2008 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Italy

Italy’s 2008 Article IV Consultation describes the country's economic developments and policies. Output has been projected to contract by about ½ percent in 2008 and 1 percent in 2009, with risks tilted to the downside, linked to a further slowing of global growth and falling consumer confidence. The economy’s ability to rebound quickly is hampered by rigidities in the product and labor markets, a lack of domestic competition, a likely slower pace of industrial restructuring, and weakness of the public finances.


Italy’s 2008 Article IV Consultation describes the country's economic developments and policies. Output has been projected to contract by about ½ percent in 2008 and 1 percent in 2009, with risks tilted to the downside, linked to a further slowing of global growth and falling consumer confidence. The economy’s ability to rebound quickly is hampered by rigidities in the product and labor markets, a lack of domestic competition, a likely slower pace of industrial restructuring, and weakness of the public finances.

I. Staff Appraisal and Executive Summary

1. The global financial crisis is taking a toll on Italy’s economy, compounding its long-standing, home-grown, weaknesses. Output is projected to contract by about ½ percent in 2008 and 1 percent in 2009, with risks tilted to the downside, linked to a further slowing of global growth and falling consumer confidence. Going forward, the economy’s ability to rebound quickly is hampered by rigidities in product and labor markets, a lack of domestic competition, a likely slower pace of industrial restructuring, and weakness of the public finances.

2. The policy agenda should focus on responding to the global crisis while addressing Italy’s longer-term challenges. Given the exceptional nature of the crisis and its impact on the domestic economy, some carefully tailored near-term counter-cyclical financial and fiscal responses are warranted. But immediate measures should be aligned with the need to respond to Italy’s real economic crisis—the relentless decline in productivity. Structural reforms should thus continue to be pursued, and indeed intensified when conditions warrant, aimed at increasing the economy’s growth potential and supported by medium-term expenditure-based fiscal consolidation.

3. While the banking system has proved resilient, further near-term actions are warranted to further strengthen financial stability. The financial system has weathered the turbulence well, helped by its relatively low risk profile and the authorities’ prudent and systematic response to the crisis. But vulnerabilities have risen, related to banks’ capitalization, funding, credit quality, profitability, and exposure to Central and Eastern Europe (CEE). To mitigate these vulnerabilities, recent financial sector support measures should be fully and promptly implemented, and additional measures should be considered, including a voluntary government recapitalization scheme. Care should be taken to ensure transparency, minimize market distortions, limit government involvement in banks’ decision-making, including via a clear exit strategy, and avoid, to the extent possible, potential spillovers for other countries, especially CEE. Efforts should also continue toward enhancing international regulatory and supervisory coordination.

4. At the same time, longer-term financial sector goals should be pursued. Additional measures should be considered which would not only further strengthen financial stability, but would also support the growth-enhancing role of the financial sector in the long run. These could include improving consumer protection, further strengthening the supervisory and regulatory landscape, and enhancing the coordination, efficiency and information sharing among regulators. Efforts should also continue to further spur competition and improve corporate governance in the financial sector.

5. The budgeted fiscal consolidation for 2009 should be delayed. The government’s innovative three-year fiscal package—which aims for a broadly-balanced budget by 2011 though spending-based measures—provides a good medium-term anchor. But the target deficit of 2.1 percent of GDP for 2009 is no longer in line with the deteriorating macroeconomic environment: staff project the deficit to widen to above 3 percent of GDP. Nonetheless, the recession warrants a counter-cyclical fiscal response, which should be tailored to Italy’s circumstances, especially its high debt. The budgeted cyclically-adjusted consolidation for 2009 (estimated by staff at around 0.3 percent of GDP) should thus be postponed. Timely, temporary, targeted and coordinated measures should be considered, while fully implementing the budget’s envisaged reductions in current spending. The fiscal package recently submitted to Parliament, which is likely to imply a broadly neutral fiscal stance for 2009, is generally in line with these considerations. If the growth outlook deteriorates significantly, a somewhat larger stimulus could be considered.

6. The government should continue to steadfastly improve fiscal frameworks to underpin the medium-term expenditure-based fiscal consolidation. The authorities have made significant progress in streamlining the budget process, increasing the productivity of public administration, improving the management of public assets, and advancing fiscal federalism. These efforts need to be reinforced and remaining gaps filled. Linkages between the reforms should also be exploited while ensuring consistency with the wider objective of achieving sustainability via expenditure-based consolidation. The opportunity could also be taken to make progress on addressing longer-term fiscal challenges, in particular, reforming the welfare system.

7. Concerted actions are needed to boost Italy’s growth potential. The structural reform agenda should focus on further liberalizing retail trade and services, continuing deregulation efforts in the energy market, and strengthening the role of competition bodies in formulating policy. A second generation of labor market reforms is required to strengthen the link between wages and productivity, allow wages to better respond to regional differences, and make permanent contracts more flexible. International initiatives should be leveraged to spur reform, while resisting tendencies toward protectionism.

8. It is proposed that the next Article IV Consultation be held on the regular 12-month cycle.

II. Context: Weathering the Global Financial Crisis


Tier I Capital Ratios and Leverage of the Largest European Banks, end 2007

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Source: IMF, GFSR.

