Italy
2010 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; Staff Statement; Statement by the Executive Director for Italy

The global crisis had a severe impact on the Italian economy despite elements of strength such as high private savings, low private indebtedness, and a resilient financial system. Executive Directors decided that the public sector wage bill should remain a key element of the consolidation strategy, and close monitoring of subnational public finances should be continued. They commended the authorities for the progress made in structural reforms but stressed that a more ambitious program of reforms needed to be pursued to address Italy’s growth potential.

Abstract

The global crisis had a severe impact on the Italian economy despite elements of strength such as high private savings, low private indebtedness, and a resilient financial system. Executive Directors decided that the public sector wage bill should remain a key element of the consolidation strategy, and close monitoring of subnational public finances should be continued. They commended the authorities for the progress made in structural reforms but stressed that a more ambitious program of reforms needed to be pursued to address Italy’s growth potential.

I. Context: The global crisis exacerbated pre-existing problems

A. Before the Crisis (1999–2007)

1. The global economic crisis hit an already structurally weak Italian economy. Despite growing employment, income growth had been anemic due to stagnant productivity and declining competitiveness over more than a decade.

uA01fig01

Real GDP Per Capita Growth

(Year-on-year change, index 1999=100)

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Source: WEO.

2. Italy has been steadily losing its market share of world trade. Economic rigidities, along with Italy’s specialization in products with relatively low value added, contributed to a steady erosion of competitiveness. Earnings growth outpaced labor productivity, and Italy’s unit labor costs grew by nearly 25 percent during 1999–2007. Italy’s market share in world trade has declined significantly (and by more than its euro area peers) since the mid 1990s.

3. Italy’s public finances were fragile going into the crisis. While government debt declined gradually from 113¾ percent of GDP in 1999 to 103½ percent in 2007, interest savings and (partly cyclical) revenue strength were offset by poor spending control. As a result, the structural primary balance deteriorated by some 2¾ percent of potential GDP during this period, and the overall deficit hovered around 3 percent of GDP.

uA01fig02

Average TFP growth

(Percent)

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Sources: EU KLEMS database.

4. In contrast, the Italian financial system entered the global crisis from a position of comparative strength. In large part, this derived from the traditional bank-based nature of the system, but also reflected previous consolidation, improved governance, and a sound supervisory framework.

Figure 1.
Figure 1.

Standard Competitiveness Indicators Indicate a Gap

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

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

B. The Global Crisis (2008–2009)

Despite the comparatively resilient financial system and the lack of a domestic credit/housing boom/bust, output fell sharply as trade and investment slumped.

Financial sector: resilient

5. Banks proved resilient to the initial phase of the global financial crisis. The banks benefited from a business model based on classical on-balance sheet lending-deposit activity, and strong customer relationships. With adequate liquidity and the absence of asset bubbles and toxic assets, this conservative business model sheltered Italian banks from the liquidity crunch at the onset of the crisis. Unlike elsewhere, Italian banks did not need emergency government intervention and recourse to ECB liquidity support schemes remained limited.

6. The subsequent deterioration of the economy nevertheless weakened banks’ asset quality and profitability. Credit risk increased during the second half of 2008 and deteriorated rapidly in 2009. Following the economic contraction, lending growth to the private sector slowed sharply, profitability declined, and asset quality deteriorated. In 2009, the stock of nonperforming loans increased by around 40 percent (from a low base) with respect to the previous year. Loan loss provisions for the 5 largest banks (as a percentage of pre-provision earnings) increased from about 30 percent in 2008 to about 56 percent in 2009, which was in line with the European average.

7. Banks increased capitalization in 2008-09, but their capital ratios still range from weak to average compared with other countries in Europe. Capitalization had weakened to just-adequate levels before the crisis. Since the crisis, banks were able to recapitalize by raising capital from core shareholders, selling nonstrategic assets, and cutting dividends (often to zero). Some banks also issued government-sponsored recapitalization bonds. Despite recent strengthening in capitalization, Italian banks still display weaker Core Tier1 ratios than their European peers. The comparison is more favorable if the leverage ratio (defined as the ratio between assets and equity) is taken into consideration.

uA01fig03
Source: IMF staff calculations on Company Reports. 2009 data.

8. Other financial institutions have also weathered the global financial crisis relatively well. The Italian insurance industry was little exposed to the crisis, with issuer defaults amounting to ½ percent of technical reserves. In 2009, premium revenues increased, and in the first semester, the insurance sector recorded a profit. Most pension funds had positive (albeit low) returns in 2009, often offsetting the losses recorded in 2008. The profitability of asset management companies, investment firms, and financial companies fell, but remained positive, in 2008.

Real Sector: adversely affected by the global crisis

9. The global financial crisis affected the real economy mainly through trade, credit, and confidence channels. The recession in Italy’s main trading partners led to a sharp fall in exports. Financing conditions tightened and credit growth fell, both to households and corporates, reflecting a combination of lower perceived borrower creditworthiness and a fall in loan demand. Corporate leverage increased, bankruptcies rose, and the profit share fell. Market indicators of expected corporate default spiked in 2009 and still remain above pre-crisis levels. Despite strong household balance sheets, private consumption declined significantly, reflecting rising unemployment and tighter consumer credit, only marginally offset by the weak rise in government consumption. Gross fixed investment and inventories also fell sharply, reflecting weak demand prospects and difficult financing conditions.

uA01fig04

Annual Growth Rate

(Percent change)

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Sources: OECD; and WEO.

