Italy
Staff Report for the 2011 Article IV Consultation; Informational Annex; Public Information Notice; Statement by the Staff Representative; and Statement by the Executive Director for Italy.

Italy’s economic development after the recession is analyzed in this study. Earnings were hampered by low net interest and high loan-loss provisions, but banks remained profitable. A large and stable retail funding base and ample collateral to access eurosystem refinancing helped Italian banks to face liquidity and funding risks. The tax system was simplified to support growth and enhance tax compliance. The execution of fiscal federalism should not undermine fiscal discipline, and measures were taken to improve employment. Flexibility introduced by the labor market was welcomed.

Abstract

Italy’s economic development after the recession is analyzed in this study. Earnings were hampered by low net interest and high loan-loss provisions, but banks remained profitable. A large and stable retail funding base and ample collateral to access eurosystem refinancing helped Italian banks to face liquidity and funding risks. The tax system was simplified to support growth and enhance tax compliance. The execution of fiscal federalism should not undermine fiscal discipline, and measures were taken to improve employment. Flexibility introduced by the labor market was welcomed.

I. Context: Existing Weaknesses Constrain The Recovery

A. The Global Crisis Left a Difficult Legacy

1. Italy suffered one of the largest output contractions in the euro area during the global financial crisis and is experiencing one of the slowest recoveries. The downturn started earlier and lasted longer than in most of the euro area (EA) countries. It was exacerbated by the economy’s long-standing structural problems and reliance on international trade. Per capita GDP and productivity in 2010 were lower than in 2000, with Italy experiencing the largest per capita GDP contraction among OECD member countries over a decade. The level of output in 2015 is projected to be around 10 percent lower than the pre-crisis historical trend (1990-2004).

uA01fig01

Output Recovery

(2009Q4-2011Q1)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: WEO; and IMF staff calculations.
uA01fig02

Real GDP Per Capita in PPPs

(2000=100)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: OECD; WEO; Haver; and IMF staff calculations.
uA01fig03

Productivity: Output per Employed Person

(2000=100)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

2. Despite the modest discretionary fiscal stimulus, public finances weakened. Constrained by the lack of fiscal space, the stimulus packages were modest. Still, the deterioration in public finances during the crisis was comparable to that of the EA average. At end-2010, Italy’s public debt stood at 119 percent of GDP. The 10-year bond yield spread vis-à-vis Germany, increased substantially over 2008-2010, reaching levels last seen in 1997, reflecting concerns over public sector financing needs—over €400 billion or about one-quarter of Italy’s GDP on average in 2009-2011.

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The State of Public Finances Before, During, and After the Global Crisis

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: WEO; Bloomberg; and IMF staff estimates.

3. During the global financial crisis, Italy’s banks proved resilient, but asset quality and profitability weakened. While banks did not suffer large losses, thanks to a traditional business model and a sound supervisory framework, overall bad debt almost doubled in 2009-2010. Credit quality, though, worsened less than during the severe 1992-1993 recession, thanks to lower interest rates and advances in banks’ credit risk management.

uA01fig05

Ratio of New Bad Debt to Outstanding Loans

(Percent)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Source: Bank of Italy1/ Data are seasonally adjusted and annualized.

B. Weak Recovery and New Challenges

Real economy: export-led recovery

4. A modest export-led recovery is under way. The economy grew by 1.3 percent year-on-year in 2010, less than the EA average of 1.7 percent, and by 0.1 percent quarter-on-quarter in Q1 2011, compared to an EA average of 0.8. External demand, supported by the depreciation of the euro and the economic rebound in Germany, drove the recovery. Domestic demand was weak. Household spending remained cautious on the back of rising unemployment, declining real disposable income, and lingering uncertainty on growth prospect. The phasing out of the car scrappage scheme in the beginning of 2010 has considerably slowed car purchases. Investment rebounded significantly in the first half of 2010 but weakened following the termination of the tax incentives for investment in June. Government consumption was flat. Labor productivity increased following a sharp decline during the crisis, with the highest gains recorded in manufacturing and services sectors. The current account deficit worsened despite robust export growth, owing to rising energy prices and high import growth.

uA01fig06

Real GDP and Exports

(Year-on year percent change)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: Haver; and IMF staff calculations.

5. The labor market remains weak. Average employment declined by 0.6 percent year-on-year in 2010 as companies continued to shed hoarded labor. Employment contracted most sharply in the South (-1.4 percent), and in manufacturing (-4.0 percent). Firms used more flexible arrangements such as part-time and temporary contracts. In fact, the employment contraction was limited to full-time permanent employees, while the numbers of self-employed, part-time, and fixed-term employees rose. Unemployment rose to 8.6 percent in Q4 2010 from 8.3 percent in the same period in 2009. However, the unemployment rate remains below the EA average, thanks in part to the state-funded wage supplementation program (Cassa Integrazione Guadagni, or CIG).1 The number of hours of wage supplementation fund benefits increased by 32 percent in 2010, declining in Q4 2010. The youth unemployment rate remains at 28 percent. Long-term unemployment, defined as those unemployed for a period of 12 months or more, constitutes almost half of total unemployment.

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Earnings, Productivity and Competitiveness 1/

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: Istituto Nazionale di Statistica; and European Central Bank.1/ Cross-country data are average annual growth rates during 1998-2010. Unit labor cost average for France and Portugal is 1998-2008 and for Denmark, Ireland, and Spain 1998-2009. Hourly wages average for Austria is 1998-2007 and for the UK 1998-2009.2/ Latest observation is as of 2011q1.

6. Inflation increased moderately due to rising energy and commodity prices. Consumer price inflation rose to 1.6 percent in 2010 from 0.8 percent in 2009. The Italy-euro area positive inflation gap closed, mainly on the back of non-core components, while the inflation differential on core prices remained relatively stable. Unit labor costs in manufacturing fell by 2.8 percent in 2010 in light of moderating hourly compensation.

7. The competitiveness gap remains significant. Wages have increased more than productivity, resulting in a loss of competitiveness. All price competitiveness measures show significant deterioration. Italian export volume shares in world markets have been consistently declining. Applications of the CGER methodologies indicate a competitiveness gap of 7 to 10 percent.

uA01fig08

Italy-Euro area Inflation Differential

(Percent, year-on-year)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Source: Eurostat.1/ Total CPI excluding energy, food, alcohol, and tobacco.
uA01fig09

Italian Competitiveness

(1999=100)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: WEO; and IMF staff estimates.

Fiscal targets achieved so far

8. The authorities comfortably achieved the 2010 fiscal target. The overall fiscal balance declined from 5.3 percent of GDP in 2009 to 4.5 percent of GDP in 2010 (Figure 4), well below the target of 5.0 percent of GDP. The improvement reflected both good revenue performance and contained budget outlays. The increase in indirect taxes partly offset the decline in capital revenues. More stringent VAT refund rules introduced in 2010 reduced refunds by over €5.5 billion (0.4 percent of GDP). The phasing out of the 2009 anti-crisis measures and cuts in capital spending and the wage bill contained outlays. Real primary current expenditure grew at the lowest rate since mid-1990s. However, payment delays increased. The positive budgetary trends continued in the first months of 2011.

