

  • Local authorities. A new Domestic Stability Pact replaces expenditure ceilings with explicit deficit targets, and grants local authorities greater taxing leeway, while cutting state transfers. The authorities rebuffed arguments that these measures will mostly operate through higher local taxes, since local authorities could (and should) increase efficiency and cut spending. There was agreement that attaining full-fledged fiscal federalism will require further institutional steps—under preparation—to reconcile local autonomy with fiscal responsibility.

  • Health care. In September 2006, the government signed a potentially promising new “health pact” with the regions, establishing multiyear financing envelopes to increase budgetary certainty, and undertaking various cost-saving initiatives. Regions in breach of their healthcare spending limits and failing to take sufficient corrective measures have been made subject to automatic increases in some regional tax rates (as envisioned in the 2006 budget)—a measure expected to exercise a particularly effective disciplining role in the five affected regions.

  • Pensions. The budget raises contribution rates for the self-employed, but contains no cost-saving measures in this area. Rather, in September 2006, the government signed a Memorandum of Understanding with the trade unions setting out broad principles and a number of potentially constructive commitments (regarding, for example, incentives to lengthen the average working life and links to demographic developments) for additional pension reform by March 2007. Staff stressed that any agreement would need, at the least, to fully preserve the financial impact of already approved reforms5 and help raise the still very low elderly participation rates, contributing to enhance potential growth. The budget also brings forward steps to promote private pensions savings, originally due to come into effect in 2008.

16. The authorities argued that the 2007 budget initiated more medium-term spending restraint than generally recognized or than most previous budgets. They felt that much of the criticism failed to consider some key constraints. First, the difficulty of the inherited situation, in the form of unrealistic spending ceilings, and consequent overruns, in the 2006 budget. And second, the short-term rigidity of spending, and the related fact that longer-term structural reforms are the real key to growth and fiscal sustainability, a process they intend to pursue in 2007. Even so, the authorities argued that appreciable progress was implied on the spending side—arresting the rising trend of current primary spending and broadly stabilizing its ratio to GDP in 2007.

17. The authorities also noted that many of the revenue items in the budget were worthy initiatives in their own right:

  • A significant portion of the revenue increase was expected to come from measures to reduce tax evasion and avoidance, and which—apart from equity considerations—would yield important efficiency gains and did not involve an increase in tax rates. The authorities have also committed to reduce tax rates in the future in parallel with gains from the proposed measures.

  • The planned unification of tax rates for final withholding on various types of financial income would remove distortions in the tax system.

  • The cut in the tax on labor would help enterprise competitiveness.

Thus, rather than constraining medium-term growth prospects, these measures were in the authorities’ view likely to enhance economic efficiency and growth potential.

18. While welcoming measures to broaden the revenue base, staff urged greater reliance on expenditure restraint and enhancing its quality. Evidence from around the world clearly shows that, to be successful and durable, fiscal adjustment needs to be based on curbing current expenditure, not raising revenue, partly because of the confidence-dampening impact an increase in the tax burden can have6—and to allow a concomitant reduction in tax rates, while safeguarding deficit reduction. Also, a higher revenue-to-GDP ratio risks providing leeway for additional spending. Staff noted that there was considerable scope for enhancing the effectiveness and efficiency of individual spending programs—a point shared by the authorities.

19. Staff took exception to the redirection of workers’ severance fund flows being treated as “adjustment.” The budget contains a measure—designed to promote supplementary pension savings—whereby workers’ contributions to firm-based severance funds would automatically be directed to a private pension fund (in most cases, an occupational pension fund) in 2007, unless the worker explicitly opts for another pension fund or for continued accumulation of severance funds. In the latter case, and for firms with over 50 employees, contributions (recorded as revenue in the fiscal accounts) would accrue to a special account at the Social Security Institute, to be used to finance public infrastructure. Staff noted that such flows (estimated at 0.4 percent of GDP in 2007) give rise to a liability to provide workers with severance payments in the future, and their diversion to the state would furthermore be costly (as the government is to match not only the previous return on such funds but also compensate enterprises for the loss of cheap financing).