10. The global crisis triggered Italy’s worst recession since World War II. The downturn in Italy started earlier and lasted longer than in most of its euro area peers. Italy’s reliance on exports and the predominance of SMEs increased its vulnerability to a global downturn. Additionally, the weak initial conditions and the decision not to engage in a large fiscal stimulus (which was appropriate in view of the high level of public debt) translated into one of the deepest output falls among large industrialized countries. Despite the sharp output fall, inflation and wage growth remained above the euro area average. Combined with falling productivity growth, this further worsened unit labor costs and squeezed profit margins.

11. Unemployment increased, though relatively mildly. Unemployment rose to 8.3 percent in the fourth quarter of 2009, 1.9 percentage points increase from end 2007, much lower than in most of its euro area peers. While this partly reflects falling participation, Italy, like Germany and France, relied on temporary lay-off and work reducing measures. In particular, the government provided additional wage supplementation funds (Cassa Integrazione Guadagni, or CIG) to sustain labor demand.

uA01fig05

Harmonized Unemployment Rate, 2009q4/2007q4

(Percent change)

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Source: Eurostat.
uA01fig06

Recent Labor Market Trends in Italy

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Sources: Istituto Nazionale di Statistica; and Eurostat.1/ Latest observation is as of 2009q3.

Response to the crisis: supportive but modest

Financial sector

12. The authorities helped the financial sector weather the crisis through a range of measures. The government guaranteed the deposit insurance fund; several instruments were established to improve bank liquidity, including a state guarantee for new bank liabilities, a facility for swapping bank assets or bonds issued by banks for government securities and a system for anonymous but collateralized interbank lending. The government also offered a recapitalization scheme, although this was used by only four banks (for a total of €4.05 billion recapitalization bonds, or less than half the €10 billion that was made available). The modest uptake of the scheme mainly reflected the conditionality as well as the recovery in global financing conditions which was already underway when the scheme was launched.

13. Government policies also focused on supporting credit to the private sector, especially to small- and medium-sized enterprises (SMEs). Besides exerting moral suasion on financial institutions, a state-controlled financial institution (Cassa Depositi e Prestiti, CDP) made funds available to banks that extend credit to SMEs, the existing guarantee fund for SMEs has been strengthened, and the Ministry of the Finance is overseeing a bank loan moratorium agreement between the banking association and the employers’ federation, which has allowed the suspension of loan repayments for €9 billion (0.6 percent of GDP). The government is also setting up a recapitalization fund for SMEs, financed by the government, the CDP, the employers’ federation, and private banks.

Figure 2.
Figure 2.

Economic Recovery is Underway

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Sources: Istituto Nazionale di Statistica; and ISAE.

Fiscal policy

14. The high level of public debt constrained the government’s ability to implement discretionary countercyclical fiscal policy. Italy’s stimulus package included facilitating access to credit for small and medium-sized enterprises (SMEs), a car scrapping program, a one-off family bonus, and wage supplementation schemes. Overall, this was one of the smallest stimulus packages among advanced G–20 countries, reflecting the limited fiscal space available, the existence of large automatic stabilizers, and concerns that the market might have reacted adversely to an expansionary fiscal stance.

uA01fig07

Italy’s real GDP loss has been one of the highest in the advanced G–20 countries, but the already large size of the government appeared to be a dominant factor for the size of the fiscal stimulus.

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Sources: WEO database; and IMF staff estimates.1/ General government expenditure, percent of GDP (average over 2005-09).2/ For Italy, estimated gross fiscal impact of revenue reducing and expenditure increasing measures is used, adjusted for the end-2009 postponement of the part of income tax payment and actual utilization of the one-off family bonus and the car scrapping scheme in 2009.

15. Although the fiscal stimulus was small, the fiscal position deteriorated sharply in 2009. Public debt increased by about 10 percentage points of GDP in 2009, reaching 115.8 percent of GDP. The overall deficit is estimated to have reached 5.3 percent of GDP, an increase of over 2½ percentage points from 2008. The resulting deficit was better than the euro area average, although the deterioration in terms of the change in the structural primary balance was similar (Figure 3). Total revenue remained robust, unlike in other countries, largely because of one-off capital tax receipts (about ¾ percent of GDP, including those resulting from a tax amnesty), which offset a slump especially in indirect and corporate income taxes. However, primary expenditure rose sharply because of increased social transfers and outlays on goods and services (including defense spending).

Figure 3.
Figure 3.

Italy: Fiscal Overview, 1995-2009

(Percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Sources: ISTAT; WEO; and IMF staff estimates.
uA01fig08

Composition of expenditure inceasing measures in 2009

(Total increase = 0.66 percent of GDP)

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Source: Ministry of Economy and Finance.

Political context

16. The center-right government that came to power in May 2008 is likely to see out its full term ending in 2013. The government retains a handsome majority, and its popularity was confirmed by the outcomes of recent local elections.

II. Outlook: A modest and fragile recovery

Basline

17. The recovery is expected to be modest. Staff projects Italy’s output to grow by 0.8 percent in 2010 and 1.2 percent in 2011, in line with most other forecasters. The rebound would be driven by the global rebound, resumption of investment, and the restocking cycle, more than offsetting the gradual withdrawal of government support. However, the recovery is likely to be moderate because: (1) the slow rebound of Italy’s major trading partners and persistent competitiveness gap will limit the scope for export growth; (2) the sustained rise in non-performing loans, enhanced lending discrimination due to the continued decline in the perceived creditworthiness of borrowers, and the need to rebuild capital in response to forthcoming new regulation are likely to constrain credit supply; (3) rising and persistent unemployment will undermine private consumption; and (4) firms will likely remain cautious on investment due to financing constraints, low capacity utilization, and falling profitability. More generally, the recovery will likely be hampered by many structural factors, including pervasive rigidities in product and labor markets, stagnant productivity, as well as the burden of the public sector.

Italy: Comparative Growth Forecasts

article image
Sources: MEF; OECD; EC; Consensus; and IMF staff estimates.