Figure 1.
Figure 1.

Italy: Cyclical Indicators

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: Istituto Nazionale di Statistica; and IMF staff calculations.
Figure 2.
Figure 2.

The Recovery in Historical Perspective

(Year-on-year change, Index, Trough=0) 1/

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: Eurostat; and Istituto Nazionale di Statistica.1/ The troughs correspond to 1975(q2), 1983(q1), 1993(q1), and 2009(q1).
Figure 3.
Figure 3.

Standard Competitiveness Indicators Point to a Gap

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: Istat; OECD; Eurostat; Bank of Italy; European Commission; and IMF staff estimates.
Figure 4.
Figure 4.

Italy: Fiscal Overview, 1997-2010

(Percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: ISTAT; WEO; European Payment Index; and IMF staff estimates.1/Percent of potential GDP.2/Basis points.3/EA = Euro area-11, excluding Italy.

9. The structural balance improved by about 1 percentage point of GDP in 2010, among the largest improvements in the EA. The fiscal consolidation is closer to the EA average if the one-off measures, which reduced the deficit in 2009, are included.

No immunity from spillovers from the European sovereign debt crisis

10. Italy’s sovereign spreads widened considerably after the Greek and especially the Irish crisis, reaching pre-euro levels. In Spring 2010, as the Greek crisis was unfolding, Italian sovereign spreads increased abruptly mostly because German yields declined. In contrast, the Irish crisis led to a significant increase in both Italy’s government bond spreads and yields. Overall, 10-year sovereign bond yields rose from around 370 basis points (bps) in mid-October 2010 to 460 bps in mid-May 2011. After peaking at almost 200 bps in late November 2010 and early January this year, government bonds spreads in mid-May were at 150 bps, still well above pre-Greek crisis levels.

uA01fig10

Structural Deficit in 2009 and Its Change in 2010

(Percent of potential GDP)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: WEO, and IMF staff estimates.
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10-Year Bond Yields, 1996-2011

(Percent, monthly averages)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Source: Bloomberg.
uA01fig12

10-year Government Bond Spread Against Germany

(Basis points)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Source: Bloomberg.
uA01fig13

5-year Sovereign CDS Spread

(Basis points)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

11. Italy remains vulnerable to market turbulence. The high public debt-to-GDP ratio, large gross financing requirements, and dismal growth performance are Italy’s main vulnerabilities. However, sound household balance sheets, the absence of housing bubbles, traditionally high private savings, low current account deficits and relatively favorable net foreign asset position are Italy’s main points of strength.

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Government Short-Term Debt and Deposits

(Billions of euro, end-period)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Source: Bank of Italy.1/ Government deposits at the Bank of Italy.

12. Despite intensified regional market turbulence, the budget was financed without major difficulty, thanks to prudent debt management, high market liquidity, and a relatively favorable risk-return profile of the Italian bonds. Lengthening debt maturity and strengthening the budget’s cash buffers reduced further rollover/financing risk.

13. The European sovereign debt crisis affected Italian banks, even though direct exposure to euro area crisis countries is limited. The five largest banks’ equity prices have dropped by over 35 percent on average since end-October 2009, and their CDS spreads have shot up by about 170 bps over the same period. In fact, the five largest Italian banks’ CDS spreads have been increasing more than the average CDS spreads of the largest EA banks since the announcement of the Greek program in April 2010, driven by Italian sovereign risks (forthcoming Selected Issues). The direct exposure of Italian banks to Greece, Ireland, and Portugal is limited, totaling about €27.7 billion, or 0.7 percent of assets, with the largest five banks exposed for less than €3 billion.

Consolidated Exposure of Italian Banks to Selected Countries

(Billions of euros, as of end September 2010)

article image
Source: Bank for International Settlements.

Unallocated sector, plus positive market value of derivatives contracts, guarantees extended, and credit commitments.

uA01fig15

European Banks’ CDS Spreads

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Source: Bloomberg.
uA01fig16

Banks’ Equity Price Change

(Percent)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Resilient banking sector, but with relatively low capitalization levels

14. Bank credit is recovering but lending rates are inching up. After a sharp fall in 2009, credit growth to the private sector started to rebound in February 2010 (Figure 5). The 12-month growth in lending to non-financial firms turned positive in September 2010, and reached 4.6 percent last March. The 12-month growth in lending rate for households remained solid at about 5 percent in March. According to the latest bank lending survey as well as recent firm surveys, credit supply conditions for firms tightened slightly in Q1 2011, and are expected to remain stable over the next three months. Credit conditions will be adversely affected by the ongoing increase in lending rates for both firms and mortgages, following the rise in the ECB policy rate, the euribor, and bank funding costs.

Figure 5.
Figure 5.

Italy: Bank Credit, Interest Rates, and Non-performing Loans

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: Bank of Italy; Bloomberg, Datastream; and IMF staff calculations.1/ Corrected for securatization.2/ Average yields of bonds issued by the five largest Italian banks.3/ The sharp increase in bad debt in January 2011 is partly due to a statistical discontinuity in the data.4/ Bad debt, substandard, restructured and overdue/overdrawn loans.

15. Bank financing needs are large, and funding costs are increasing. Stable retail funding (deposits and retail securities) account for over 75 percent of the total funding for the largest five banks. However, banks currently face large refinancing requirements, with over €65 billion and €104 billion of bonds coming to maturity for the largest five banks during the rest of 2011 and in 2012, respectively. Nonetheless, in the first three months of the year the largest banks refinanced about 75 percent of wholesale bonds due to mature in 2011. Funding costs have been increasing since the second half of 2010. Deposits rates have risen by 20-80 bps since end-May 2010, and yields on banks’ securities have climbed by about 80 bps over the same period, driven by sovereign risk and the higher euribor (Figure 5). Recently, banks have been issuing more covered bonds than before to hold down funding costs.

uA01fig17

Amortization of Debt Securities for the Five Largest Italian Banks

(Billions of euros)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: Bloomberg; and IMF staff calculations.1/ Includes senior unsecured, notes, and certificates of deposit.
uA01fig18

Bond Issuance of the Five Largest Italian Banks

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

(Billions of euros)

16. Italian banks’ use of Eurosystem lending facilities has grown. Refinancing operations have been on average relatively low throughout the global financial crisis, but they increased in the summer 2010 and remain volatile. They were slightly above €40 billion in April 2011. As of mid-April 2011, for the 32 largest banks the eligible collateral for Eurosystem refinancing operations was on average about 7 percent of their assets, while their average monthly cash outflow (assuming no rollover of maturing obligations) was around 3 percent of their assets.

uA01fig19

Italian Banks’ Refinancing Operations with the Eurosystem

(Billions of euros)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: Bank of Italy, European Central Bank.

17. Italian bank asset quality and profitability remain low. While non-performing loans have increased steadily since 2008, the most recent data on the inflows of new bad debt point to some stabilization in bad debt growth. Due to higher provisions for loan losses and lower net interest income, profits dropped significantly in 2008-10, and large banks’ returns are currently underperforming compared to other European peers (Figure 6).

Figure 6.
Figure 6.