Longer-term fiscal sustainability

20. Achieving long-term sustainability means going beyond EDP targets. Staff projections show that without deficit reduction beyond that contained in the EDP commitment to bring the deficit below 3 percent of GDP in 2007, public debt will be on an explosive path. By contrast, further consolidation through 2010, along with a modest improvement in productivity growth, would put the debt ratio on a firmly declining trend (Box 3). While the authorities’ official Medium-Term Objective—a small overall surplus by 2011—is consistent with that proposed by staff (the same surplus by 2010), a legacy of missed budget targets and persistent failure to undertake expenditure-based fiscal adjustment has severely eroded its credibility.


Deficit Forecasts/Outcomes, 2003-06

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 064; 10.5089/9781451819991.002.A001

1/ In 2006, excludes impact of railroad debt (0.9 percent of GDP).

21. The mission called for a multiyear spending framework with clear targets for outer years, backed by structural expenditure-saving measures. Such measures should be defined soon to be effective before the next budget round, with the aim of bringing the fiscal accounts into balance at least by 2010. Without such measures, Italy’s reentry below the Maastricht threshold could be short-lived: indeed, staff projects a deficit of 3.0 percent of GDP in 2008, and official forecasts also see the deficit creeping back up to 2.9 percent of GDP in the absence of further measures. A credible framework to ensure that any revenue overperformance be used for deficit reduction would also help.

22. The authorities’ medium-term plan envisages reducing public debt to below 100 percent of GDP by 2011. This is to be done essentially by rebuilding the primary surplus—now negative (partly reflecting one-off factors)—to just under 5 percent of GDP by 2011; the medium-term plan does not contain any explicit assumptions about debt reduction via privatization or asset sales. The authorities explained that while sales of public equity and other assets would proceed as and where possible (with some being planned for 2007), they viewed skeptically the feasibility of large-scale operations being studied by the previous government. They furthermore did not wish to nourish any illusion of an “easy” solution beyond the hard work of rebuilding a sufficiently large primary surplus. They nonetheless shared staff’s call for continued public divestment and for deep restructuring of several financially distressed public enterprises (Box 4).7

Fiscal Sustainability—Averting a Debt Explosion

Baseline scenario – debt explosion. The baseline assumes current policies through 2010 and thereafter keeps revenue and non-age-related spending ratios to GDP constant. Age-related spending reflects the authorities’ demographic projections and recent pension reforms (part of which remain to be implemented). Given unchanged policies, it assumes only a modest rise in labor productivity growth (to 1¼ percent annually, slightly above the rate achieved over the last few years) and in the employment ratio (by 5 percentage points over the next 20 years). Both assumptions are less optimistic than official projections, and together result in long-run annual real GDP growth of ¾ percent (and per capita GDP growth of slightly under 1 percent). The medium-term TFP growth would slightly lag labor productivity, but its estimation is hampered by significant data uncertainties. In any case, the growth in labor productivity would have to be supported by a combination of fairly modest employment gains and strong gross fixed capital formation. Under these assumptions, the fiscal deficit would decline over the next few years, but would rise thereafter, due to increased aging-related spending and, later, interest payments. The debt ratio would explode to almost 300 percent in 2050. In addition, failure to implement already legislated pension reforms would lead to even more explosive debt dynamics (Table 5).


Fiscal Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 064; 10.5089/9781451819991.002.A001

Adjustment scenario – debt stabilizes below the Maastricht threshold. The staff’s adjustment scenario features further structural consolidation of 0.8 percentage point of GDP every year in 2008–10 through spending cuts, reaching a small overall surplus. Assuming current and future structural reforms, productivity growth would increase by ¼ percentage point over the baseline. Interest bill savings would finance higher age-related spending, with the debt ratio falling to around 55 percent by 2035 and then stabilizing. The stark gap between the two scenarios derives from the accumulated difference in the fiscal balance through 2010 and the (upward) impact of (slower) growth on the pension/GDP ratio. These results underscore that achieving debt sustainability depends on both further fiscal consolidation and growth-promoting structural reforms.