18. Inflation is expected to gradually increase in line with the recovery and rising energy prices. Inflation rose sharply from 0.1 percent year-on-year in August 2009 to 1.1 percent in December. Core inflation reached 1.5 percent year-on-year in December 2009, and the differential with the euro area widened further, largely due to service prices, likely reflecting weak domestic competition. Inflation is projected to rise to 1.4 percent in 2010 and 1.7 percent in 2011 owing to strengthening demand, and rising energy prices.

uA01fig09
Sources: Istituto Nazionale di Statistica; and Eurostat.1/ Latest observation is December 2009.

19. The competitiveness gap remains significant. Staff estimates of the equilibrium real exchange rate based on the CGER methodology indicate that there could be a competitiveness gap (real exchange rate overvaluation) of the order of 7–8 percent by 2015. Italy’s competiveness has been eroding not just because of low productivity growth, but also because of higher than average inflation compared to the euro area (affecting trade within the euro area) and the strength of the euro (affecting trade with the rest of the world). The former (in particular) will be difficult to reverse, and may weigh on activity for some time, reinforcing the importance of advancing structural measures.

uA01fig10

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 2010, 157; 10.5089/9781455207626.002.A001

Source: WEO.

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.

20. The current account deficit is projected to gradually improve. The current account has been deteriorating since 2005. It did not improve in 2009, despite a sharp decline of imports, because Italy’s export market share continued to shrink. Export growth is expected to pick up in line with the global economy and import growth will likely remain constrained by weak domestic demand. Despite the improvement, overvaluation issues are likely to remain and the current account deficit is expected to remain above the CGER current account norms in the medium-term.

uA01fig11

Earnings, Productivity and Competitiveness 1/

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Sources: Istituto Nazionale di Statistica; European Central Bank;1/ Cross-country data are average annual growth rates during 1998-2008 for Austria, Greece, Ireland, and Luxemburg. All remaining data are average growth rates during 1998-2009.2/ Latest observation is as of 2009q4.

21. A significant and permanent output loss will probably be the legacy of the global financial crisis. After an initial rebound, growth is expected to slow over the medium term, converging to potential. The level of output in 2015 is projected to be around 10 percent lower than the pre-crisis historical trend (for 1990-2004), mainly reflecting (1) the sharp fall in capital accumulation experienced during this recession, (2) higher structural unemployment, (3) the deterioration in total factor productivity associated with the credit slowdown and lack of incentives for industrial restructuring, and (4) weaker growth in partner countries.

22. The authorities believed that staff projections for potential output were too pessimistic. They argued that Italy’s recession reflected only a severe external demand shock. However, unlike some other countries, Italy did not suffer from asset bubbles, a domestic financial crisis, or the prospect of lost or shrinking sectors. This could lead to a quick rebound once external conditions improve. Staff stressed that, even though the crisis may have had an external origin, it has likely lowered the potential growth of some of Italy’s trading partners and could therefore have a permanent effect on foreign demand for Italian goods and services. Staff also noted that prolonged demand shocks (of whatever source) could have permanent adverse effects on idle labor and capital through hysteresis effects. The authorities and staff concurred that considerable uncertainty surrounded post-crisis medium term dynamics.

Risks and spillovers

23. Risks are, on balance, tilted toward the downside in the near term and become more negative in the long term. In the near term, there is an upside scenario where the global recovery and the inventory cycle could gain more momentum. On the downside, continued tight credit and falling profitability might further limit private investment, while rising unemployment may restrain consumption. There is also the danger of destabilizing spillovers from regional financial market turbulence. In the longer term, there is a risk of prolonged economic stagnation, resulting from the failure to address structural issues, leading to rising structural unemployment and a deteriorating fiscal situation.

24. Spillovers from market turbulence in Greece, Spain or Portugal are not unlikely but have been limited so far. Italian sovereign bond spreads over bunds have declined from their peak in early 2009 and have so far been only marginally affected by recent regional turbulence. Italy’s high debt-to-GDP ratio, the large gross financing (mostly debt rollover) requirement (about 25 percent of GDP annually), and dismal growth performance could make Italy susceptible to reversals in market sentiment. On the other hand, markets should take comfort from Italy’s strong corporate and household balance sheets, the absence of a housing bubble, the strength of its banking sector, its small competitiveness gap, its relatively favorable net foreign asset position and its traditionally high private savings. However, market sentiment could turn sharply negative if the government does not specify sufficiently promptly detailed plans to reduce the fiscal deficit according to its medium-term plan.

uA01fig12
Sources: Thomson Financial/DataStream; and Bloomberg.

III. The Policy Agenda: Renewing the Reform Momentum to Foster Sustained Growth

25. The downside risks could be mitigated if Italy were to embark on a program of comprehensive reforms in order to raise its longer-term growth potential. Although significant reforms have been undertaken in recent years, much more is needed—especially after the recent global crisis—to significantly improve longer-term economic performance. This calls for tackling with greater vigor the long-standing problems of poor productivity and fiscal weakness. Such a strategy would also help financial markets differentiate between Italy and other highly indebted advanced countries. International experience shows that the implementation of such reforms require determined political leadership over many years and can take considerable time to bear fruit.

26. Other countries have overcome similar challenges from very difficult starting positions with comprehensive policy packages. Canada, Australia, United Kingdom, New Zealand, Ireland, and the Netherlands all undertook path-breaking fiscal and structural reforms in the 1980s and 1990s in the wake of severe recessions. Indeed, Italy itself significantly cut its debt, liberalized its labor market and reformed its pension system during this same period. Empirical evidence suggests that recoveries from economic crises can often serve as an opportunity for reform. Broad-based support can be harnessed through such institutions as the independent commissions to set the agenda (France’s Attali Commission and Australia’s Productivity Commission) or monitor public finances (Sweden’s Fiscal Policy Council), and pacts with social partners (the Netherlands’ Wassenaar agreements).