Italy: Indicators on the Five Largest Banks

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: Bloomberg; and IMF staff calculations.

18. Bank capital levels are relatively low, but rising. Thanks to capital increases, retention of profits, asset sales, and the issuance of securities subscribed by the Ministry for the Economy and Finance (MEF), capital buffers rose in the past two years, with the average core tier 1 ratio of the five largest banks up from 6.0 percent in 2008 to 7.4 percent in 2010. Nevertheless, large Italian banks’ capital ratios continued to be low by international comparison at the end of last year. Since January, five of the six largest banks have completed or announced recapitalization plans for a total of €11.7 billion. The financial leverage of the largest Italian groups, measured by the ratio of total balance sheet assets to tier 1 capital, is lower than in other European peers (Figure 6).

19. Italian banks have a large volume of operations in Central and Eastern Europe and little exposure to Northern African countries. As of December 2010, Italian banking groups’ exposure toward Central and Eastern European (CEE) countries amounted to €160 billion (around 4 per cent of the banking system’s total assets). Most of CEE exposure is towards countries for which the market’s risk assessment (as gauged by CDS spreads on sovereign debt) is relatively less severe. As of December 2010, Italian banking groups’ exposure toward the Northern African countries amounted to around €5 billion (mostly toward Egypt, with Libya accounting only for €8 million).

uA01fig20

Core Tier 1 Ratio

(Percent)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: Banks’ financial statements; and IMF staff calculations.1/ Including announced recapitalizations, net of governemnt recapitalization bonds reimbursements.2/ Simple average by country of the largest banks’ core tier 1. For Italy, average of the largest five banks. For the other euro area countries the banks considered are Erste, Raiffesein, Dexia, KBC, BNP Paribas, Credit Agricole, Societe Generale, Deutsche Bank, Commerzbank.

20. Non-financial corporate balance sheets are rather fragile. Financial conditions of Italian firms are undermined by low capitalization levels, relatively high leverage, a large share of short-term debt, and the prevalence of variable rate loans, which increases the risks stemming from rising interest rates. Bankruptcies have grown steadily since 2007. The MEF is promoting a number of initiatives to support lending to small and medium enterprises (SMEs), as well as their recapitalization, in collaboration with the private sector and the Cassa Depositie Prestiti—a joint stock company under public control. These include, among others, the creation of a bank specialized in credit to firms in Southern Italy and a private equity fund. Household debt remains low by international comparison, but variable rate mortgages have grown sharply in past few years, and now account for almost 70 percent of the total stock, creating some potential risks in the context of increasing interest rates.

uA01fig21

Non-financial Corporate Leverage

(Percent)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Source: Bank of Italy.1/ Ratio to equity.
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Italy: Firm Bankruptcies and Pre-liquidation Procedures

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Political context

21. Some political commentators suggest that the center-right government has weakened, with some high-ranking public officials indicted and tensions within the coalition intensifying. The coalition relies on a thin parliamentary majority. However, an important fiscal reform is under study and may be implemented before the end of the legislature.

II. Outlook: Structural Weaknesses Limit Growth

Italy: Comparative Growth Forecasts

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

22. Italy’s growth is expected to continue at a modest pace. Staff projects Italy’s output to grow by 1 percent in 2011 and 1.3 percent in 2012, in line with most other forecasters. By end-2012, the Italian economy would have recouped only half of the output loss suffered during the crisis. Growth is expected to continue to be driven by exports and the resumption of investment from low crisis levels. However, it will likely be held back by subdued domestic demand and further fiscal consolidation. Such a modest pace of activity will not allow a significant recovery in employment. Persistent labor market weakness, sluggish income growth, a decrease in government transfers, and a rising cost of credit will curb household spending. A persistent competitiveness gap hindering export growth, and slow progress in structural reforms, will also limit growth.

23. Italy’s permanent medium-term output losses associated with the crisis are estimated to be around 10 percent of pre-crisis trend. Potential growth is projected to remain below one percent, with the output gap currently estimated around 3 percent and is projected to be closed by 2016.

24. Inflation is expected to increase due to rising energy and commodity prices. Consumer price inflation is forecast to increase to 2.5 percent in 2011 and 2.2 percent in 2012. Capacity utilization is rising but remains well below normal levels; and the private consumption recovery is likely to remain anemic given the lack of a turnaround in the labor market. As a result, domestic inflationary pressures will be modest, and core inflation will broadly stabilize. Rising energy and commodity prices will exert some upward pressure on headline inflation.

25. The authorities agreed with staff on the pace of the recovery but are more optimistic on the medium term. The authorities substantially revised downwards growth projections in the April update of the Stability Programme. However, they are more optimistic than staff on the contractionary effects of fiscal consolidation after 2012.

Risks

26. The main downside risk comes from market turmoil in the euro area periphery. Renewed tensions in EA periphery countries may turn capital markets against highly indebted countries like Italy, leading to higher spreads. Declining public bond prices would worsen the banks’ and insurance companies’ balance sheets, with a possible vicious cycle. Even absent this, continued tight credit and uncertainty could hinder private investment, while rising unemployment may weigh heavily on consumption. Fiscal tightening could further depress aggregate demand.

27. Another decade of stagnation poses also a major risk. The decline in potential output and policy inaction may prolong economic stagnation; rising financing costs could produce a vicious circle. Another decade of disappointing growth would make public debt difficult to sustain.2

28. Other uncertainties on outlook persist. The recent turmoil in Libya is expected to have only limited impact on growth, mostly through higher energy prices. On the upside, the global recovery and the inventory cycle could gain stronger momentum, and the vigorous pursuit of fiscal consolidation objectives could increase confidence and investment.

III. The Policy Agenda: Maintaining Financial Stability And Fiscal Sustainability While Raising Growth Through Reforms

29. The government’s overarching goal is to increase potential growth while maintaining fiscal consolidation. The government has started a few reforms to address some long-term structural bottlenecks, including low quality of education, regional disparities, and public sector inefficiencies. Fiscal federalism, and the reforms of the universities and the public sector will take time to implement, and their effects on growth will take even longer to bear fruit. Staff pointed out that other reforms, especially in the product and labor market areas, should also be implemented. While Italy’s potential growth slowly builds on the back of reforms, the near-term policy agenda must focus on preserving fiscal sustainability, strengthening financial stability, and implementing labor and product market reforms.

30. International pressure is helping Italy implement needed reforms. The implementation of the “European Semester” is strengthening fiscal planning. The Basel III agreement is putting pressure to increase banks’ capital adequacy.

A. Fiscal Policy: Consolidation and Better Expenditure Quality Required

Fiscal outlook

31. The Authorities target a deficit below 3 percent of GDP by 2012 and a near-balanced budget by 2014. Measures for 2011-2012 have been identified but measures for 2013-2014 need to be announced.

  • Identified adjustment in 2011-2013: The July 2010 fiscal package identified measures for €12 billion for 2011 (¾ percent of GDP) and €13 billion for 2012. Expenditure-saving measures, accounting for about ¾ of the adjustment, include a reduction in transfers to sub-national governments, a public wage freeze, and cuts in public investment and social transfers. The rest is expected to come from fighting tax evasion. The 2011 budget weakened somewhat the quality of the adjustment. A one-off receipt from a tender of broadband licenses (€2.4 billion) and some additional revenue administration measures will offset some increases in recurrent expenditure and tax relief. Furthermore, waivers from the 2011 Domestic Stability Pact for local governments have been introduced.

