Statement by Mr. Carlo Cottarelli, Executive Director for Italy July 21, 2017

2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Italy


2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Italy

We thank the IMF staff for a set of well-written papers. The Italian authorities broadly concur with the staff’s current short-term macroeconomic projections and with their assessment of the medium-term challenges faced by the Italian economy. However, in several cases, they believe the staff report could have better recognized the progress made so far in reforming the Italian economy, as well as the difficult circumstances under which policy-making had been managed during the last few years as Italy was hit by both the global economic and financial crisis and the euro-area confidence crisis. They also believe staff could have better recognized some important elements of strengths of the Italian economy and be more balanced in evaluating Italy’s performance vis-à-vis its peers.

The pace of economic growth is now firming up since the nascent signs of recovery in 2014. Non-financial firms are overcoming the deep and prolonged crisis while reaping the benefits of the policy measures introduced to spur innovation and investment. Public finance has undergone a significant adjustment, in compliance with the European fiscal framework, which has been effective in reining in public expenditure, improving its composition while also stabilizing the public debt ratio. The identified vulnerabilities in the banking sector have also been addressed, in line with the EU framework. This said, my authorities agree on the importance of making further progress on the road of reforms.

Macroeconomic outlook, the real sector and the external sector

There is broad agreement on several aspects in this area. Staff projects GDP growth at 1.3 percent this year, broadly in line with the current projection of the Italian authorities. This is higher that the prudent assumption underlying the budget (1.0 percent), and almost twice as large as projected by staff in the January WEO update (indeed ½ percentage points of GDP higher than projected even in the more recent April WEO). Growth remains below the euro area average, but the growth differential projected by staff for 2017 is the lowest since 2010. Over the medium-term, under the assumption of a continuation of the reform effort, Italy’s growth rate is likely to surpass the projections of the IMF staff. This said, we agree that estimates of potential output and the output gap are subject to a high degree of uncertainty, as reported in footnote 2 on page 7 of the report (see more on this below).

Regarding external developments, my authorities share with staff the view that competitiveness could be improved, but believe that the staff’s assessment of the competitiveness gap and of the external position are much gloomier than warranted, and are mainly based on a backward-looking analysis which does not acknowledge recent improvements. In 2016 the Italian current account (CA) surplus – the fourth in a row – almost doubled compared to 2015 (to 2.6 percent of GDP). The NIIP notably improved reaching −15 percent of GDP at end-2016, down from −23.5 at end-2015, with a further significant improvement to −13.5 percent in the first quarter of this year. This notwithstanding, staff worsened their assessment of the Italian external position compared to last year, moving from ‘broadly in line’ to ‘moderately weaker’ than suggested by fundamentals and desirable policies.

The worsening envisaged by staff is due to an increase of the CA norm, which the EBA-model now estimates at 4 percent of GDP (albeit corrected to 3.5 by staff judgment), i.e. 2 percentage points higher than in 2014 and 4 compared to 2013. Such large revisions are puzzling and cast doubts on the reliability and robustness of the model. Altogether, my authorities believe that the staff’s current estimate of the norm is too high. The possible overestimation of the Italian CA gap on the side of staff is also confirmed by the indication of a slight undervaluation of Italy’s REER stemming from the EBA REER models. Furthermore, my authorities are under the impression that staff did not fully account for the impact on the CA norm coming from the implemented labor market reform and from the recent legislation on the increased retirement age of workers (67 years as of 2019, with subsequent upward revisions based on increases in life expectancy). All in all, my authorities believe that the external position is in line with fundamentals.

Relatedly, my authorities do not agree on the extent of the cost competitiveness gap. ULC indicators tend to overestimate the cost of utilizing manpower in Italy, because they do not take into account wage developments of many workers formally classified as self-employed but that are, de facto, employees. These workers include a high number of less qualified or younger workers whose wages have responded very flexibly to the business cycle and structural changes, rising much less than the wages of other workers included in the ULC calculation. They also note that, in any case, based on alternative competitiveness indicators, for example PPI-based, the competitiveness outlook appears less gloomy. This is confirmed by Italy’s export trends, whose share in world trade has remained broadly stable.