9. Italy’s financial sector has not avoided the global financial crisis, but has so far withstood the turbulence. Financial markets were shaken as the international crisis intensified: equity prices plunged, the interbank market froze, corporate issuance dried up, and some large Italian banks came under pressure. Nevertheless, the system as a whole remained solid, and no institution failed or fell short of regulatory requirements. Italian banks’ recourse to ECB lending increased but remained commensurate with their asset share in the euro area, and they continued to fund themselves through bond issuance to domestic retail investors—an option unavailable to many European peers—financing robust loan growth up to mid-2008. However, surveys indicate significant tightening ahead (mostly in terms of pricing and lending standards), and household lending has already sharply declined, chiefly for demand reasons. Third-quarter profits for the major banks remained positive, albeit much lower than last year and helped by the application of the new international accounting rules.1 Bank CDS spreads, while higher, remained below those of other European peers, reflecting their relatively safer risk profile: the traditional, relationship-based banking business model that has supported a broad and stable funding base (composed mainly of retail deposits and bonds), low leverage ratios, a comparatively high-quality traditional asset portfolio with little exposure to “toxic” assets, and relatively low dependence on wholesale interbank funding (Box 1). These factors have been supported by a firm bank regulatory and supervisory environment, strong intervention and resolution frameworks, and pre-existing high levels of depositor protection that exceeds the EU minimum (Annex III).2

Bank Losses, Subprime Crisis

(USD billions)

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Source: BankScope, Bloomberg

Large European Banks: Funding Composition, 2007

(percent of total liabilities)

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Figure 1.
Figure 1.

Financial Indicators 1/

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Sources: Thomson Financial/DataStream; and Bloomberg.1/ The latest observation is as of December 1, 2008.2/ MPS stands for Monte dei Paschi di Siena.

The Relative Resilience of Italian Banks—Some Explanatory Factors

A few factors could explain why banks did not engage in high-risk/high-yield strategies involving structured products, which would have put them more at risk in the current crisis:

  • Financial intermediation is relationship based and dominated by banks. This, combined with an extensive bank-branch network and a sound deposit-insurance system, helps ensure a solid deposit base and a retail market for other bank liabilities. In addition, most other financial services (i.e. asset-management and insurance) are also channeled via banks’ networks. Profits are more stable, which, perhaps, supports safer business strategies. Indeed, even throughout the financial turbulence, and unlike many of their peers, Italian banks managed to sustain a steady pace of income and deposit growth.

  • Low (until recently) contestability of the system, combined with still high net interest margins and retail banking fees, insulated banks from competition, lowering their appetite for risk. Recent evidence indicates that net margins in Italy increased over the past year and that banks have been able to pass the increases in their funding costs onto customers.

  • Growth opportunities elsewhere (until recently). Italian banks have rapidly expanded into fast-growing emerging markets, such as new EU member states and Russia, engaging primarily in core banking business. These subsidiaries (until recently) generated double-digit profit growth. However, these exposures are turning into vulnerabilities as the financial crisis takes its toll on the region (see ¶21).

  • Regulatory provisions may have inhibited riskier strategies. For example, regulatory provisions issued by the Bank of Italy, including those on derivatives, while in line with EU norms and the Basel Accord, have been more stringent than in other countries. The regulation for covered bonds, which has been recently finalized (May 2007), contains strict eligibility requirements as regards capital ratios for issuers and limits on amount of assets allowed to be transferred to an SPV.

  • Past scandals could have reduced banks’ appetite for risk-taking. After corporate fraud scandals with Parmalat and Cirio, banks have been heavily sanctioned by regulators.


Large European banks: Net Interest Margin, 2007

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Source: Bank Scope.

Large Banks: Net Income Growth, 2008Q2

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

10. The system’s resilience has been supported by the authorities’ prudent and systematic response. From the onset of the crisis in 2007, the Bank of Italy (BoI) intensified monitoring and disclosure of banks’ risky exposures and communicated the (generally reassuring) results to the markets. Capitalizing on already strong practices, and in line with international recommendations, the BoI also intensified liquidity monitoring (with weekly reporting requirements for the large banks), prudential oversight of risk management and contingency plans of banks, and targeted inspections, and required leading banks to regularly report counterparty risk and stress test more frequently.3 The high-level interministerial committee on financial stability held frequent ad-hoc meetings, and, as the crisis intensified in September 2008, the securities regulator (Consob) banned short sales. In addition, the government passed two enabling decrees that: (1) allow the government to inject capital into troubled banks on a case-by-case basis, through non-voting preference shares, with conditionality attached; (2) guarantee new bank liabilities; (3) permit the BoI to swap government debt for low-quality bank collateral (for up to €40 bn; operations have already started)—if needed, the Treasury will guarantee the BoI loans; (4) boost the BoI’s powers to initiate prompt and early bank resolution to avoid losses; and (5) fully underwrite the deposit guarantee fund. The details of the scheme—especially the pricing of the state capital injections and bank obligations—are awaiting the implementing legislation.

11. The ensuing global slowdown precipitated the economy’s fall into recession. Output contracted by ½ percent in each of the middle two quarters of 2008. With confidence at its lowest level in over a decade, consumption continued to decline despite still-positive employment gains and substantial easing of inflationary pressures. Gross fixed investment slowed sharply in the first half of 2008, due to pessimism about demand prospects and tighter financing conditions. The contribution of net exports turned firmly negative as partner country demand weakened. The housing market has also been cooling, but less so than in many other European countries, given that house prices had not risen as sharply.4

Figure 2.
Figure 2.

Economic Momentum Has Flagged

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Sources: Istituto Nazionale di Statistica; and ISAE.

12. The revenue-based fiscal consolidation has come to an end. The structural fiscal balance improved by 2¾ percent of GDP in 2006–07, mainly due to exceptionally strong revenues, with the overall deficit narrowing to 1.6 percent of GDP in 2007. But, reflecting the expansionary budget, weaker revenues, and some temporary factors, the deficit likely rebounded to 2¾ percent of GDP in 2008, entailing a loosening in structural terms and a higher expenditure ratio, with the primary current spending ratio reaching a record high. The global turmoil and economic weakness have already dented corporate profit taxes. Sovereign 10-year spreads over bunds exceeded 140 bps in December (compared to less than 30 bps a year ago), reflecting greater risk aversion and lower bund yields—overall sovereign yields have, however, fallen (which the authorities have moved quickly to lock in).

Italy: Fiscal Developments: 2005-08

(percent of GDP)

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Assumes staff’s output gap, and net of one-off measures.