  • Additional adjustment needed in 2013-2014: In the April 2011 Stability Programme Update, the authorities have committed to additional 2.3 percent of GDP consolidation in 2013-14—about €20 billion each year. The plan envisages an expenditure-based consolidation but does not outline any specific measures.

32. The authorities’ consolidation plan is appropriate but its implementation could be problematic. The plan rightly focuses on expenditure measures, including a further strengthening of the pension system, and acknowledges the importance of combating tax evasion. However, more than half of the expenditure reduction in 2011-2012 is to be delivered by sub-national governments, which is politically difficult, while revenue increases rely on administrative measures.

uA01fig23

Italy: Composition of the Fiscal Adjustment Package, 2011-2013 1/

(Percent of total net fiscal impact of 1.4 percent of GDP)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

1/ Based on the authorities’ estimates.

33. While welcoming the authorities’ commitment to sustain consolidation after 2012, staff expressed concerns about the plan to achieve the targeted adjustment. In particular, the plan lacks specific measures, and it uses optimistic assumptions on the growth effect of the envisaged fiscal consolidation. Also, while most recent evidence of strengthened fiscal rigor is encouraging, the track record of past fiscal plans offers little optimism. Overall, the success of the consolidation depends on ongoing fiscal structural reforms, including fiscal federalism reforms and the reform of public administration.

uA01fig24

Past Fiscal Plans: Overall Balance Targets and Outturn

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Source: Balassone, Momigliano, and Rizza, Medium-term fiscal Planning under (mostly) Short-term Governments: Italy 1988-2008 (forthcoming).Note: EFPD = Economic and Financial Planning Document.

34. With less optimistic revenue assumptions, the fiscal deficit would likely exceed the target 3 percent of GDP in 2012 (Figure 7). The overall balance will reach 3 percent of GDP only in 2015, assuming that real primary current expenditure growth averages zero in 2011-2016 (compared to over 2 over 1999-2008), and less optimistic revenues from administrative measure. Public debt, after stabilizing at close to 120 percent of GDP in 2011-2013, will decline to about 118 percent of GDP by 2016. Public debt dynamics are most sensitive to a shock to real GDP and the assumed fiscal adjustment effort but are less sensitive to an interest rate shock (Figure 8; Box 1).

Figure 7.
Figure 7.

Italy: Medium-Term Fiscal Outlook, 1997-2016

(Percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: Bank of Italy; ISTAT; WEO; Ministry of Economy and Finance; and IMF staff estimates.1/ Billions of euros.2/ SP2011 = Stabililty Programme (April 2011).3/ Excluding one-off measures.4/ Excluding one-off measures (percent of potential GDP, right hand side).5/ Based on staff projections for the primary fiscal balance. For discussion of methodology, see IMF SPN/09/18.
Figure 8.
Figure 8.

Italy: Public Debt Sustainability: Bound Tests 1/

(General government gross debt; percent of GDP, unless otherwhise indicated)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: WEO; and IMF staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2012, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Characteristics of Italy’s Public Debt

Despite its size, Italy’s public debt is relatively resilient to interest rate shocks. Of the total gross general government debt: (i) over 75 percent is long-term debt; (ii) close to 85 percent has an initial maturity of over 1 year; and (iii) less than 12 percent is at variable rates. The authorities extended the average maturity of debt from 5.7 years in 2000 to 7.2 years as of end-March 2011. Simulations suggest that a 100 basis point increase in interest rates will increase the deficit by about 0.2 percentage points of GDP in the same year.

Budgetary Sensitivity to Interest Rate 1/

(Percentage points of GDP)

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Impact of 100 basis points interest rate increase (shift of the w hole yield curve) in T=2011. Source: Ministry of Economy and Finance; Stability Programme Update (April 2011).

Non-residents held about half of the total public debt at end-2009. The share of non-resident holding is close to that of Germany and lower than in France (around 65) or Portugal (over 75), but higher than in Spain (about 40) or the UK (30). During the crisis, the share of non-resident holdings of short-term debt more than doubled, but remained broadly unchanged for medium-and long-term debt.

uA01fig25

Italy: Composition of Government Securities by Holders

(Percent of respective total aggregates; end-2009)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Source: Bank of Italy.

35. The authorities pointed out that Italy’s longer-term fiscal outlook compares favorably to that of euro area peers. The European Commission (EC) projects Italy’s public debt to be the lowest in the euro area by 2060, on unchanged policy relative to 2009 (EC Sustainability Report, 2009). Staffs baseline estimates, which assume an average annual growth rate of about 0.9 percent in 2017-2060 and no reform, project the debt-to-GDP ratio close to 220 percent by 2060, well below the EA average. In addition to the assumed medium-term fiscal effort, the relatively contained debt dynamics reflects the impact of the enacted pension reform.

uA01fig26

Projected Gross Government Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: EC 2009 Sustainability Report; and IMF staff estimates.1/ Updated estimates for Italy based on IMF staff long-term sustainability analysis, which reflects staff’s basline fiscal projections for 2010-2016 and assumes average real GDP growth of 0.85% in 2017-2060. All other projections are from EC (2009).

36. Achieving the SGP debt target of 60 percent of GDP poses a big challenge for Italy (Figure 9). Given the projected large negative growth-interest rate differential, primary surplus has to be close to its historical maximum for the debt-to-GDP ratio to reach 60 percent by 2030. This would be similar to the authorities’ policy scenario presented in the 2011 Stability Programme Update.

Figure 9.
Figure 9.

Italy: An Illustrative Range of Possible Levels of Public Debt in 2030

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Source: IMF staff estimates.Note: The figure shows combinations of primary balance (PB) and growth-interest rate differential (g-r) that would result in the same levels of debt in 2030. In paritcular, by 2030: (i) with PB and (g-r) kept at historical average levels, the debt would reach about 80 percent of GDP; (ii) with PB and (g-r) kept at their 2010 levels, the debt would reach about 150 percent of GDP; and (iii) with PB and (g-r) kept at their expected 2014 levels as projected in the authorities’ April 2011 Stability Programme Update (SP2011), the debt would reach close to 60 percent of GDP. Historical averages and maximums refer to the perod of 1999-2007.

37. The authorities and staff concurred that public expenditure remains very inefficient, and the tax burden is large. Italy scores poorly in terms of the quality and efficiency of public expenditure, while standing out among countries with highest tax burden and lowest tax compliance (Figure 10). Overall, progress on improving public expenditure as identified in previous reviews (such as, Libro verde sulla spesa pubblica) has been limited, with few exceptions. Some steps on improving the budget classification, institutionalizing spending reviews, and reorganizing public administration have been taken. The public administration modernization reform (“Brunetta reform”) is still in an experimental phase, and is constrained by the fiscal cuts. Fiscal consolidation is also difficult given the size of transfers to sub-national governments, large entitlement programs, and the sizeable interest expenditure (Figure 11). Recognizing that the tax system is unduly cumbersome and prone to abuse, the government recently initiated a technical review of tax expenditure. A broader tax reform has been one of the authorities’ goals but still remains under study. Staff urged the authorities to a more forceful action to improve the efficiency of public expenditure instead of resorting to horizontal cuts.