Public Debt Dynamics

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 064; 10.5089/9781451819991.002.A001

Table 1.

Italy: Summary of Economic Indicators

(Annual percentage change, unless noted otherwise)

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Source: ISTAT, IMF Staff Projections.

Staff estimates and projections, unless otherwise noted.

Contribution to growth.

In percent of GDP.

Twelve-month domestic credit growth, adjusted for securitizations. 2006 data refer to August.

Excludes currency in circulation held by nonbank private sector. 2006 data refer to November.

Data for 2006 refer to December.

Table 2.

Italy: General Government Accounts, 2002–08

(In percent of GDP)

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Sources: ISTAT; Ministry of Economy and Finance, and Fund staff calculations and estimates.

Includes revenue from severance payments contributions (TFR), from 2007 onwards.

In 2006 capital spending is increased by the VAT reimbursement of 1.2 percent of GDP (of which 0.9 percent of GDP relates to prior years) and the assumption of railways-related debt of 0.9 percent of GDP.

In percent of potential GDP, assumes staff’s output gap.

For 2007, the “budget” public debt ratio is based on the authorities’ nominal GDP.

Table 3.

Italy: Financial Soundness Indicators

(In percent, unless otherwise noted)

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Source: Bank of Italy, Eurostat, Fund staff calculations.
Table 4.

Italy: Selected Indicators of 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, excluding gold.

Definition of M3 excludes currency held by the public.

Data refer to banks, including cooperative and mutual banks.

Table 5.

Italy: Public Sector Debt Sustainability Framework, 2003–50

(In percent of GDP, unless otherwise indicated)

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Sources: ISTAT; Ministry of Economy and Finance, and Fund staff calculations and estimates.

Assumes the baseline, and a scenario in which the 2004 pension reform is reversed and the life-expectancy coefficients are not updated as mandated by the 1995 reform.

Fiscal Risks from Italy’s Public Enterprises

Italy’s once vast public enterprise sector has been significantly reduced over the last two decades. In 1992, 12 of the 20 largest Italian firms (by sales) were state-owned, and the state’s holding companies were among the largest employers in the country. Despite being sheltered by legal monopolies and enjoying exclusive state concessions, the vast majority were unprofitable. Enabled by legislative and institutional changes, about 80 major privatizations, totaling some €125 billion, were completed during 1993–2005. Receipts were channeled to the Debt Retirement Fund, created in 1993, significantly reducing public debt.

The state’s current portfolio includes holdings in four listed companies and some twenty unlisted companies. The listed companies are performing well, with the notable exception of the airline company Alitalia; their market value was estimated at €32 billion (about 2 percent of GDP) at end-October 2006. Unlisted companies operate in various sectors; the Ministry of Economy and Finance intends to divest the most profitable over the next few years (with an estimated value of about 2 percent of GDP). However, the road company (ANAS) and the railway holding company (FFSS) are running losses financed by state transfers and reserve drawdowns.

These companies’ shaky finances pose fiscal risks. Even if the government, according to corporate law, would not be directly responsible for their liabilities in case of default, it is likely that these companies, that jointly employ more than 100,000 workers, would be considered “too big to fail.” At the same time, the government has also been transferring risks to these companies, by cutting their capital transfers (deep cuts in the 2006 budget had to be reversed with midyear supplementary allocations when they proved unfeasible). While needed restructuring will take time, early steps to secure timely reporting and enhanced transparency of these companies’ operations will be key to any reform effort.