Sovereign CDS, 3y bond

(basis points)

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Source: IMF, WEO.

Sovereign Debt Spreads to 10y German Bond

(basis points)

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

III. Outlook and Risks: Continued Weakness

13. The near-term outlook is bleak. The global financial crisis has been affecting Italy’s real economy mainly through the growth/trade and confidence channels, though the credit channel is likely to prove substantial going forward, and Italy starts from an already relatively weak base (Box 2). Output is projected to fall by about ½ percent in 2008 and 1 percent in 2009, given negative carry-over from the worse-than-expected output declines in Q2 and Q3 2008, weak recent indicators, and expected weaker partner country demand. The projected deterioration in Italy’s growth rate between 2008 and 2009 reflects Italy’s relatively low level and variance of potential growth, but also some potentially insulating factors: its resilient banking system, low private sector leverage ratios, a less inflated housing market, and the industrial restructuring of recent years.


Projected growth decline in select countries

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Source: IMF, WEO.

Italy: Low growth volatility at the cost of low average growth

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Source: OECD.

14. Negative risks dominate the outlook, and the eventual recovery will likely be slow and weak. Uncertainty about the outlook is exceptionally large. Given the Italian economy’s particularly high reliance on exports, downside external risks dominate, stemming from the feedback loop between continuing strains in the global financial system and slowing global economic activity. But domestic risks associated with additional falls in consumer confidence, linked to the deteriorating macroeconomic context and rising uncertainty, are also important. Staff estimate that in the event of a prolonged credit crunch (i.e., decline in loan volumes accompanied by further widening of spreads), investment could decline significantly, resulting in an additional output loss of up to 1 percent a year for two years (Box 2). Going forward, the economy’s ability to rebound quickly is hampered by pervasive rigidities, lack of domestic competition, the likely slower pace of industrial restructuring, and the limited scope for a fiscal response. Hence, growth is expected to pick up only modestly in 2010, staying below its already weak potential.

Channeling the Financial Turmoil to the Real Economy

The Italian economy has, so far, been mostly affected by the impact of the global financial crisis on partner country demand, with Italy’s growth plunging in sync with that of other industrial countries.

  • Investment. To date, bleak demand prospects at home and (especially) abroad weighed heavily on business confidence and hence investment. At the same time, the direct effect of tighter credit conditions has been more moderate, chiefly due to the fact that Italian firms, on average, rely less on external funding for investment and growth.1 The slowing economy has eroded the self-funding capacity of firms, but the increase in credit costs to date (over 70 bps) did not affect the pace of credit growth to corporates (though overall corporate borrowing did slow as bond placements have dried up since Q2), with most of the tightening occurring via prices rather than quantities. Staff estimates that, to date, the global downturn subtracted more than 1 percentage point from fixed investment growth, while the contribution of tighter credit conditions has been more recent and limited (about ½ ppt).

  • Consumption. To date, consumption has been dampened by weak confidence, and, until recently, by eroding disposable incomes due to rising inflation. The direct effect of the financial turbulence on consumption has been moderate due to the negligible wealth effect of housing and generally low recourse to borrowing for consumption purposes. Going forward, employment prospects will continue to define the confidence and consumption outlook. In addition, although households are relatively under-leveraged, debt burdens are rising (from low levels), and household surveys indicate growing concerns about the ability to meet mortgage payments (although delinquency rates are still low).


Corporate borrowing held up well, but household borrowing slowed sharply.

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Sources: Datastream/Thomson Financial; European Comission; and IMF, IFS and WEO.

Household debt, selected countries, 2006

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Sources: Eurostat, Federal Reserve, IMF
1See “Financial Intermediation And Growth in Italy” in Italy: Country Report No. 07/65.

15. Inflation is expected to moderate in line with the slowdown in growth and global commodity prices. Inflation moderated in November—coming down from a decade high peak—largely due to declining global prices for oil and food. Core inflation, however, remained elevated, and the differential with the euro area widened further, with weak competition in the service sector (especially in domestic trade) likely contributing. As the output gap widens further, inflation is projected to slip well below 2 percent in 2009.


Headline inflation is coming down rapidly, in line with the Euro Area, but the positive core gap persists.

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Sources: Istituto Nazionale di Statistica; and Eurostat.1/ Latest observation is November 2008.2/ Latest observation is October 2008

16. The current account deficit is projected to widen to around 3 percent of GDP in 2008 and further in 2009 and decline only gradually over the medium term. So far this year, nominal export strength has roughly offset the higher energy import bill, while non-energy imports were subdued. But data for October/November indicate an accelerating contraction in both exports and (to a lesser extent) imports. The trade account is expected to deteriorate slightly in 2008–2010, due to weakened global demand weighing on exports, although imports are also expected to suffer as a result of lower domestic demand. Over the medium term, export growth is expected to gradually pick up as the global economy recovers, while lower import prices would help reduce the trade deficit and, gradually, the current account deficit. The main downside risks are slower partner country growth and a further deterioration of competitiveness.

17. A modest competitiveness gap persists. Italy’s market share in world trade declined markedly (and more than its peers) since the mid 1990s. Moreover, CPI—and ULC-based real exchange rates point to a continued appreciation that has dampened real exports. Recent staff estimates of the equilibrium real exchange rate based on the CGER methodology support this conclusion, indicating a competitiveness gap of some 8–9 percent.


The current account deficit has increased relative to the norm, but is expected to gradually decline over the medium run.

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Estimates Applying the CGER Methodology to Italy 1/

article image

Positive numbers indicate that REER is above equilibrium.

Macroeconomic balance.

Reduced-form equilibrium real exchange rate.

External stability.

Figure 3.
Figure 3.

Standard Competitiveness Indicators Indicate a Gap

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Sources: Istat; OECD; Eurostat; Bank of Italy; and IMF staff estimates.