A. Fiscal Sector: Deep Expenditure-Based Consolidation Required

Short- and medium-term outlook

27. The 2010 budget targets a deficit of 5.0 percent of GDP, representing a small reduction with respect to the outturn for 2009. This targeted improvement in the deficit reflects the phasing out of some 2009 one-off outlays, and implementation of the expenditure rationalization measures. The budget also includes a few stimulus measures equivalent to 0.4 percent of GDP, to be covered mainly by some revenue collection postponed from 2009.

Italy: Finance Law 2010—Summary of Main Budget Interventions

(Percent of GDP)

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Sources: Stability Programme Update, January 2010; and Ministry of Economy and Finance.

28. The government plans to reduce the deficit to below 3 percent of GDP by 2012. The plan, which is outlined in the January 2010 Stability Program Update, envisions a reduction of the deficit below 3 percent of GDP one year earlier than for most of other Excessive Deficit Procedure (EDP)-subject countries (due to its high debt and relatively modest deficit). This will require a fiscal consolidation of over 1 percent of GDP in 2011–12 compared to that based on existing legislation. The authorities have not yet specified the measures through which fiscal consolidation will be achieved.

Italy: Comparison of Medium-Term Fiscal Projections, 2008-2012 1/

(Percent of GDP)

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

Based on Jan 2010 Stabililty Programme Update, including the impact of the 2010 Finance Law.

One-off measures in 2009, estimated at 0.6 percent of GDP, include mainly receipts of tax amnesty and substitute taxes net of some spending on anti-crisis measures, support to the earthquake zone, and securitization operation. One-offs amount to 0.2 and 0.1 percent of GDP in 2008 and 2010, respectively.

29. The government’s fiscal adjustment strategy raises some concerns:

  • Realism of consolidation plans. Reducing the deficit to about 2¾ percent of GDP by 2012 would require cuts in primary current spending of 2 percent every year over the period in real terms, even assuming GDP growth of 2 percent in 2011-12. This compares with increases in such spending averaging 2 percent a year over the last decade. Moreover, the plan relies on very optimistic assumptions on spending efficiency, combating tax evasion, unspecified saving in local governments deriving from fiscal federalism, and one-off measures.

  • The planned consolidation is not ambitious enough. Meeting the minimum requirement under the Stability and Growth Pact (an annual structural adjustment, net of one-offs, of ½ percent of GDP) in 2010–12, would still not deliver the medium-term objective (MTO) of structural balance by the end of the period. Moreover, debt service costs rise continuously, and the debt ratio would likely remain well above 100 percent of GDP a decade from now, with potentially further negative implications on growth.

  • Withdrawal of stimulus. The plan assumes that the existing anti-crisis measures will largely expire by 2012. However, as unemployment rate is still rising and will persist a while, there may continue to be a need for income and employment support.

  • Weaknesses in the budget process. Plans to have a more streamlined and targeted budget have proven difficult to implement, with amendments and new extensions of existing provisions having quickly followed the just-approved budget.

  • Tax amnesty. The recent tax amnesty, despite its announced success in terms of volumes of repatriated capital, could decrease already low tax compliance while the impact of accompanying measures to deter future tax evasion is yet to be seen. Unlike recent initiatives in other countries that focused on disclosure, Italy’s amnesty provides full anonymity to the taxpayer, immunity against further administrative or criminal investigations, and allows the regularization of funds held abroad in connection with tax evasion in return for paying a relatively low final tax.

uA01fig13

Public Debt, 2003-2019 1/

(Percent of GDP)

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Source: IMF staff calculations.1/ Assumes primary balance path in 2010 -12 in line with the authorities’ policy scenario (Stability Programme Update, Jan 2010; and Notadi Aggiomamento 2010-12); primary balance is assumed to stay constant after 2013.
uA01fig14

The tax compliance gap with euro area average has been widening in recent years.

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Source: World Competitiveness Online.

30. The staff’s medium-term scenario is less optimistic than the authorities’ (Figure 4). The overall deficit in 2010 is projected to remain at about the same level as in 2009, and only slowly declines in following years. Less sanguine assumptions about expenditure savings (especially on current spending), together with different macroeconomic assumptions after 2010, explain most of the difference. While the structural primary balance would stabilize at about 1¼ percent of GDP over the medium term, rising interest and pension cost will make structural consolidation difficult, and the debt ratio could increase to about 125 percent of GDP by the end of the projection period.

Figure 4.
Figure 4.

Italy: Fiscal Projections, 1996-2015

(Percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Sources: ISTAT; MEF; and IMF staff estimates.1/ Excluding one-off measures.2/ Excluding one-off measures (percent of potential GDP, right scale).3/ Based on staff projections for the primary fiscal balance. For discussion of methodology, see IMF SPN/09/18.

31. Local governments have some exposure to derivative products. The use of derivates by local authorities has been banned on a temporary basis since 2008 while new and more stringent legislation is being prepared, and recently a special parliamentary commission found the problem to be limited in scale. Even though a comprehensive assessment of all fiscal risks arising from exposure to derivatives at the local level is not available, Bank of Italy’s data suggest that potential losses from such instruments contracted with Italian banks could be of the order of €1–2 billion (0.1 percent of GDP) in total, and thereby manageable from a macroeconomic perspective.

32. The authorities reiterated the commitment to reducing the deficit to below 3 percent of GDP by 2012 and to further consolidation in the longer term. They agreed that assumptions on growth may be optimistic but pointed out that corrective measures could be taken if necessary.