23. Reform of the tortuous budget process is critical. This is widely agreed, in good part because of the following considerations:

  • The budget’s unwieldy “omnibus” presentation, fragmented into thousands of budget forecasting units, and set out in various documents using different aggregations and accounting methods, renders it inaccessible to most and fails to provide a clear picture of government finances even to the initiated.

  • These same features—combined with a complex approval process and delays in the availability of some key documents—also render the budget almost impossible to approve in line with the parliamentary schedule, leading to systematic recourse to confidence votes, even by governments with comfortable majorities.

  • Budget preparation and execution is focused on legal compliance rather than on efficiency and quality of public services, with a related lack of accountability for results.

Momentum is thus building for budget reform, including a move to performance-based budgeting.8 Staff also called for improvements in the timeliness of some key budget documents and for greater institutional independence of budget assessments and projections. The authorities are pursuing some initiatives designed to enhance independence of fiscal analysis, largely based on the existing institutional framework.

C. Returning to Growth

Stepping up structural reforms

24. There was agreement on many areas of structural reform needed to address insufficient competition and overregulation, but not on labor markets. The OECD reports that Italy has the most highly regulated product markets in the EU-15, and various cross-country reviews identify excessive regulation as a continuing problem in key sectors, accounting also for Italy’s undersized services sector and high energy prices. In part due to these problems, Italy’s ranking in cross-country surveys of the business environment is poor (and worsening). Significant labor market rigidities (notwithstanding important progress) also inhibit growth by slowing labor reallocation. There was agreement that reforms to promote competition and eliminate bureaucratic impediments are thus essential to foster innovation and restore competitiveness. Indeed, these arguments feature prominently in the government’s medium-term program, which presents a compelling illustration of the benefits of greater competition for households’ budgets and firms’ costs (though it is short on details). In labor markets, however, staff and the authorities differed on the appropriate prescriptions on how best to address concerns about “precarious” employment.

25. After a promising start, the liberalization process has encountered stiff resistance from interest groups. In July 2006, the government approved a package of measures that liberalized aspects of transportation, professional services, retail trade, and banking and insurance services. Some of the reforms subsequently fell hostage to sectoral opposition, with, for example, protests by taxi drivers leading to maintenance of a key restriction to market access; supermarkets and other nonpharmacy outlets encountering supply difficulties for over-the-counter drugs they are now authorized to sell; and banks seeking means to hinder the effective portability of accounts and by-pass the disposition allowing their free closure. The Antitrust Authority has been proactive in attempting to ensure that such resistance would not dilute the reforms’ impact, promptly initiating enquiries into possible anticompetitive behavior, and has availed itself of new powers, including those over competition in the banking sector (previously vested in the Bank of Italy). It also expected the newly introduced “leniency policy” (whereby companies that provide information about a cartel in which they participate could receive immunity from fines) to be a potent instrument—as has been the case in other countries (including the United States).


Italy’s Economy Remains Rigid

Citation: IMF Staff Country Reports 2007, 064; 10.5089/9781451819991.002.A001

Source: OECD, EC, Eurostat, ISTAT.

26. The government has vowed to persevere with deregulation and liberalization, and a number of draft laws are in the works—but they too face opposition. The main initiatives concern energy, local public services, class action suits, and professional services. Several of these proposals face opposition—including from within the coalition—and thus an uncertain fate in Parliament. Resistance is particularly strong vis-à-vis initiatives that would open up local utilities to a competitive bidding process (the current practice of direct assignments to municipal companies being a long-standing font of patronage, in addition to a source of inefficiency); the easing of access to the professions; and the introduction of class action lawsuits, where fear of abuses may considerably enfeeble the scope for consumer redress. As to reform sequencing, there was agreement—based also on the July 2006 experience—that a bold stroke, simultaneously affecting economic rents across several markets, could help promote consensus and balance the interests of opposing stakeholders. Staff accordingly encouraged ambitious, broad, and early liberalizing moves. At the same time, given the dispersion of ministerial responsibilities, it saw a need for a strategic view and enhanced coordination in the pursuit of the liberalization agenda.