18. The authorities recognized that the macroeconomic outlook had deteriorated significantly, but views on the severity of the downturn differed. While the Ministry of Economy and Finance (MEF) has not officially revised its growth projections of 0.1 and 0.5 percent for 2008 and 2009, respectively, which underlie the budget currently in Parliament, there was broad recognition that downside risks were materializing. Nevertheless, they saw a milder downturn than staff, highlighting that Italy’s stronger banking system and healthy household balance sheets should help it weather the downturn, and that Italy should benefit more than other countries from the weaker euro and declining energy prices. The BoI’s views on the outlook were more negative and similar to staff’s. All interlocutors saw negative risks dominating. Although neither the MEF nor the BoI have released revised forecasts, there was a broad agreement with the mission on the inflation outlook.

Italy: Near-Term Outlook, Comparisons

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Sources: MEF, BoI, Confindustria, EC, OECD, and IMF staff estimates

IV. The Policy Agenda: Responding to the Crisis and Reinforcing Long-Term Goals

19. Short-term actions are warranted to counter the effects of the global crisis. The exceptional nature of the crisis and its repercussions for the domestic economy require near-term actions to strengthen financial stability and a countercyclical fiscal response both at the national and international level. But such actions should be tailored to Italy’s specific circumstances—especially its high public debt and widening spreads, which constrict the scope for an aggressive fiscal policy response—being mindful of international spillovers.

20. But immediate actions should be aligned with the need for longer-term reforms to address Italy’s main challenge—its chronic lack of growth. Beyond the present cyclical slowdown, the real economic crisis confronting Italy is the decline in productivity over the last decade, which has spawned stagnating incomes, rising unit labor costs, a significant competitiveness gap, and tepid growth. And Italy’s large and unproductive public sector—with its poor quality spending, high effective tax burden, and persistent deficits—compounds the problem. The government should thus set short-term measures with longer-term goals in mind, aimed at increasing productivity and ensuring fiscal sustainability.

A. Preserving Financial Soundness

21. While the financial system remains sound and well supervised, vulnerabilities have risen. These are mainly related to:

  • Liquidity and funding: Banks’ funding maturity mismatch is rising, given their increasing reliance on relatively shorter-term ECB refinancing and retail bond issues. For a number of large institutions, which are more reliant on wholesale and interbank international market funding, sizeable debt redemptions are coming due in the next 24 months, and although 12-month ahead redemptions are largely pre-funded, some gaps remain. In addition, recourse to the retail bond market could be more limited going forward, as scope for switching away from other investments narrows and the market becomes saturated.

  • Capital: While the banking system’s capitalization meets regulatory requirements, core Tier I capital in a few large banks has fallen below 6 percent since late 2007. And despite steps taken by large banks to boost capital, including through rights issuance and scrip dividend, markets may view their new ratios as weak compared to many peers elsewhere, especially those that have received government-sponsored recapitalizations. In addition, banks’ important shareholders—foundations that hold more than half of the capital of listed banks—may have limited financial capacity to quickly boost banks’ capitalization if needed.

  • Profitability. Despite high margins and fees, inefficiencies have led to relatively low profitability even in good times, which is set to decline further as activity flags. As of June, annualized return on equity fell to 10 percent (from 13 percent a year ago) and individual bank financial reports also suggest that some large banks would have registered losses in the third quarter, were it not for the boost to profitability due to the new accounting rule.

  • Regional exposures. Two large Italian banks are major players in several CEE countries, where unwinding of imbalances is leading to some hard landings.5 Although banks’ overall exposures seem moderate (below 10 percent of consolidated equity) and their lending strategies relatively prudent, most regional subsidiaries previously required funding from the parent, and these requirements could increase if conditions in the host countries deteriorate. In addition, exposures to Western Europe (Germany) have already proven to be a significant negative factor. Profitability is also likely to suffer from such regional exposures.

  • Credit quality. Households and corporate debt burdens, though low, are increasing, and impaired loans are rising, prompting banks to build up reserves. As the recession deepens and funding costs rise, credit quality is likely to worsen, with small enterprises likely to come under particular pressure.

  • Cross-border regulatory risk. A number of Italian banks have substantial operations in other European countries, as do foreign banks in Italy. Yet, even in the midst of the crisis, Europe still lacks a well-defined and binding mechanism of cross-border supervision and crisis-resolution and effective information-sharing.


Large redemptions are coming due in 2009-10

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Source: Bloomberg.

Market Perception of the Capital Shortfall and New Core Tier 1: An Example 1/

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Source: J.P. Morgan, staff calculations.

Relative to the 8% threshold for Core Tier I Capital. Data as of October 2008.


Large Banks: Return on Average Equity (ROAE), 2007

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Sources: BankScope; and Bloomberg.

If the financial crisis and credit crunch intensify, so too will these vulnerabilities.

22. Additional steps to strengthen financial stability, many of which are already in train, could help mitigate these vulnerabilities. Recent bank support packages need to be fully implemented to shore up confidence, especially by making fully operational the funding guarantee scheme. In addition, a voluntary pre-emptive recapitalization scheme, available to sound banks, could play a useful role in supporting investor confidence and fostering credit growth. The modalities of this scheme should be carefully designed to minimize market distortions and limit government involvement in banks’ decision-making (for example, on credit growth), including via a clear exit strategy. In this regard, ensuring full transparency is crucial. Experience in other countries also suggests that: (1) the operation should be on commercial terms, but not unduly expensive in order to increase take-up by banks, encourage private capital raising, and support credit growth; (2) dividend policy should reflect the need to shore up confidence and repay government holdings; and (3) full and quick loss recognition needs to be actively fostered, especially to encourage the re-capitalized banks to minimize credit tightening going forward; and (4) conditionality (for example on lending) should be limited. These principles are also reflected in the recent EU Communiqué (of December 5) on bank recapitalization schemes.