Figure 10.
Figure 10.

Italy: Selected Fiscal Structural Indicators

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: European Commission (Economic Papers 382, July 2009); ISTAT; and Sustainable Governance Indicators 2009.1/ 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.
Figure 11.
Figure 11.

Central Government Expenditure by Main Missions in 2011

(Percent of total €533 billion accrual-based initial allocations as per 2011 Budget Law, excluding debt amortization of €210 billion)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: Ministry of Economy and Finance, and IMF staff calculations.1/ Includes mainly accounting adjustments and tax refunds.2/ Includes mainly participation in EU budgetary policies.3/ Constitutional bodies and Presidency of the Council of Ministers.

38. The pension system has been strengthened further in 2010 but remains generous and generationally inequitable.3 The July 2010 fiscal consolidation package increased the retirement age for female public sector employees, extended the so-called “exit-windows,” effectively postponing retirement, and linked the retirement age to life expectancy from 2015, with an estimated saving of up to 0.5 percentage points of GDP by 2030. Still, at 13.5 percent of GDP by 2060, Italy’s pension expenditure will remain among the highest in Europe, along with relatively high replacement rates. As a result of a slow transition to the notional defined contribution scheme, a large burden of the reform is yet to be borne by future generations.

uA01fig27

Official Pension Expenditure Projections

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Source: Ministry of Economy and Finance.

Fiscal consolidation should continue

39. The authorities and staff concurred that fiscal consolidation should be sustained beyond the medium term. Without continued fiscal retrenchment after 2012, the slow reduction in debt-to-GDP ratio will not be long-lasting, and debt would stay at over 100 percent of GDP level in the long term (Figure 12). The authorities rightly aim at continued fiscal retrenchment in 2013-2014, well above the euro area average. Fiscal consolidation at a pace of at least ¾ percentage points of GDP per year during 2013-2015 (similar to the authorities’ planned €20 billion annual adjustment) would help reach a balanced budget by 2015, bringing up the structural primary surplus back to its end-1990s levels, while the debt would steadily decline to reach 60 percent of GDP by 2035.

Change in Structural Primary Balance

(Percent of potential GDP, unless otherwise indicated)

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Sources: WEO, and IMF staff estimates.

Stability Programme Update (April 2011) policy scenario; percent of GDP.

Figure 12.
Figure 12.

Italy: Long-Term Fiscal Sustainability, 2000-2060—Illustrative Scenarios 1/

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: Ministry of Economy and Finance; and IMF staff estimates.1/ Assumptions underlying the illustrative scenarios (growth rates are average rates for 2017-2060): A: Fiscal projections as in the staff’s baseline for 2010-2016 (adjustment of 1.2% of GDP in 2011-2012 and loosening of about 1.0% of GDP in 2013-2016); long-term real GDP growth of 0.85%.B: Fiscal projections as Scenario A; long-term real GDP growth of 1.1%.C: Sustained fiscal adjustment, including 1.3% of GDP in 2011-2012 and 0.75% of GDP in each 2013-2015; long-term real GDP growth of 1.1%. Structural balance is kept unchanged at zero once the headline overall balance reaches zero in 2015. The overall size of the adjustment in 2011-2014 is similar to that envisaged in the authorities’ April 2011 Stability Programme Update.

The challenges of durable fiscal consolidation

40. The authorities and staff discussed ways to achieve durable fiscal consolidation. Public expenditure should be rationalized through periodic expenditure reviews. Pension reform should be further accelerated. Tax expenditure should be reduced substantially. Budgetary procedures should be strengthened further. Fiscal federalism should enhance the fiscal discipline at all levels of government.

41. Staff stressed the need for structural changes to underpin sustained fiscal consolidation. To avoid indiscriminate spending cuts, structural changes should be designed well in advance (Box 2). The budget framework reform, started with the implementation of the 2009 Accounting and Public Finance Law, should continue and be strengthened further through the adoption of new EU-wide fiscal governance rules (Box 3). Tax evasion should be tackled including through the use of anti-money laundering measures, and the tax system should be simplified, particularly by streamlining tax expenditure.

Italy: An Illustrative Package of Fiscal Consolidation Measures in 2013-2014

(Percent of GDP)

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Source: IMF staff estimates.Underlying assumptions:

Potential savings in regions with health-sector deficits;

Streamlining overlapping functions (e.g., public order and security forces);

Reducing current expenditure of provinces by one-third;

Including bringing forward the increase in early retirement age and increase in private sector women retirement age;

Lower nominal growth of non-pension transfers in 2013-2014;

Reducing direct tax expenditure by 10 percent;

Increasing VAT C-efficiency by 5 percentage points (reducing exemptions and reduced-rate taxation, and increasing tax compliance).

Box 2: Lessons from the Literature on Fiscal Consolidations1

Fiscal consolidations are contractionary. Fiscal consolidations are likely to be particularly contractionary when policy rates are near zero, and when many countries consolidate simultaneously—two conditions relevant to Italy’s current environment. However, some features of fiscal consolidation may lessen the contractionary effects and enhance potential output.

Fiscal consolidations are less contractionary when they are expenditure-based. The contractionary effects of fiscal adjustments may be mitigated or even inverted in specific cases. Evidence shows that expenditure-based consolidations are more likely to be expansionary. At the same time, increasing revenue may help before governments can selectively cut current spending.

Targeted spending cuts are preferable. Successful adjustments rely mostly on cuts in primary current expenditures, especially government wages, transfers and subsidies. Civil service reform (and the related question of the right balance between salaries and number of employees) seems critical to achieving wage bill retrenchment. The evidence that successful consolidations preserve investment is less clear-cut, probably because of a sequencing problem: in many successful cases, countries start their consolidation by retrenching capital spending but reverse the cuts in due course thereafter.

Fiscal consolidation may stimulate growth through both demand and supply channels. Fiscal stabilizations are expansionary if agents believe that the fiscal tightening eliminates the need for a larger adjustment in the future. This effect is stronger when the initial debt-to-GDP ratio is high and when the fiscal contraction is large. Moreover, reducing public spending, in particular wages and unemployment benefits may lower unit labor costs. Finally, fiscal consolidation may also eliminate rents, helping reduce corruption and improve private sector incentives.

Intense consolidation efforts are difficult to maintain overtime. Evidence shows that longer consolidation periods increase the probability of ending the adjustment (“consolidation fatigue”).

The involvement of sub-central tiers of government is crucial to achieving cuts in expenditure, particularly when it comes to the wage bill. Central governments appear to exert a strong influence on the expenditures of sub-central tiers through their grant allocations; control of these allocations is therefore essential to “force the hand” of local governments to adjust spending.

1 WEO (2010); Giavazzi, F., and M. Pagano (1990); Alesina, A., and R. Perotti (1996); Von Hagen, J., Hallett, A. H., and R. Strauch (2002); Darby J., Muscatelli, V., and G. Roy (2005); Tsibouris, G., Horton, M., Flanagan, M., and W. Maliszewski (2006); Alesina, A., and S. Ardagna (2009).