Longer-term outlook

33. Official longer-term fiscal projections seem relatively favorable compared to those of euro area peers. Although Italy had the highest pre-crisis debt ratio in the euro area, it is projected to have the lowest debt ratio in the euro area in 2060 (206 percent of GDP versus an average of 422 percent of GDP), according to the 2009 Sustainability Report of the European Commission (EC). Similarly, various long-term fiscal sustainability analyses place Italy among the countries with the lowest sustainability gap. This positive outlook is largely due to the projected stabilization of pension spending despite the rapidly aging population, as a result of a series of past pension reforms with future implications. Pension spending, however, will still remain among the highest in the world.

Ageing Related Government Expenditure, 2007-2060

(Percentage points of GDP)

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Source: European Commission.

34. These results, however, hinge on a number of optimistic assumptions. The projections, while based on the commonly applied EC assumptions, assume a long-term average labor productivity growth of over 1.6 percent, well above the stagnant growth rate experienced in the past decade. They are also based on the key assumption that the pension reform would be fully implemented, including periodic revisions of the conversion coefficients and the maintenance of the contributory principle. Moreover, the remaining reform is heavily back-loaded, with about two thirds of the adjustments in benefits expected to take place after 2020 compared to only about half of the adjustment after 2020 for reforms in other advanced economies. The sharp fall in the replacement ratio, from 67 percent in 2007 to 49 percent in 2060, could be politically challenging. Further risks would likely arise from the growing use of flexible labor market arrangements which reduce the pension revenues and result in lower pension benefits.

Figure 5.
Figure 5.

Italy: Pension System, Reforms, and Risks

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Sources: Country authorities; European Commission; OECD; and IMF staff estimates.1/ Estimates are based on the 2009 Ageing Report and do not reflect subsequent official revisions.

35. Stronger medium-term fiscal consolidation and increased growth will be necessary to ensure fiscal sustainability. Without a fiscal effort additional to what is envisaged, the debt ratio would become unsustainable in a low growth scenario (with real GDP growth of about 0.8 percent over the long term). In a scenario with somewhat higher growth (1.1 percent), an adjustment effort generating a structural improvement equivalent to about 2¼ percent of GDP over 2010-12 (against the authorities’ envisaged 1¾ percent of GDP, of which about 1¼ percent of GDP is yet to be identified) would be necessary to broadly stabilize the debt ratio over the long run. Additional savings from age-related expenditure (equivalent to cutting nominal pensions by 5 percent over the long term) would still be needed to bring debt ratio to 60 percent.

uA01fig15

Italy: Long-Term Fiscal Sustainability, 2000–2060—Illustrative Scenarios

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Sources: Ministry of Economy and Finance; Stability Programme Update, January 2010 (SP); and IMF staff estimates.Assumptions underlying the illustrative scenarios (growth rates are average rates for 2015-2060):A. Lower growth; no fiscal adjustment: Labor productivity growth 1.00%; employment growth -0.18%; fiscal projections as in staff baseline for 2010-2015.B. High growth; no fiscal adjustment: Labor productivity growth 1.62% and employment growth -0.13% (macroeconomic assumptions used in the Ministry of Economy and Finance projections); fiscal projections as in staff baseline for 2010-2015.C. Adjustment as in SP; average growth: Fiscal adjustment as in the Stability Programme Update (1¾ percent of GDP in 2010-2012); labor productivity growth 1.20%; and employment growth -0.13%.D. Stronger fiscal adjustment; average growth: Fiscal adjustment of 2¼ percent of GDP in 2010-2012); labor productivity growth 1.20%; and employment growth -0.13%.E. Stronger fiscal adjustment; average growth: Scenario D and nominal pension reduction of 5 percent.

36. The pension system should be adjusted to build buffers and to distribute the fiscal burden of reform more equally across generations. Pension reform should proceed as planned, but additional reforms should be considered to ensure long-term sustainability, including revisiting the current high replacement rates and increasing the age of retirement age. In this context, the enactment of the recently legislated indexation of the retirement age to changes in life expectancy, though starting from 2015, could be brought forward, possibly saving as much as 0.3–0.7 percent of GDP a year over the medium term. A more front-loaded adjustment effort would also help balance the intergenerational distribution of the fiscal burden arising from past pension reforms.

37. The authorities considered the pension system sustainable but were open to the idea of bringing forward the already scheduled increase in the retirement age.

38. Fiscal consolidation should be based on rationalizing current spending. The authorities’ plans concerning the reduction in personnel costs (mainly via slowing the turnover in public employment), and containing the growth of intermediate consumption of ministries and of healthcare spending (particularly, on pharmaceuticals) should be fully implemented. Consolidation should also include strict adherence to budget targets, including minimizing new spending initiatives outside the budget process, a commitment to save any revenue overperformance, and implementing the recommendations of the recently completed expenditure reviews. On the revenue side, the already high labor income tax-wedge would limit feasibility for tax rate increases, but there remains scope for broadening the tax base. One-off revenue measures should generally be avoided.

39. Fiscal framework reforms underway should benefit fiscal consolidation (Box 1). The current debate in key areas of fiscal decentralization and reform of the budget framework provides an important opportunity to help make public expenditure more efficient and strengthen fiscal discipline. Improving the quality and sustainability of public finances should entail: setting binding multiyear aggregate expenditure ceilings and sanctioning a strict top-down budgeting procedure; more formal scrutiny of macroeconomic forecasts by an independent institution; maintaining commitment appropriations at least for capital expenditure; a decisive switch to a baseline design based on current policies (instead of current legislation); and making a statement of fiscal risks and long-term fiscal projections part of budget.

uA01fig16

Quality of public finances remains poor.