23. Fostering international coordination is critical. Italy’s advocacy of a more coordinated international approach to crisis resolution and stronger cross-border supervision is welcome. This should be continued, along with Italy’s implementation of the international financial reform agenda, including the remaining FSF recommendations and finalizing implementation of EC Directives (in particular MIFID and the Takeover Directive). The Italian authorities should be mindful of potential spillovers from their bank support actions for other countries, especially in CEE. For example, government recapitalization funds should not be prevented from being used to recapitalize subsidiaries in other countries, if this were deemed an efficient way of supporting the domestic bank.

24. The agenda for achieving longer-term financial sector goals should continue to be pursued. Immediate measures aimed at ensuring financial stability should also support the growth-enhancing role of the financial sector in the long run. In particular, the supervisory and regulatory landscape could be further strengthened by: establishing a personal bankruptcy law, which is especially important given the weak growth outlook; intensifying efforts to ensure transparency and consumer protection, as banks become increasingly reliant on bond issuance to retail investors; completing legislative efforts to reduce the number of regulators and improve coordination among them;6 and finalizing the removal of banks from the ownership of the BoI. The work to enhance the BoI’s stress testing to incorporate complex interlinkages across institutions and the macroeconomic environment should also continue. The strides made in recent years to spur competition and improve corporate governance, which appear to positively affect growth, should be preserved and built upon. In addition, other efficiency-enhancing measures, such as the reform of cooperative banks (which could also support financial stability), should not be sidelined.7

25. The authorities broadly agreed with staffs’ appraisal of the financial system and main recommendations. They recognized the growing vulnerabilities in the financial system and the need to fully implement remaining measures to mitigate them; indeed they assured that work was well under way and the remaining legislation would be issued shortly. They also noted that emergency recapitalization scheme has been operational, but no recourse to it has been necessary. On the voluntary bank recapitalization scheme, the BoI and the Treasury saw continued financing of the economy as a main objective of the measure; the BoI favored relatively light conditionality. The authorities stressed the need to ensure close coordination among European countries, especially in the design of the various bank support packages. In this respect, they pointed to the spillover on Italian banks from the global “race to the top” to reach high capitalization ratios, even though the situation of Italian banks was very different. More generally, the MEF pointed out that the financial turmoil has stressed the well-known drawbacks of the European supervisory architecture and has called for an urgent review aimed at introducing effective coordination instruments.

B. Providing Short-Run Support While Maintaining Fiscal Sustainability

26. The government’s innovative three-year fiscal package targets significant adjustment in 2009 and a broadly-balanced budget by 2011. These commitments, in line with Italy’s undertakings under the SGP, are positive signs of policy continuity and key steps toward debt sustainability. The adjustment plan is appropriately expenditure-based (though perhaps overly ambitious with respect to reducing investment spending) and targets an increase in the cyclically-adjusted balance of 0.6 percentage points in 2009, with a headline deficit of 2.1 percent of GDP, while the public debt and spending ratios are projected to fall. This plan is based on real growth rising from 0.5 percent in 2009 to 1.2 percent in 2011.

27. But the near-term fiscal outlook has since sharply deteriorated, in line with the macroeconomic environment. Staff projects the fiscal deficit in 2009 to be above 3 percent of GDP, mainly due to weaker growth, while the expenditure ratio would rise, even if nominal spending plans are observed. And adjusting for staff’s output gap and other minor factors, the cyclically-adjusted balance (and excluding the impact of the package announced on November 28) would increase by 0.3 percent of GDP (and by 0.5 percent of GDP net of one-off measures). In addition, there are risks that tax elasticities could shift adversely during the downturn and expenditure savings would be not be fully realized. The debt ratio will likely rise further, reflecting the gap between the still-high average interest rate on government debt and falling growth rates, a lower primary balance, and possible bank support operations.

28. Nonetheless, macroeconomic considerations and the need for a coordinated international response argue for delaying the planned structural consolidation in 2009. While preserving and fully implementing the budget’s envisaged reductions in current spending, timely, temporary, targeted and coordinated counter-cyclical measures could lessen the impact of the output decline without significantly undermining fiscal sustainability. As in other countries, the measures could include one-off outlays for vulnerable groups, bringing forward planned maintenance spending, and reductions in government payments delays. In this context, the recent measure limiting interest deductibility for banks could be deferred, and its modalities reconsidered. Public infrastructure spending, especially accelerating existing projects, would support both short-term demand and longer-term growth if implemented rapidly, transparently, and efficiently, with due regard to fiscal risks and using the recommendations of the recent spending review. While policy diversification is important, given uncertainty about the effectiveness of different measures, piecemeal responses should be avoided and a credible path to the MTO maintained. The “anti-crisis” package of fiscal measures recently (after the mission’s conclusion) submitted to Parliament is broadly in line with these considerations, implying a broadly neutral fiscal stance for 2009 (Box 3). If the growth outlook deteriorates significantly, a somewhat larger fiscal stimulus could be considered.

29. Italy, unlike many other advanced countries, is ill-placed to launch a more aggressive fiscal response to counter the effects of the global financial crisis. With its large debt, spiking spreads over Bunds, and the prospect of debt issuance rising globally, delays in adjustment will likely raise interest costs and undermine confidence. Also, Italy’s growth problems stem from low potential, not cyclical, growth, and past relaxations have not proven to be effective.

Italy’s Recent Fiscal Measures to Counter the Crisis

On November 28, the government passed an “anti-crisis” decree that aims to support the flagging economy. The package’s gross cost is around ½ percent of GDP, but it aims to be broadly neutral in net terms taking into account offsetting (mainly revenue-raising) measures. But the total economic impact could go beyond the fiscal cost, especially if measures to accelerate investment projects prove to be effective. The main countercyclical measures fall into three broad categories:

  • Support to families/individuals (the bulk of the fiscal cost of the package): the main measure is a one-off bonus to low-income households. There are also provisions to cap interest rates on mortgages, make additional social payments, cut taxes on productivity bonuses, and limit road tolls and household utility payments.