42. Staff recommended that fiscal federalism should proceed cautiously. Reducing further the local governments’ transfer dependency should improve the overall fiscal performance, as supported also by robust cross-country evidence (see forthcoming Selected Issues). The share of sub-national own spending financed with transfers declined from 70 percent in 1992 to 40 percent in 2007 (Figure 13)—one of the largest reductions among the OECD countries. However, transfers and borrowing as a share of sub-national own expenditure remain above the OECD average. The ongoing fiscal federalism reform aims at closing the gap further. The government has already approved most of the decrees to implement the reform. But its impact remains uncertain, given: the long and still unclear transitional arrangements; many yet-to-be-quantified features; the large and persistent regional differences; and the track record of bailouts. Local authorities should be allowed to tax all real estate properties. Clear safeguards need to be established to guarantee deficit neutrality (at the minimum) and avoid increases in the tax burden. The reform should also be integrated with the envisaged fiscal consolidation.

Figure 13.
Figure 13.

Italy: Fiscal Decentralization, Vertical Imbalance, and Fiscal Performance by Level of Government, 1980-2009

(Percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: OECD; ISTAT; WEO; and IMF staff calculations.1/ Share of sub-national expenditure (excluding transfers paid) in general government expenditure .2/ Share of sub-national own revenue (excluding transfers received) in general government revenue.3/ Vertical fiscal imbalance is defined as the share of sub-national own expenditure financed with sources other than own revenue (i.e., transfers and borrowing).4/ Own revenue/expenditure is defined as revenue/expenditure net of transfers received/paid.5/ National government is consolidated central government and social security.6/SNG = sub-national government; NG = National government; GG debt = general government gross debt
Figure 14.
Figure 14.

Italy’s Labor Market Outcomes in Cross-Country Comparison, 2010

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Source: Eurostat.1/ Data for Greece and the UK is as of 2010. All other data are as of 2011q1.

European Semester and Italy

The new EU fiscal policy framework introduces more stringent fiscal targets. It retains the medium-term objective (MTO) of a close-to-balance fiscal structural position and introduces the principle that annual expenditure growth should not exceed (prudent) medium-term GDP growth (“prudent fiscal policy making”).

The EU fiscal governance reforms could have important implications for Italy. At a projected 2.8 percent of GDP deficit by 2016, Italy’s structural position would still be far from the MTO and worse than the EA average structural deficit of about 1.6 percent. Italy would comply with the prudent fiscal policy making rule under the staffs baseline projections of real primary expenditure and GDP growth for 2011-16 (for example)—on average, -0.3 percent and 1.3 percent, respectively. The new framework proposes to adopt a numerical benchmark for the debt-to-GDP ratio declining over the previous three years at a rate of the order of 1/20th per year of its distance from 60 percent of GDP threshold. This rule would call for a debt reduction of 3 percent of GDP per year in Italy. However, the rule indicates that the level of the private sector debt should be taken into consideration.

Domestic budget procedure has been modified to incorporate the new EU fiscal framework. This is expected to strengthen the budget reform law (Legge di contabilità e finanza pubblica) enacted in 2010 by explicitly banning the use of windfall current revenue to finance current expenditure and extending the application of medium-term spending limits to all the state budget expenditure. However, some of the previously identified shortcomings persist, including the lack of a formal scrutiny of macroeconomic forecasts and policies by an independent national institution.

43. Staff recommended that pension reforms should be accelerated further. The retirement age for women working in the private sector should be raised from 60 to 65 years as for men. The planned increase in the early retirement age could be brought forward from 2013 to 2012. The automatic retirement age adjustment to changes in life expectancy will increase the retirement age by up to 3.5 years by 2050, but its effectiveness depends on policies to encourage longer participation of older workers. Private pensions should be encouraged.

Standard Pension Eligibility Age and Labor Market Exit Age

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Source: European Commission (Occasional Papers 71, Nov 2010).

= Age requirement is half a year higher for self-employed; for civil servants, the statutory retirement age of women equalizes that of men, starting from 2012; further increases in the retirement age after 2020 accounts for about 4 months every three years.

= Retirement age evolves in line with life expectancy gains over time, introducing flexibility in the retirement provision.

B. Financial Sector: Continuing to Boost Capital Buffers

44. Bank profitability is expected to improve gradually, but vulnerabilities will remain. Net interest income is expected to increase moderately, due to the rebound in loan growth and the rise in lending rates. The pace of deterioration in credit quality is likely to slow in 2011 and especially in 2012 thanks to the recovery. However, given the accumulated high level of non-performing loans and fragile corporate balance sheets, banks will continue to face high loan-loss provision costs. A large and stable retail funding base and ample collateral to access Eurosystem refinancing will help Italian banks face liquidity and funding risks, which have intensified with the EA sovereign crisis. However, Italian banks’ funding costs remain sensitive to market sentiment about the Italian sovereign and may undermine profitability.

45. The implementation of the Basel III regulations will require a substantial increase in bank capital. In the stress tests conducted by the Committee of European Supervisors last summer, the five largest Italian banks were found to be sufficiently capitalized, but one of them nearly failed to meet the 6 percent tier 1 threshold. The authorities have urged banks to shore up capital buffers. According to the Quantitative Impact Study (QIS) carried out by the authorities, the capital shortfall if Basel III capital definitions and requirements were applied immediately would be around €40 billion for the entire banking system. The new capital definition will be the main driver of the changes vis-à-vis current rules with the largest impact deriving from the new treatment of participations in insurance companies and deferred tax assets. Parliament has approved an amendment to the treatment of tax assets, which could allow deferred tax assets to be considered part of capital even under Basel III regulation and reduce significantly this capital shortfall. The authorities are currently seeking the endorsement of the Basel Committee and the EU commission on this matter. According to the QIS, the forthcoming changes on the computation of risk-weighted assets and the introduction of leverage and liquidity ratio requirements will have a limited impact on Italian banks.

46. Staff recommended that banks should recapitalize further and that recapitalization should be front-loaded. The recently announced recapitalizations go a long way towards the goal of strengthening banks’ position. But the implementation of Basel III regulations requires a substantial capital increase, and financial markets demand capital reinforcements well in advance of the phase-in period. Italian banks’ capital ratios are also low compared to peers. Therefore, the announced recapitalization plans should be swiftly implemented. Banks that remain with a relatively low capital base should strengthen it through earnings retention, disposal of non-strategic assets, by taking advantage of the outstanding convertible instruments, and by raising capital from the market. Further bank mergers could also be part of the recapitalization strategy. The objective should be to build core tier 1 capital beyond the minimum ratios required under Basel III, in line with evolving international best practice.

47. Staff suggested that consideration should be given to introducing governance reforms in the banking system. Charitable foundations (Fondazioni)—which remain significant shareholders in a number of major banks—have proven to be stable and committed investors. However, better governance and more transparency would be desirable (Box 4). Improving the governance of Banche Popolari would also strengthen shareholders’ protection. Reforms could include raising limits on proxy voting, encouraging institutional investor representation at the board, and measures to ensure access to adequate, accurate, and timely ownership information.