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Source: ECFIN.1/ Scores range from -30 to +30 with an EU-15 average of 0: (-30,-10) = very poor; (-10,-4)=poor; (-4,+4) = average, (+4,+10) = good; (+10,+30) =very good.

40. The authorities saw fiscal federalism as the key priority to achieve fiscal consolidation, improve the quality of public spending, and revive the South. Imposing tougher budget constraints and moving away from the culture of soft, centrally-financed budgets is seen as sine qua non for the establishment of fiscal discipline at local level while fostering development in southern regions. The authorities were aware that fiscal federalism in other countries had often been associated with an increase in fiscal expenditures overall, but expressed their determination to ensure a fiscally-prudent fiscal federalism in Italy.

Recent Fiscal Framework Reforms

Budget reform. The 2009 Accounting and Public Finance law (Legge di contabilità e finanza pubblica) marks a first step in bringing Italy’s public financial management in line with best international practices. Its focus on harmonizing accounting systems, strengthening expenditure control and monitoring, and enhancing performance orientation of the budget is welcome. But the reform falls short on resolving some key issues such the establishment of a strict top-down budgeting process, the adoption of binding medium-term expenditure ceilings, the use of a credible current-policy baseline, the introduction of long-term scenarios, the (further) enhancement of transparency, and the strengthening of independent scrutiny of forecasts and policies. The law also envisages a move, over three years, toward a cash concept in budgeting (though informed by accrual-based accounting) but its pilot-based implementation implies uncertainties as to the outcome of this proposal.

Fiscal federalism. In May 2009, the Parliament adopted a Delegation Law outlining the main principles of fiscal federalism. The law stipulates that fiscal federalism must be consistent with Italy’s commitments under the Stability and Growth Pact and gives the government the authority to issue main implementation decrees by May 2011. In addition, it states the general principle that standard costs, fiscal discipline, and accounting uniformity will be important features. The key principles of harmonization of public sector budgets are expected to be defined by mid-May 2010 but the work of the technical commission is still lagging, and only a decree on transferring public property to local authorities (federalismo demaniale) has been introduced. The bulk of reform implementation measures, including determination of standard costs, subnational revenue assignments, and the size and sharing of the equalization fund will be adopted by May 2011.

B. Financial Sector: Mitigating Vulnerabilities

41. Going forward, Italian banks will benefit from improved macroeconomic conditions, but vulnerabilities will remain. In line with the projected output recovery, revenues are expected to increase moderately, due to a low rate of lending growth, a limited rise in interest rates, and some positive contribution from commission income. A more favorable environment for corporates and households is expected to slow the pace of deterioration in credit quality. However, given the still fragile economy, and the lag between economic recovery and improvement in asset quality, banks will continue to face a high level of credit risk for the next two years. For the two largest banks, further deterioration of credit risk in central and Eastern Europe could add to earnings pressure.

Scenario Analysis of the Banking Sector

According to a scenario analysis run by staff, the five largest banks would not be able to generate sufficient profits to significantly strengthen capital ratios. The Base Scenario takes into consideration a macroeconomic outlook in line with IMF estimates of a 2010 GDP growth of 0.8 percent, and 1.2 percent in 2011. As a result, loans are expected to grow by 1–3 percent in 2010–11, revenues by 1–3 percent, loan loss provisions to further increase by 6–9 percent in 2010, before falling by 3–0 percent in 2011. Under such assumptions, cumulated loan loss provisions in the 2010–2011 periods would be one third higher than in the 2008–2009 periods. Earnings would slightly improve in 2010 and in 2011, but would continue to remain significantly lower than before the crisis. Assuming a dividend distribution of the order of 10–30 percent of earnings, aggregated Core Tier1 ratio would rise in the 2010–11 period by less than 0.5 percentage points by 2011. The capital shortfall with respect to an 8 percentage Core Tier1 level would on average progressively close by 2011, although with significant bank by bank convergence differences.

In a more severe scenario with a more sluggish economic recovery and a weaker corporate landscape, earnings would shrink further and capital ratios would deteriorate. The Severe Scenario takes into consideration a harsh macroeconomic outlook, with GDP declining by -1.7 percent in 2010 and by -1.3 percent in 2011 (or a cumulative 2.5 percentage points lower than in the Base Scenario). Under this scenario, loans would remain flat, revenue growth would be negative, and loan loss provisions could increase by some 18-22 percent, in both 2010 and 2011. The cumulated loan losses would be 65 percent higher than in 2008-09. Such scenario would generate a significant erosion of profitability. On an aggregated level, the Core Tier1 ratio would deteriorate to below the 7 percent mark, for several banks.

42. Efforts to strengthen banks’ recapitalization should thus continue. Banks, which will already have a hard time raising capital under existing guidelines (see Box 2), will also need to comply with a new regulatory framework that will call for more and higher quality capital. The impact of the new capital rules on Italian banks should be manageable, given the stringent requirements already applied by the Bank of Italy with regard to capital deductions and to hybrid capital limits. However, given the still moderate outlook for profitability, it will be difficult to significantly reinforce capital through earnings retention, even assuming low dividend distributions. Banks should thus be encouraged, on a case by case basis, to continue to dispose of non strategic assets and raise capital from the market, as market conditions improve. In particular, banks that took advantage of the recapitalization bonds will need to prepare an alternative recapitalization strategy as the interest rate on these securities rises sharply in three years.

43. The authorities should guide the domestic banking system towards the prompt adoption of the latest recommendations of the Basel Committee on Banking Supervision. Although implementation of the proposals will take time, Italian banks should begin to adapt their capital strategies around the new regulatory framework, and the authorities should quickly adopt the new international rules, as soon as possible after they are defined.