  • Support to enterprises: these mainly take the form of “cash-flow” support: postponing the timing of certain tax payments and reducing payment delays by the government. There is another important measure on guaranteeing bank borrowing, with specific targets for financing small and medium-sized enterprises—its modalities are to be clarified in a separate decree.

  • Acceleration of investment: including appointing special officials to take charge of key projects, with a view to accelerating their implementation, more investment financing for railroads, and additional financing for the main national projects.

The package—while not perfect—appears to be broadly appropriate for Italy. The likely ex-post fiscal cost of the decree—even assuming some shortfall of offsetting revenue-raising measures in a weak economy—is likely to be 0.2-0.3 percent of GDP, within the available scope for fiscal stimulus, though some further measures could be considered, especially if there are high-quality investment projects being delayed essentially for lack of financing. The key measure (bonus) is timely, temporary, and targeted, although not all measures conform to these principles. The omnibus structure of the “decree-law” offers the dual advantage of immediate effect and “policy diversification” (though perhaps too diversified). At the same time, there would be some flexibility of future implementation in follow-up decrees on specific issues, such as on bank borrowing guarantees. Appropriate implementation—and in particular controlling fiscal risks stemming from bank guarantees and investment projects—will be important to maximize the package’s effect on confidence and contain costs.

Figure 4.
Figure 4.

Revenue Boom No More

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Sources: Eurostat; and IMF staff calculations.1/ Percent of GDP
Figure 5.
Figure 5.

Spending Has Yet to be Reined in

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Sources: Eurostat; and IMF staff calculations.
Figure 6.
Figure 6.

The Medium-Term Budget Appropriately Targets Spending, but Risks Are Significant

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Sources: Eurostat; and IMF staff calculations.1/ The authorities’ “no-measures” (”current legislation”) scenario underlying the 2009-11 budget.2/ Risks from the slippage of spending measures in the 2009-11 package, additional wage bill risk (assuming constant ratio to GDP), and a one-off indexation of wages/pensions to the inflation spike in 2008, on which negotiation is ongoing.3/ In addition to 2/ assumes slippage in curbing investment spending, the feedback on interest expenditure, and revenue increase generated by additional wage spending.4/ Assumes constant structural primary balance from 2010 onwards.
Figure 7.
Figure 7.

Opportunity (Largely) Wasted for Debt Reduction

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Sources: Eurostat; EC, and IMF staff calculations.1/ Annual average, for 2008, year to date average (through end-September).

30. The current crisis should not eclipse the need for bolder action to address longer-term fiscal challenges. Long-term debt sustainability is far from assured, especially if the higher sovereign spreads prove permanent, and hinges on reaching the MTO and achieving productivity growth well above that of recent years. As outlined in the government’s recent green paper, further reforms to the welfare system are needed. In particular, legislating additional future increases in the retirement age (especially for women) could tackle Italy’s still-comparatively-high pension spending. This could allow for faster debt reduction and/or freeing resources to strengthen Italy’s weak social safety net.


Public Debt Dynamics (Percent of GDP)

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Sources: MEF; and IMF staff calculations.1/ Unchanged policies assume constant primary structural balance from 2010 and average labor productivity growth of 1.2% in 2011-50, some 0.5 percentage point lower than in the stability programme.

31. Italy’s fiscal framework has been improving steadily over time, but insufficiently to fix its fragile public finances. In particular, the perennial need for consolidation was typically addressed in a piecemeal fashion, often by closing the most visible gaps through “emergency” annual packages that were only partially effective. Efficiency-oriented reforms based on strategically decentralizing the budget process through greater managerial flexibility (initiated in 1997) and fiscal federalism (2001) were repeatedly delayed or scaled back partly to safeguard short-term outcomes. As a result, both the quantity and quality of fiscal adjustment suffered.

32. The government should build on steps recently taken to improve fiscal frameworks, which are crucial for the viability of the expenditure-based adjustment. Important actions have already been taken, including: (1) streamlining the budget process and strengthening its medium-term orientation; (2) increasing the productivity of public administration by containing the cost of public employees and implementing a comprehensive plan to reduce the burden of administration; (3) advancing measures to improve cost effectiveness in the education sector, following the recent spending review; and (4) finalizing the draft law on fiscal federalism, currently with Parliament, which aims at increasing the fiscal autonomy and discipline of all levels of government. But these steps need to be built upon to achieve longer-term objectives, including by:

  • Deepening budget system reform: For next year’s medium-term plan, the realism of the baseline projections should be enhanced and fiscal targets should reflect agreements with sub-national governments. Rigidities need to be reduced, including by overhauling the budget law, streamlining legislation related to spending programs, and increasing flexibility in the management of civil servants (Annex I).

  • Pursuing cost-conscious fiscal federalism: This requires a transparent, formula-based, equalization scheme, a robust and independent regime for monitoring fiscal targets, harmonized accounting, and greater civil service mobility. Given that sub-national governments need sufficient revenue autonomy at the margin to finance spending preferences or cost overruns, a comprehensive review of property taxation would be useful, especially since the tax on primary residences has recently been eliminated. Should the reform seem set to result in higher costs, bolder offsetting measures could be considered, including streamlining the structure of sub-national governments.

  • Better managing public sector assets: Care should be taken to ensure that the potential proceeds from sales of public assets do not delay consolidation.8 Faster progress needs to be made on divestment and minimizing the drain on the public purse, with a focus on enhancing competition. These objectives would be helped by ensuring full transparency of any bank-support operations and government guarantees, and producing timely consolidated accounts for the non-financial public sector.

Transfers to Key Enterprises

(Percent of GDP)

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Source: Combined report on the economy.

Transfers by the central government.