48. Further recapitalization or restructuring of enterprises may be necessary. The actions taken by the authorities in the past two years in support of SMEs are still in place, and the bank loan moratorium agreement has been extended. While supporting SMEs was appropriate, these measures could result in additional loan losses in the future if they are not accompanied by recapitalization or corporate restructuring when needed. In this context, the private equity fund for SMEs recently set up jointly by the government and the private sector could strengthen the capital base of viable firms. Some improvements to the existing bankruptcy regime could also help rehabilitate distressed, but creditworthy, firms and the speedy liquidation of non-viable enterprises. The reorganization and debt restructuring frameworks could be ameliorated, for instance, by clarifying the scope of the judicial review of the restructuring plans. The current eligibility criteria for bankruptcy trustees could also be reexamined to better promote the appointment of trustees with firm management and restructuring skills.

The Role of Foundations as Shareholders in the Italian Banks

Non-profit foundations (Fondazioni) are significant shareholders in a number of major banks. Foundations were created during the process of banks’ privatization in the early 1990s, when state-owned banks transferred their banking operations to newly-formed joint-stock companies, and turned themselves into non-profit foundations. In the late 1990s, foundations were recognized as private legal entities, with full statutory and operational autonomy, and in most cases were obliged to sell their controlling interests in banks. Nevertheless, the foundations continue to be important shareholders in several banks. As a whole, foundations hold stakes of more than five percent in over fifty banks, including the largest three, and own more than 20 percent of two of the largest three banks.

The foundations have proven to be long-term stable investors, but their role and the way they operate also raise some issues. During the global crisis, and also more recently, the foundations have provided stability to the banking system, by remaining committed shareholders, and by subscribing for repeated capital increases. However, local politicians who control foundations may exert undue political interference in banks’ governance. Furthermore, their strong influential power in several banks’ boards may deter other potential investors.

Enhancing the regime of foundations would be desirable to improve their autonomy, transparency, and accountability. To strengthen their autonomy, current eligibility requirements regarding members of their governing bodies could be refined and expanded. To boost accountability vis-à-vis their social mandate, foundations could develop and disclose on a regular basis detailed criteria on their investment strategies and exercise of ownership rights. The existing supervisory arrangement, whereby foundations are supervised by the Minister of Economy and Finance, should be reconsidered, given the risks of blurred lines between supervised entities and the supervisor.

Foundations are already mandated by law to diversify and obtain adequate returns on their investments. Given increasing international integration and harmonization among banking systems and their institutional structures, part of their stakes in banks should eventually be taken up by other, more market driven investors. In fact, it would be in the foundations’ best interest to dismiss some of their bank stake holdings, as that would allow greater investment diversification and higher returns.

49. The authorities agreed that the recently announced recapitalization will strengthen banks. They agree that some further efforts to shore up capital buffers may be needed. They also share with staff the view that more restructuring and recapitalization may be necessary in the non-financial corporate sector. The authorities are well aware of the corporate governance issues concerning Fondazioni and Banche Popolari, and, on the latter, they are pushing for reforms.

C. Structural Reforms: Comprehensive Reforms to Address Long-Term Weaknesses

50. The gap in GDP per capita relative to the EU average is increasing. Italian income per capita was 97 percent of the income of the major Western European countries in 1995 and it is currently at a level similar to the 1970s. The decline started before the euro adoption and continued during and after the global financial crisis. The decline persisted regardless of the various policies pursued by the governments.

51. The authorities concurred with staff that increasing growth potential is the key policy priority. They stressed that large regional differences within Italy require very different approaches. In the Center-North, excessive bureaucracy should be cut. SMEs should be encouraged to grow bigger and to internationalize. The government should have only a catalytic role to favor these processes. In the South, basic infrastructure, better education, security, and rule of law should be ensured.

52. Staff pointed out that there has been little progress on structural reforms, even some slippage. Stronger momentum is needed. The government recently introduced: measures to reduce the bureaucratic burden for starting businesses; performance-related pay in public administration; the possibility to file class action lawsuits against public sector inefficiencies; and competitive tendering for local public services contracts. However, parliament is undoing some previous product market liberalization, for instance reintroducing minimum tariffs for lawyers’ services.

Structural Reforms Gaps in European Economies: A Heatmap 1/

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Sources: OECD; World Economic Forum; Fraser Institute; and IMF staff calculations.

The heatmap is constructed based on a variety of structural indicators from alternative sources in order to flag areas where a country has the greatest need to implement structural reforms. For a discussion of the methodology and detailed components, see IMF, 2010d, “Cross-Cutting Themes in Employment Experiences During the Crisis,” IMF Report SM/10/274, http://www.imf.org/external/pp/longres.aspx?id=4499 (Washington: International Monetary Fund).

53. The EU Services Directive was implemented with some delay. In adherence with the EU Service Directive, the government has completed a review of 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. The EC is now in the process of assessing to what extent all the required changes in specific legislation have been implemented. “Points of single contact” for business start-ups are not available online yet.

54. The National Reform Program identifies some key priorities, but more needs to be done to unleash sustained growth. In addition to the reforms already in the implementation stage, the plan envisages some new measures mostly in the energy sector and education. Some decree laws were recently introduced to spur economic development, including simplifying administrative and fiscal procedures, increasing corporate tax credit for R&D and for hiring in the South, and establishing “zero bureaucracy areas” in the South. But further labor and product market reforms are necessary to address long-lasting structural problems. The authorities were open to staff’s suggestion about a “growth commission.”

55. Further product market reforms are necessary to remove impediments to competition. Regulation should be more effective, promoting a higher degree of competition by opening up further services and network industries, and reducing public ownership, especially at the local level. The conflict of interest deriving from local authorities’ dual role as regulators and shareholders should be resolved.

56. Policies should address labor market duality and the low participation rate. Indeed, the partial liberalization in the labor market may have undermined investment in human capital and innovation, especially in the context of incomplete product market liberalization. Harmonizing labor contracts and legislation between protected and unprotected workers can boost employment. The authorities agreed that the high level of youth unemployment is a problem. They pointed out that a recently approved legislation on apprenticeship will facilitate entry into the labor force.

uA01fig28

Employment versus Key Product Market Regulations

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: OECD; and Eurostat.1/ data as of 2010Q4.

57. Staff stressed that wage setting needs to promote job creation. Nationally-bargained wages are less binding in the North, but too high for the South. In the private sector, more decentralized bargaining would better align wages with productivity and boost competitiveness. Recently, the Fiat car company has managed to negotiate with Italian trade unions more flexible contracts outside the framework of nationally-negotiated and binding collective contracts, which could shepherd in a more decentralized wage bargaining system. In the public sector, regional differentiation of wages should be introduced to reflect the cost of living. This could also lead to private sector wage moderation in regions with high public employment concentration.