44. Consideration should be given to loosening the current tax rules on the deductibility of loan write-downs. These rules are stricter than those in force in other major European countries, and while the existing fiscal treatment of loan losses has the advantage of creating substantial deferred tax assets that currently can be included in banks’ regulatory capital, this will not be allowed under forthcoming new regulations. Such action would also help support earnings, recapitalization, and lending in the face of increasing non performing loans.

45. Government sponsored loan guarantees to support SMEs were appropriate in the circumstances, but an exit strategy should be planned. Measures to support credit to the SMEs are justified in view of the sharp recession and credit drought, especially given the very large size of the SMEs sector in Italy. However, recourse to government guarantees should be temporary and appropriately priced. Nor should government support to firms prevent needed restructuring. Some improvements to the existing bankruptcy regime could be useful to help rehabilitate distressed, but creditworthy, firms and the speedy liquidation of non viable enterprises. For example, consideration could be given to the enhancement of the mechanism to support prompt provision of new financing to enterprises during the restructuring period in line with international best practices. The current eligibility criteria for bankruptcy trustees could also to be reexamined to better promote the appointment of trustees with firm management and restructuring skills.

46. The authorities concurred with the staff on the need for further capital strengthening of banks. They saw this as necessary, in view of the forthcoming changes in international regulation and increasing loan loss provisions. The authorities also expressed concerns that banks could be too conservative in their lending practice, which could hinder the credit rebound and the recovery.

C. Renewing the Structural Reform Momentum

47. Persistent low productivity growth in Italy has deep structural causes. The main structural factors are: (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 typically unable to exploit fully economies of scale; (3) limited process and product innovation, hindered by labor market rigidities; (4) outdated specialization patterns, given a production structure (especially in manufacturing) based on traditional low skill products; and (5) relatively poor human capital.

48. Although some structural reforms have been undertaken in recent years, further progress is needed. The government has, inter alia: (1) passed the local public services bill; (2) began abolishing obsolete legislation; (3) strengthened the transparency and accountability of public administration management; (4) implemented a law instituting competition assessments and regulatory impact analysis; and (5) incorporated the Antitrust Authority’s recommendations in a competition bill to be discussed by Parliament annually. Given the electoral cycle and the urgent need to reinvigorate growth, the next three years represent a unique opportunity to push forward the reform agenda.

49. Further reforms are necessary to remove impediments to competition and reduce the high cost of doing business in Italy. The second package of the 2007 structural reform reduced regulatory barriers in retail trade, retail banking, insurance and professional services. Further measures are needed to reduce state ownership in business activities in key network sectors, including electricity, gas, postal services, and transport, limit local government involvement in enterprises providing local services, eliminate entry barriers to professional services, continue deregulation the energy market, strengthen the enforcement of the rule of law, and enhance the role of competition bodies in formulating policy.

50. The EU Services Directive should be implemented without further delay. In adherence with the EU Service Directive, the government is currently in the process of reviewing all existing regulations on service activities at the central, regional, and local level to ensure consistency of existing regulation on service activities at all government levels with the EU legislation. While the review at the central government level has been completed and is in the final stage of the preparation of amendments, regions are lagging.

uA01fig17

Italy is relatively weak

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Source: World Economic Forum.
uA01fig18
Sources: OECD Product Market Regulation Database; European Commission; and European Central Bank.1/ Administrative regulation covers the low-level indicators within the sub-domains “Regulatory and administrative opacity” as well as “Administrative burdens on startups” in the domain “Barriers to entrepreneurship”.2/ Index 0–6 from least to most restrictive.

51. Despite substantial improvements over the past decade, labor market performance still lags behind that in other European economies. Significant labor market reforms over the past decade have improved employment, labor force participation, and unemployment rates, but Italy’s (measured) employment-to-population ratio continues to remain among the lowest in the euro area. In addition, unemployed workers still take a long time to find work—nearly 50 percent of the unemployed have been out of work for more than one year, substantially above the euro area average. 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.

52. A second generation of labor market reforms is needed. Italy’s social safety net is generous for some worker groups, but virtually nonexistent for (most) others; the extent of employment protection varies substantially across worker groups; and the aggregate wage distribution is highly compressed. The existing wage bargaining system exacerbates these disparities: nationally bargained wages are less binding in the North, but too high for South, and the lack of a broad social safety net, particularly for those in the South, prevents sufficient spatial mobility. The public sector should take the lead in decentralizing wage bargaining arrangements, taking into account regional differences in productivity and cost of living. In this respect, a program to enhance transparency and productivity-related rewards in the public administration has been introduced, although significant effects on wage negotiations to be seen.

53. The authorities pointed out that many reforms especially in the labor market had already taken place, though with unequal effects across the country. At the same time, the authorities saw the next three year—during which no elections are scheduled—as a golden opportunity to proceed with growth-enhancing reforms. The authorities indicated that government would announce decisive reforms in the next few months, especially in the area of fiscal federalism and tax policy.

Figure 6.
Figure 6.

Italy’s Labor Market Outcomes in Cross-Country Comparison, 2009

Citation: IMF Staff Country Reports 2010, 157; 10.5089/9781455207626.002.A001

Source: Eurostat.1/ All data are as of 2009q3.

IV. Staff Appraisal

54. Although the worst effects of the global financial crisis on Italy’s economy have mostly passed, key vulnerabilities remain. The high private savings rate, low private indebtedness, and the resilience of the financial sector are important elements of strength. However, the elevated level of public debt and the disappointing growth performance could make Italy vulnerable to future external shocks. The ongoing regional market turbulence could also be destabilizing. Public debt management has been conducted prudently, by lengthening the debt maturity and building buffers. These efforts should help strengthen the government’s financial position. But they cannot be a substitute for a sustained fiscal consolidation.