33. The authorities agreed with the need for some limited temporary measures to address the impact of the crisis, while remaining committed to their adjustment plan. While agreeing that the worsening macroeconomic conditions warranted some scaling back of planned consolidation, the MEF stressed Italy’s relatively limited room for maneuver, especially the high debt burden and the rising spreads, and believed the deficit could still be below the 3 percent limit in 2009. Accelerating investment spending and supporting credit extension were seen as the most effective way of stimulating growth.

34. Views on prospects for longer-term reforms were mixed. On pension reform, the MEF pointed to political sensitivities, a potential negative impact on confidence, several reforms of recent years, and risks of implementation delays and reversals, as had occurred with the 2004 reform. Also, the MEF’s long-term age-related spending projections for Italy do not indicate any urgency for such reforms. Most interlocutors suggested that reforms to the budget process and fiscal federalism structure would proceed, though admittedly slowly. The MEF is keen to build on the pilot spending review exercise and reduce rigidities in the system, but recognized the medium-term nature of the reform program. Fiscal federalism reforms will be largely dependent on follow-up legislation that is to evolve over the next couple of years. Some interlocutors considered that the forthcoming retirement of many public employees offered a key opportunity to generate cost savings, as did the potential revision of the accounting law.

C. Enhancing Competitiveness and Productivity

35. The real crisis confronting Italy is the chronic lack of growth due to declining productivity. Italy experienced an unprecedented fall in factor productivity over the last decade, both in manufacturing (from a high level) and services (from a low level), which lies behind the relentless increase in unit labor costs and Italy’s falling behind its peers in GDP per-capita terms. This has been linked to a number of structural factors, including: (1) policy and regulatory rigidities limiting competition and hindering the business environment; (2) low efficiency, linked to the preponderance of small and medium-sized enterprises that are unable to exploit fully economies of scale; (3) limited process and product innovation, hindered by labor market rigidities; and (4) outdated specialization patterns, given a production structure (especially in manufacturing) based on traditional low skill products.


TFP growth weakened over time, and compared to peers,…

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001


…with most sectors weighing negatively on productivity growth. 1/

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Sources: OECD Product Market Regulation Database; European Commission; and European Central Bank.1/The vertical axis shows the cumulative contribution of sectors to TFP growth, while the horizontal axis shows the cumulative value added shares for 1996–2004 (horizontal axis). Sectors are ordered according to their TFP growth rates (with faster growing sectors closer to the origin). The dotted lines indicate the average rate of TFP growth for the entire economy.

36. Despite recent industrial restructuring and structural reforms, Italy still lags its peers.

  • Recent, but modest, improvements in Italy’s micro-based competitiveness indicators reflect a private-sector driven restructuring in sectors already exposed to competition. And although some reallocation toward more dynamic and high-tech sectors occurred, it was slower than in EU peers, with Italy missing out on opportunities to develop its service exports, especially in tourism (Box 4).9 Thus, while the authorities’ policies are promoting domestic stability, and hence the external stability of the union as a whole, productivity and labor utilization need to improve to ensure longer-term stability.

  • Building on progress made in recent years in product and service market liberalization, the government has: (1) passed the local public services bill (albeit falling short of requirements); (2) simplified legislation; (3) implemented a law instituting competition assessments and regulatory impact analysis; and (4) incorporated the Antitrust Authority’s recommendations in a competition bill to be discussed by Parliament annually. But the reform momentum appears to have slowed.

  • Significant labor market reforms over the past decade have improved employment, labor force participation, and unemployment rates, but Italy’s employment-to-population ratio continues to remain among the lowest in the euro area. Moreover, while the deregulation of fixed-and part-term contracts in recent years has improved labor market flexibility, it has also resulted in more “atypical” employment, contributed to stagnant labor productivity, and exposed workers to increased employment risk without commensurate improvements in the social safety net, implying that recent employment gains can be easily reversed.


Piecemeal reforms only partially improved professional services…

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001


…and heavily regulated product markets.

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Sources: OECD Product Market Regulation Database; European Commission; and European Central Bank.1/ Preliminary estimates for 2007 before next OECD updates, taking into account the two “Bersani” decrees as calculated by OECD.2/ Average for accountancy, architectural, and engineering work.3/ Index 0–6 from least to most restrictive.

Temporary employment has been the key driver of employment growth.

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Source: OECD, Labor Force Statistics, 2007.

Is Italy Gaining Competitiveness by Restructuring?1

Standard measures indicate that Italy has a modest competitiveness gap. But it is often countered that Italy’s exports have been robust in nominal terms, and there is much anecdotal evidence of trade-based firm restructuring in response to the challenges of globalization. Could such restructuring imply that Italy is substantially more competitive than standard indicators suggest?

On the positive side, there is evidence of moderate export quality upgrading, proxied by unit value growth (though this is an imperfect proxy also indicative of cost pressures), and some redirection toward dynamic markets and increase in outsourcing. More ambiguously, recent staff analyses indicate that competitive pressure on Italy’s exports has been consistently higher than for key EU comparators. While this has been a factor pushing firms to restructure, it also reflects “unfavorable” specialization. Less encouragingly, there are no major positive competitiveness trends emerging from the sluggish services sectors, FDI flows, and the technological content of Italy’s exports.

The restructuring may also have much further to go. The intersectoral reallocation of resources away from traditional activities has been limited, and the dynamics of competition from emerging markets have yet to play out, especially as these countries may intensify their upgrading. And while Italy may retain certain niches, a deeper downsizing in some sectors is also a possibility. On balance, export quality improvements are likely to have alleviated some of the competitiveness gap, but not enough to substantially offset the broader structural shortcomings weighing on external performance.

1/See “Trends in Italy’s Nonprice Competitiveness” IMF WP 08/124.