58. Italy’s dismal economic performance has deep-rooted causes.4 Educational attainment and the quality of education (as measured by PISA) are among the lowest across OECD countries. Exports, which are specialized in low value-added products, have been losing market share to competition from emerging markets in the last decade. The tax burden is heavy, but the quality of public services is low. Regional income disparities are very large. Several regions are plagued by organized criminality.5 A dual labor market, where highly protected older workers co-exist with younger temporary workers, exacerbates inequality and contribute to the low employment outcomes. Youth and long-term unemployment rates are among the highest in OECD countries. Employment rates, especially among women, youth, and older workers remain significantly below the EA average, with large regional disparities. Labor market duality is also exacerbating income and wealth inequalities (See Box 5). High-level of business and service regulation hinders competition, especially for professional services. Delays of civil justice procedures are among the longest across OECD countries.

Italy’s Income Inequality in the Wake of the Crisis

Income inequality and poverty in Italy grew rapidly since the 1990s. Italy has one of the largest gaps between rich and poor among OECD countries. The average income of the poorest 10 percent of Italians is around $ 5,000 in purchasing power parities - below the OECD average of $ 7,000, while the average income of the richest 10 percent is $ 55,000—above OECD average. Wealth is distributed more unequally than income: the top 10 percent hold some 42 percent of total net worth, while the richest 10 percent have 28 percent of total disposable income. Furthermore, social mobility is low. The government has partly offset the growing gap between rich and poor by increasing household taxation and spending more on social benefits for the poor.

uA01fig29

Development of Income Inequality 1/

Citation: IMF Staff Country Reports 2011, 173; 10.5089/9781462301195.002.A001

Sources: OECD; and IMF staff calculations.1/ After taxes and transfers.

Labor markets play a crucial role in explaining income disparities. Unemployment, especially long-term unemployment, has a regressive impact on income equality. A higher employment rate, especially for women and youth, is associated with lower economic disparities. Currently, the shares of employed youth and women are especially low in Italy relative to the OECD average, underscoring the potential equity gains from increased utilization of these groups. Dual labor markets worsen inequality. A low level of education attainment is associated with an uneven income distribution.

Inequality was exacerbated during the crisis, mainly through the increase in unemployment. The rise in unemployment during crisis is estimated to have increased inequality by 2.6 percentage points in Italy. The recession also increased the number of discouraged workers who dropped out of the labor force, a factor that is likely to have further exacerbated income disparities. On the other hand, social safety nets are likely to have cushioned the impact of unemployment on inequality. A jobless recovery or engrained long-term unemployment could further worsen economic disparities.

IV. Staff Appraisal

59. Despite some elements of strength, key fragilities persist. Low private indebtedness, the resilience of the financial sector, and the ongoing fiscal consolidation are mitigating the spillover from international financial turbulence. However, the large public debt, disappointing growth performance, and lagging structural reforms are persistent weaknesses. The ongoing regional market distress is affecting domestic financial markets. The recovery is disappointing, and growth prospects are weak. The structural reform agenda stalled. Further delay in implementing comprehensive reforms may increase financial instability.

60. The overarching priority should be to boost the economy’s potential growth, while maintaining fiscal discipline and financial stability. Fiscal consolidation is not sustainable if it is not accompanied by solid growth. But growth potential can be increased only with a (still missing) comprehensive program of structural reforms. The government is committed to gradual fiscal consolidation but has not yet taken decisive steps to foster reforms.

61. Given the high level of public debt and the current market turbulence, fiscal discipline is a prerequisite for growth. The ongoing fiscal consolidation is a fundamental factor of stability and should continue.

62. The authorities’ welcome commitment to reduce the fiscal deficit to close to zero by 2014 needs to be accompanied by action. However, the authorities’ plan appears optimistic on the growth effect of the envisaged fiscal consolidation. Also, the authorities have so far resorted to across-the-board cuts and have not specified measures to achieve consolidation beyond 2012. The large size of the envisaged fiscal retrenchment requires structural changes which must be designed well in advance. This calls for a strong political consensus and careful planning.

63. The fiscal adjustment should rely on expenditure rationalization and help boost potential growth. There is considerable scope for growth-enhancing savings in the public sector. Containing public sector wages could generate positive spillovers for the private sector. An increase in the retirement age for women in the private sector will boost employment participation and generate savings. The province system could be streamlined, removing an extra layer of bureaucracy.

64. The tax system should be simplified to support growth and to reduce tax evasion. Recognizing that the tax system is unduly complex and subject to abuse, the government initiated a review of the preferential tax regimes. Staff welcomes this initiative and sees it as an important component of the fiscal consolidation plan.

65. The fiscal federalism reform should be integrated with the fiscal consolidation. Clear safeguards need to be established to guarantee deficit neutrality and avoid an increase in the tax burden. Local authorities should be allowed to tax all real estate properties. Federalism at variable speeds should be considered, reflecting the regional differences in administrative capacity.

66. The authorities’ strong call for capital increases and the banks’ prompt response are welcome and the announced recapitalization plans should be swiftly implemented. Financial markets demand capital reinforcements well in advance of the Basel III phase-in period. Banks should be encouraged to keep ample capital buffer. Banks that remain with a relatively low capital base should strengthen it through earnings retention, disposal of non-strategic assets, by taking advantage of the outstanding convertible instruments, and by raising capital from the market. Further bank mergers could also be part of the recapitalization strategy.

67. Further recapitalization or restructuring of enterprises may be necessary. The anti-crisis measures to sustain SMEs have been appropriate, but these actions should not prevent needed restructuring or recapitalization. The private equity fund for SMEs recently set up will be useful to strengthen enterprise capital. In addition, improving further the bankruptcy regime would help rehabilitate distressed, but creditworthy, firms and liquidate non-viable ones.

68. The National Reform Program is a step in the right direction, but Italy’s pervasive structural problems require further efforts. Italy’s chronically weak growth performance has deep-rooted causes, including deep regional disparities, a heavy and distortive tax burden, public service inefficiencies, high business and service regulations, labor market duality, low education attainment, and export specialization in low value-added products. The reform plan envisages some new measures mostly in the energy sector and education but substantive reforms in other areas are missing.

69. Only a comprehensive reform package can deliver growth. Complementary labor and service sector reforms are essential to boost job creation, investment, and growth. Promoting decentralized wage bargaining would allow wages to be better aligned with productivity, providing firms with stronger incentives to invest. Harmonizing labor contracts and employment legislation between permanent and temporary employment would reduce labor market dualism and raise employment. Whenever fiscally possible, the authorities should reduce the tax wedge, which is among the largest in EU. Competition in product market and services need to be strengthened by giving more power to the antitrust authority. Combating organized crime, corruption, and related money laundering, should remain a priority.

70. A national commission for growth should be considered. A comprehensive structural reform package could raise productivity and enhance growth potential. Establishing an independent review and advisory body for reforms (“growth commission”) could foster consensus and focus policies on priority areas, while ensuring the continuity of the reform agenda. Ownership of reforms at all level of government is a crucial prerequisite.

71. 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; and IMF staff calculations.

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 (National Presentation), 2008-2016

(Percent of GDP, unless otherwise indicated)

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

Percent of potential GDP.

Percent.

DEF/SP = Documento di Economia e Finanza 2011/Stability Programme Update (April 2011); unchanged legislation scenario. SP-P = Documento di Economia e Finanza 2011/Stability Programme Update (April 2011); policy scenario.