27. The government’s preoccupation with reducing the precariousness of employment threatens the recent liberalization of labor contracts. The liberalization of labor contracts in 2002–03 coincided with sharp employment growth, with the growth of “liberalized” employment outpacing that of “traditional” employment. Despite this, the level of temporary contracts in Italy is still comparatively low. There is nonetheless strong pressure (from trade unions and from within the coalition) to take steps to make employment more “stable” and reduce its precariousness. Proposals are still being developed, but are likely to include the suppression of some atypical contracts, limitations on the use and renewal of fixed-term contracts, and other steps to reverse the cost advantages of fixed-term contracts. In contrast, staff reiterated the need to further reduce the still high protection afforded to regular contracts, alongside introducing a well designed unemployment benefit scheme—whose absence underlies concerns about precariousness and inhibits risk-taking and mobility. It noted that simulations in other European countries suggest that, absent reforms affecting the rigidity of regular contracts, the initial employment spurt from liberalizing contracts will eventually fade. While instituting an adequate unemployment safety net is part of the official policy agenda, the authorities firmly ruled out easing dismissal protection, as contrary to the coalition’s electoral platform.9

Further developing the financial system

28. The new leadership of the Bank of Italy has supported banking sector consolidation, with tangible results. Shortly after taking office, the new Governor criticized the Italian banking system’s “strategic inertia” and made the case for a sustained, market-driven, consolidation effort. In this vein, the Bank of Italy abolished the requirement to notify the supervisory authorities of merger plans even before they are submitted to the board of directors. There has been appreciable movement over the past year: some sizable mergers are underway, including one that would create Europe’s third largest bank and, notably, cross-border mergers have also taken place or are being discussed.10 This process should enhance efficiency in the banking system—where the costs of banking services for customers are still high—and promote growth. The process is also testing the new joint oversight of merger activity by the Bank of Italy and the Antitrust Authority: while there remain some transition issues to resolve, both parties felt that matters were proceeding relatively smoothly. For its part, the Bank of Italy has announced a plan to reorganize its structure and staffing levels over time.

29. There was agreement that, to support growth and innovation, Italy’s financial system needs to further develop its capital markets (Box 5).11 The stock, insurance, and corporate bond markets are developing rapidly, but remain undersized. A range of key indicators are below the euro-area average, some considerably: the number of listed companies and the ratio of their total capitalization to GDP; the proportion of private equity investment dedicated to venture capital operations and, even more so, to start-ups; the capacity of small firms with innovative projects to raise funds on the capital markets; and the role of specialized intermediaries and pension funds. The situation is attributable to a range of impediments: bankruptcy and debt recovery procedures remain lengthy; the enforcement of corporate governance provisions has shortcomings; and a history of high tax evasion may compound these problems, as family-owned firms may believe they can more easily avoid the scrutiny of the fiscal authorities if they do not open themselves to outside capital. Against this, the authorities saw potential in their plans for a supplementary pension pillar. Staff concurred, but stressed that—given the complexity of the mechanism for the allocation of workers’ severance payment flows—there was a need for a clear educational campaign to allow informed choices. Free and fair competition between classes of asset managers and types of retirement schemes would also be important.

Finance and Growth in Italy

International experience suggests Italy’s growth prospects would benefit from further diversifying and deepening its financial system. Not only is financial development in general associated with higher growth, there is also some macro evidence suggesting that industrial countries with financial systems dominated by a particular type of intermediation, especially relationship lending, are less able to seize growth opportunities.1 The effect is particularly pronounced in countries that have specialized in more traditional industries, such as Italy.