55. The overarching goals should be to maintain fiscal discipline, reduce the burden of public debt, and raise the economy’s long-term growth rate. Although the fiscal stance was appropriate during the crisis given the very high level of public debt to GDP ratio, efforts must now swiftly be made to reduce the fiscal deficit in a sustainable way. Public debt needs to be put back on a declining path. Policies to reinvigorate growth should focus on removing structural bottlenecks, improving the quality of public services, and strengthening the financial sector.

56. Staff endorses the authorities’ fiscal targets of reducing the deficit to below 3 percent by 2012. However, it cautions that the planned fiscal adjustment is based on the optimistic assumption of a strong and sustained recovery, full implementation of the earlier envisaged consolidation plans, and additional measures that have yet to be announced. Close monitoring of sub-national public finances should be maintained. Consideration should be given to advancing the pace of fiscal consolidation if market turbulence continues.

57. Staff concurs with the authorities’ objective of an expenditure-based fiscal consolidation. Containment of the public sector wage bill should be a key element of the consolidation strategy. The progressive reduction of public employment should continue, and a firm control of public wages is needed, especially at the local government level. The 2009 Accounting and Public Finance law marks a step in bringing Italy’s public financial management in line with best international practices, and could help in the consolidation effort, but effective implementation is crucial.

58. The tax burden is high and weighs disproportionally on salaried and retired workers. When the expenditure-based consolidation is firmly underway, the authorities should consider a tax reform with the view to reducing the tax wedge while increasing tax compliance. This reform should decrease the cost of labor and increase the employment rate, which continues to be one of the lowest in Europe. Ad-hoc revenue measures which could be detrimental to tax compliance in the long term should be avoided.

59. Fiscal consolidation must be a key guiding principle in the implementation of the federalism. The authorities see fiscal federalism as an opportunity to strengthen fiscal responsibility at all levels of government. However, international experience shows that implementation of fiscal federalism is often associated with fiscal expansion. The government should consider offsetting measures if the reform is to result in higher costs. In addition, the authorities will need to strike the right balance between regional autonomy and transfers across regions in the context of large local income disparities.

60. Italy has implemented bold pension reforms, which have significantly improved the sustainability of the pension system. However, the remaining adjustment in benefits is back-loaded and long-term sustainability projections are based on optimistic assumptions about economic growth. These factors raise questions about intergenerational equity. Therefore, the authorities should consider bringing forward the already scheduled increase in the retirement age. Efforts to develop private pension schemes should also be intensified.

61. Italian banks should increase their capitalization, as recommended by the Bank of Italy. Banks will face a number of challenges over the medium term. Owing to the weak economy, they will continue to encounter a high level of credit risk, low lending growth, and significantly lower profitability than before the crisis. Furthermore, the international regulatory rules will be tightened in several respects, including capital requirements. Banks should be encouraged to dispose of non-strategic assets, retain earnings, and raise capital from the market. Consideration could also be given to relaxing the current tax rules on the deductibility of loan write-downs, which are stricter than in other major European countries, also in light of the possible new capital regulation on deferred tax credits.

62. The next few years offer an important opportunity to pursue an ambitious program of structural reforms. The global crisis has further exposed the structural weaknesses of the economy, underscoring the urgency of structural reform. Progress in the structural reform agenda will be the key to unleash Italy’s growth potential. This will require multi-faceted reforms to enhance competition, raise productivity, and reduce the high cost of doing business in Italy. Such reforms could include enhancing the efficiency of public services, improving the quality of public investment and infrastructure, streamlining bureaucratic requirements, reforming civil justice and accelerating legal processes, and strengthening enforcement of the rule of law. The EU Services Directive should be implemented without further delay to ensure the consistency of existing regulations on service activities at all government levels with the Directive.

63. Labor market performance still lags behind that in other European economies. Previous reforms have helped to reduce unemployment. Nevertheless, Italy’s employment rate still remains among the lowest in Europe, productivity is lagging, and the labor market is split between highly protected workers with permanent contracts and ill-protected temporary workers. This gap needs to be bridged by making permanent contracts more flexible and temporary workers more protected while simplifying the labor market legislation. A second generation of labor market reforms is also needed to strengthen the link between wages and productivity, allow wages to better respond to regional differences, and foster adequate spatial mobility.

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

Table 1.

Summary of Economic Indicators

(Annual percentage change, unless noted otherwise)

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Sources: National Authorities; Eurostat; and IMF staff calculations (April 2010 WEO).

Staff estimates and projections, unless otherwise noted.

Contribution to growth.

Twelve-month credit growth, adjusted for securitizations.

Excludes currency in circulation held by nonbank private sector.

Percent of GDP.

Table 2.

Italy: General Government Accounts, 2007–2015

(Percent of GDP, unless otherwise indicated)

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Sources: ISTAT; Ministry of Economy and Finance; and IMF staff estimates (April 2010 WEO).

Percent of potential GDP.

Percent.

SP-T = Stability Programme Update (unchanged legislation scenario), January 2010

SP-P = Stability Programme Update (policy scenario), January 2010

Table 3.

Italy: Financial Soundness Indicators

(Percent, unless otherwise noted)

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Sources: Bank of Italy and IMF staff calculations.

Bad debts plus substandard loans.

Assets on Tier 1 capital.

Not in percent.

Appendix 1. Italy: Scenario Analysis of the Banking Sector

Scenario Analysis: Main Assumptions

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Source: IMF staff calculations.
uapp01fig01

Appendix 2. Italy: Financial Indicators, 2007–2010

uapp02fig01
Sources: Thomson Financial/DataStream; and Bloomberg.1/ MPS stands for Banco Monte dei Paschi di Siena.