37. The structural reform agenda should continue to be pursued to boost Italy’s growth potential. Given Italy’s history of sluggish liberalization and reform and complex judicial and regulatory system, a comprehensive structural reform strategy remains critical for reviving Italy’s growth potential. Piecemeal reforms run the risk of paralysis and reversals, while broad-ranging reforms would produce synergies (Annex II). Building on the progress to date, and rather than allowing it to be eclipsed by the current crisis, the government’s reform agenda should continue to be pursued, and indeed expanded when conditions warrant, including by adopting the recommendations of the Antitrust Authority and OECD, focusing on: further liberalizing retail trade and (especially professional) services; continuing deregulation efforts in the energy market, particularly gas; strengthening the role of competition bodies in formulating and influencing policy at an early stage; and eliminating cross-vetoes for infrastructure projects of national interest. The policy agenda and its public acceptance could be strengthened by making greater use of public discussion documents and expert committees (e.g., Australia’s Productivity Commission).

Figure 8.
Figure 8.

Micro-Structural Competitiveness Indicators are Somewhat Less Negative

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Sources: Comtrade; UNCTAD; OECD; Eurostat; IMF Balance of Payment Statistics; national authorities; and IMF staff calculations, see WP 08/112.1/ SEA-5 (Italy, Spain, Portugal, Greece, and France).2/ EU-13 (excluding Ireland and Luxembourg).3/ The data are based on year 1996–2005 for France, 2001–04 for Greece, 1996–2004 for Italy, 1994–2003 for Portugal, 1994–2004 for Spain, and 1996–2005 for Germany.

38. A second generation of labor market reforms is needed. Key constraints on labor market performance that should be addressed include: a wage determination mechanism that prevents wages from being more strongly linked to productivity; an inefficient, and unequal, social safety net that prevents sufficient labor reallocation; asymmetric regulation of different contract types that tilts incentives toward atypical employment contracts; and high labor taxation that reduces the incentives for employment creation. Although not well suited as a short-term stimulus measure, broadening and streamlining the social safety net, in particular the unemployment benefit system, could provide some support for the likely increase in redundancies and widen the scope for public acceptance of reducing dismissal restrictions of permanent contracts. Such reform could be financed in part by reducing replacement rates and spending on active labor market policies, and by eliminating piecemeal measures such as tax reductions on overtime/bonus pay which are costly and unlikely to substantially improve outcomes. More generally, any reductions in labor taxation should be broad-based and combined with modifications of the wage bargaining framework that increase the scope for firm-level bargaining. Labor market reform, together with employment and real wages, would also benefit from early product market reforms (Annex II).

39. International initiatives provide an opportunity to spur structural reform. The government’s new national reform program aligns priorities for the next three years with the revised Lisbon Agenda’s objectives. All levels of government should follow through on these plans, working to reduce the large transposition deficit, including by an ambitious transposition of the EU Services Directive by the end-2009 deadline.10 Also, any tendencies towards protectionism, for example, creating barriers to foreign ownership of Italian firms, are likely to undermine Italy’s economic prospects and should be resisted.


Italy is relatively weak in implementing the Lisbon Agenda

Citation: IMF Staff Country Reports 2009, 045; 10.5089/9781451820027.002.A001

Source: World Economic Forum: Lisbon Review 2008.

40. The authorities broadly agreed with staff’s assessment of trends in competitiveness and labor market performance. They, however, stressed that aggregate indicators do not yet fully capture the effects of the industrial restructuring underway in recent years, reflected in some recent micro-economic evidence on rising variability in profitability, which is also in line with the strong growth in nominal exports and rising export unit values. The BoI also pointed to recent, albeit limited, evidence in the micro data of firm turnover and an increase in the average firm size as signs of a higher level of competition. The authorities expected unemployment to rise further, along with slowing, and possibly negative, employment growth. They also agreed on the main shortcomings of labor market institutions, namely, a wage bargaining mechanism that leaves too little scope for firm-level negotiations, and an insufficient social safety net that is uneven across sectors and contract types.

41. The government considered their structural reform plans adequate and did not see scaling up efforts as a top priority at this time. The BoI agreed that the structural reform momentum had slowed and that it needs to be revived. The MEF and other interlocutors pointed to the government’s commitment to policy continuity and the progress achieved to date. The government expressed doubt as to whether reforming the unemployment system could form part of an immediate crisis response, given the implementation lags and permanent expenditure involved. In line with this view, the government has recently opted for supplementing existing instruments, such as the industry-specific unemployment support schemes (“cassa integrazione”), rather than overhauling the welfare system. On wage determination, the government pointed to ongoing tripartite negotiations aimed at increasing the use of firm-level bargaining by linking nationally bargained wages to projected inflation (excluding imported inputs) and reducing taxation on supplemental wages negotiated at the firm level.

Table 1.

Summary of Economic Indicators

(Annual percentage change, unless noted otherwise)

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Sources: National Authorities; and IMF staff calculations.

Staff estimates and projections, unless otherwise noted.

Contribution to growth.

Twelve-month credit growth, adjusted for securitizations. 2008 data refer to Sept.

Excludes currency in circulation held by nonbank private sector. 2008 data refer to Sept.

Data for 2008 refer to Sept. on 6-month interbank rate, and Oct. on Government bond rate.

Percent of GDP.

Table 2.

Italy: General Government Accounts, 2002-2009

(Percent of GDP)

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

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

In 2006 capital spending is increased reflecting the assumption of railways-related debt of 0.9 percent of GDP.

Percent of potential GDP, assumes IMF staff’s GDP and output gap.

Budget numbers for public debt are calculated with the authorities’ (not staff’s) nominal GDP, at which all other numbers are calculated.

Table 3.

Italy: Balance of Payments

(Percent of GDP)

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Sources: IMF, World Economic Outlook; and the national authorities.
Table 4.

Italy: Financial Soundness Indicators

(Percent, unless otherwise noted)

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Sources: Bank of Italy; Eurostat; and IMF staff calculations.

The 2008 data are as of June.

The 2008 data refer to the five largest groups.

Table 5.

Italy: Selected Indicators of Vulnerability 1/

(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 IMF 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.