Analysis of Italian micro data supports the tenet that availability of alternative sources of financing is associated with higher productivity and growth. The results, set out in a Selected Issues Paper, hold even when controlling for firm-specific financing decisions and industry-specific effects. In particular:

  • Debt financing has a positive marginal effect on firms’ future investment, innovation, and revenues. In particular, bond leverage is especially important in high-growth and tech-intensive sectors. And bond debt may mitigate the (generally negative) effect of concentrated ownership.

  • Diversification of bank lenders improves a firm’s future growth.

  • Public equity financing is strongly correlated with high growth and innovation. And firms that decide to list are more likely to operate in high-growth sectors, with high capital requirements and leverage.

Policies that could promote alternative financing sources include measures to: promote bank competition; reduce listing costs; enhance the effectiveness of corporate governance, accounting, and disclosure requirements; further enhance minority shareholder protection; discipline insider dealing reduce the overall administrative burden of doing business; and increase investor and creditor protection. EU-wide initiatives such as Financial Services Action Plan aimed at eliminating the remaining fragmentation in capital markets, offer a useful legal framework. Development of a private pension pillar and further public divestment could also help. While there has been progress across several of these areas in Italy, it remains uneven and insufficient.


See Levine, R., 2005, “Industry Growth and Capital Allocation: Does Having a Market- or Bank-Based System Matter?” in Governance: An International Perspective, Vol. 2; pp. 538–71; Elgar, Massachusetts, and IMF, World Economic Outlook, October 2006.

D. Maintaining Financial Stability

30. The 2005 FSSA found that Italy’s financial system was in good health from a stability standpoint, and subsequent developments have been favorable. In an environment of cyclical strength and only modestly higher interest rates, financial soundness indicators have tended to improve, some rapidly: bank net profits rose by 9.2 percent in 2005, and the nonperforming loan ratio, though still higher than elsewhere in Europe, fell markedly. Capital adequacy ratios have declined marginally, but remain well above the legally required minimum.

31. Important regulatory reforms are progressing. A revised Bank of Italy Statute, which, inter alia, establishes fixed terms for all members of the Bank’s Directorate and enhances the transparency and collegiality of its decisions, was adopted at end-November 2006. A Code of Ethics was also introduced earlier in the year. Decisions regarding changes to the Bank of Italy’s ownership (currently majority-owned by private sector banks) need to be implemented by the government within three years, according to the 2005 Savings law, with the Bank stressing the importance that its independence be fully safeguarded in the process. Progress has also been made on other FSSA recommendations, notably on rules governing the classification of impaired loans (gradually moving to the standard 90-day past due criterion) and regulation of lending to related parties.

32. Where possible, the Bank of Italy favors replacing detailed rules with supervisory principles and self-regulatory mechanisms. It views such a shift as allowing market forces to better express themselves, especially in a setting where constant financial innovation can result in the rapid obsolescence of formally rigorous rules. At the same time, it acknowledges that such an approach increases the responsibility of the supervisory authority, requiring it to be fully transparent in accounting for its actions. In this vein, staff suggested issuing regular forward-looking Financial Stability Reports—these could also contribute to much-needed financial education. The Bank was reviewing this possibility, with an eye also on evolving practices elsewhere (including at the Bank of England and the FSA for the United Kingdom) and on avoiding overlap with other analogous reports (e.g., by the ECB).

E. Other Issues

33. Italy’s statistics are broadly adequate for surveillance. The recent ROSC update reported some improvements, notably on reconciling the discrepancy between the fiscal deficit and the borrowing requirement. Further progress is however needed in the context of developing an integrated presentation of government finance statistics.

34. Italy’s ODA almost doubled in 2005 to 0.29 percent of GNI, but remains well short of the targeted benchmark. Due to stringent budgetary conditions, ODA is expected to decline in 2006–07, to 0.21 and 0.19 percent of GNI respectively (excluding planned participation in new financing mechanisms such as the International Finance Facility for Immunization).

III. Staff Appraisal

35. While a start has been made, the current economic recovery and the beginning of a new government’s term provide an opportunity for adjustment and reform that Italy can ill afford to miss. Growth is picking up, some progress has been achieved on the structural reform agenda, and buoyant revenues are helping the fiscal outturn. International experience suggests that reforms are best undertaken early in a legislature’s mandate. All in all, the current economic environment is likely to prove “as good as it gets” for fully implementing the authorities’ ambitious medium-term economic plan needed to unshackle Italy’s growth potential.

36. Remarkably strong revenues pushed the 2006 deficit below its original target, but record spending highlights fundamental problems. The strong revenue performance—at least partly structural—could strengthen the fiscal accounts in the medium term, but only if spending pressures are contained. The ratio of primary current spending to GDP is at its highest level in at least a quarter century. Rebuilding the primary surplus and driving down debt will require addressing the factors that account for this persistent rise in spending.

37. The 2007 budget seems well set to secure a key objective—reducing the deficit to below 3 percent of GDP—but relies entirely on higher revenues. The trend of rising primary current expenditure would be arrested (but only just) as envisaged savings will be offset by new expenditure initiatives. The budget contains some initial measures that could, over time, contribute to containing expenditure pressures. But they fall short of addressing comprehensively the structural determinants of such pressures. At the same time, scope for additional spending is created by the transfer of severance fund contributions to the public sector—an accounting measure that does not constitute underlying adjustment. Italy’s reentry within the Maastricht deficit limit—itself an important milestone—could thus prove short-lived, with the higher revenue-to-GDP ratio simply fueling the country’s relentless public spending machine.

38. Although a greater emphasis on overall expenditure control in the 2007 budget would have been warranted, some revenue measures are well-founded. Among these, curbing evasion would help improve equity and eliminate distortions that reduce Italy’s growth potential. The commitment to abandon tax amnesties should also encourage better tax compliance, provided it is fully adhered to. The resultant widening of the tax base would, along with durable progress in reducing spending, create scope for further tax reductions, building on the cut in the tax wedge planned for 2007, while safeguarding underlying adjustment.

39. Structural reforms in priority spending areas should be initiated now so as to make them effective before the next budget round. Planned discussions on civil service reform should begin promptly, with a view to reducing the relatively high wage bill and enhancing efficiency, including by increasing mobility, essential for the planned territorial reorganization. Domestic Stability Pact revisions that shift from spending to deficit limits are a step forward, but Italy is still far from a fiscally responsible system of federalism. The agreed health pact should be rigorously implemented. A series of pension reforms adopted over the years will—if implemented faithfully—significantly reduce the fiscal costs associated with an aging population. To this end, it is essential that the pension agreement sought by March 2007 fully preserve the financial impact of already legislated reforms. Finally, several state enterprises need restructuring to put them on a sounder financial footing, reducing another drain on public resources.

40. The growing interest in reforming budget procedures is well-placed. Current budget procedures concentrate on legal requirements and financial inputs, but not results; a shift to a program orientation can generate greater efficiency and accountability, both lacking. While reforming budgetary procedures can take years, introducing pilot projects along these lines can help initiate the process. A multiyear spending framework with clear targets for outer years would also facilitate planning. An explicit commitment to use revenue overperformance solely for deficit reduction would also be useful, as would greater institutional independence of budget assessments and projections.

41. Excessive regulation and protection continue to hamper growth: accelerating competition-enhancing reforms should be a high priority. Protection results in high prices for consumers and reduced competitiveness: a tax imposed on the majority for the benefit of the few. Measures to promote competition are critical to generate a more dynamic, efficient, and fundamentally fair economy. The liberalizing decrees introduced in the summer of 2006 provided an important initial signal, which should now be followed by appropriately ambitious liberalizing initiatives in the various areas under consideration. Moving forward, the liberalization agenda will need to be pursued within a well-coordinated strategy and with explicit timeframes. Proceeding on a broad front, addressing rigidities in a variety of areas simultaneously, can help promote consensus and a balance across the interests of different stakeholders.

42. Reforms to labor contracting have been critical to employment growth, and need to be safeguarded and extended. Notable improvements in Italy’s labor market have been made in recent years, resulting in strong employment growth. While fixed-term contracts have been an important path to traditional, open-ended employment for many, concerns have been raised about the precariousness of employment under these schemes. Rather than scale back these reforms—and with them much of the employment gains of recent years—the response should be to develop an adequate safety net, offering better, and appropriately conditional, unemployment support in tandem with further paring employment protection, for Italy to be able to compete in the global economy.

43. Over time, pension reform can also contribute to growth. Population aging stands to have a dramatic effect on Italy’s growth potential, particularly as participation rates for older individuals remain very low. Reforms that provide incentives to lengthen the average working life, by establishing a closer link between pension contributions and benefits and eliminating rules that bar retirees from working while receiving pensions, would enhance growth potential and allow a higher standard of living for the elderly.

44. To fully play its role in promoting growth, the financial sector needs to move beyond its heavy reliance on bank intermediation. Nonbank funding sources, in particular venture capital, are important for financing new firms. Here, action across a broad front to remove impediments is needed, including measures to improve the enforcement of the legal framework.

45. Recent developments in the banking sector have been positive. Financial soundness indicators have generally improved, and credit growth has remained robust. There has been significant progress in implementing the recommendations of the 2005 FSSA: in particular, responsibility for regulating anticompetitive behavior has been transferred to the Antitrust Authority, and the Bank of Italy’s Statute has been modified to increase transparency and accountability.

46. The Bank of Italy’s openly encouraging attitude toward bank consolidation is promoting efficiency-enhancing changes. Signs of greater contestability in the system, including by cross-border players, are encouraging. Greater transparency in banks’ interactions with clients will also lead to increased competition in the sector, and the Antitrust Authority’s commitment to monitor this carefully is welcome.

47. It is proposed that the next Article IV consultation be held on the standard 12-month cycle.


Estimates indicate that “atypical” contracts (i.e., those other than permanent contracts) reduce labor costs by about 20 percent.


Despite the government’s commitment, the 2007 budget does contain a limited amnesty for social security contributions to facilitate the emergence of irregular work situations.


A Selected Issues Paper looks into the structural causes of spending growth.


Namely the European court-mandated refund of VAT collected on the sale of company cars and the government’s assumption of railroad-related debt, amounting to some 2 percent of GDP.


Two legislated changes to the pension system remain to be implemented: (i) the adjustment of pension replacement rates in line with developments in life expectancy (mandated to take place every ten years under the 1995 “Dini” reform, but not implemented in 2005); and (ii) a step increase in the retirement age for seniority pensions (from 57 to 60), set to occur in 2008 under the “Tremonti-Maroni” reform of 2004.


Research in this area has in the event been spearheaded by Italian academics (including Alesina, Perotti, Tabellini and others); for an international overview see, “Experience with Large Fiscal Adjustments,” IMF Occasional Paper, No. 246.


A Selected Issues Paper examines potential fiscal risks arising from two large public enterprises, based on the criteria identified in “Public Investment and Fiscal Policy—Lessons from the Pilot Country Studies,” IMF (April, 2005).


Such changes would be in line with the recommendations of the 2002 ROSC.


At the same time, in policy circles, the Danish “flexicurity” model—far removed from the Italian reality—tends to exercise a somewhat facile appeal. For the difficulties of generalizing this model, see Zhou, Jianping, “Danish for all? Balancing Flexibility with Security: The Flexicurity Model,” IMF Country Report No. 06/342.


With consolidation also involving cooperative banks, the Bank of Italy has called for adapting the corporative governance rules of such banks and, in early December, the government announced its intention to revise their voting structure.


A Selected Issues Paper explores links between the financial system and growth.

Italy: 2006 Article IV Consultation—Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Italy
Author: International Monetary Fund