Structural policies

My authorities are in broad agreement on the need to further advance on the reform agenda in product and service markets, the labor market, the public administration and the judicial system, while also strengthening the banking sector. To this end, it is worth mentioning the efforts in enhancing firm competitiveness by the Industry 4.0 Initiative, which should support a technological upgrade of the productive system; the stepping up of the fight against tax evasion; the improvement in the efficiency of the judicial system (pending cases in civil courts have declined by 25 percent between 2010 and 2015, while further progress is needed), including through refinements to the insolvency framework. It is also worth reminding that other several reforms have been completed such as the budget reform, which is aimed at improving the efficiency and effectiveness in the use of public resources, and the tax administration reform, which is already delivering substantial improvements in the relations with taxpayers. Additionally, as regards social policy, authorities recently introduced the first universal anti-poverty instrument to improve living conditions of vulnerable households.

However, my authorities disagree with staff on various aspects regarding ongoing structural reforms. The draft competition law does already include important measures in many sectors, such as insurance, banking, pension funds, communications, utilities and regulated professions. While my authorities agree on the need for a more decentralized wage bargaining system, they point at the important tax incentives introduced in the 2017 budget to enhance decentralization at the plant level, and underscore that, ultimately, it is the responsibility of social partners to decide on the preferred wage bargaining system. Finally, regarding public sector reforms, my authorities believe that the description of the process of public administration reforms is not fully accurate: the objectives of the public-sector reform approved in 2015 are indeed far reaching, encompassing activities relevant for citizens, firms and public sector workers. Most of the implementing acts deriving from the reform have been adopted. Regarding the decree on the rationalization of publicly-owned enterprises, my authorities concur that its implementation has been delayed as a result of a ruling from the Constitutional Court. However, they disagree that such provisions have been weakened with respect to its contents.

Fiscal policy

My authorities agree on the need for further fiscal consolidation, in compliance with the EU fiscal rules and striking the appropriate balance between stability and sustainability needs. Italy’s high public debt must be put on a firmly declining path to reduce the economy’s vulnerabilities. Despite very modest growth rates, the Italian public debt ratio has already stabilized, due to a continued fiscal effort implemented by the government, notably primary surpluses which are among the highest in the EU. In line with the approach put forward by the European Commission in the 2017 EU Semester Package, published on May 22, my authorities’ strategy aims at maintaining a gradual fiscal adjustment, which would ensure debt reduction while not negatively hinging on the incipient recovery. Against this background, at the end of May, the Italian authorities welcomed the intention of the European Commission to consider, in evaluating the appropriate country-specific fiscal stance, the uncertainties related to cyclical conditions, with an unusual recovery still affected by the legacy of the crisis. Consistently, they informed the European Commission of their intention to implement a structural fiscal adjustment in 2018 equal to 0.3 percentage point of GDP. The Authorities underscore that their fiscal approach strikes the right balance between the need to continue the process of fiscal consolidation and the need not to jeopardize the continuation of the ongoing economic recovery from Italy’s deepest recession since the 1930s. The adjustment path put forward by the Italian Authorities would allow to continue reducing the headline deficit at the same pace observed in recent years and will ensure a decline in the debt-to-GDP ratio. A recent reply by the European Commission to the Italian Authorities confirms the appropriateness of the proposed strategy.

My authorities do not agree with the staff qualification of the Italian fiscal stance as being ‘markedly expansionary’ in 2014-17. Staff’s assessment is based on the change in the structural primary balance. We already noted on several occasions that measuring the fiscal stance based on changes in structural balances can be quite tricky in countries that have experience a prolonged period of weakness in aggregate demand. In such circumstances, the usual techniques to measure potential growth yield estimates that are quite cyclical, and reflect more aggregate demand developments than the underlying growth potential of the economy under normal demand circumstances (by the way, the same critique applies also to the approach followed by other institutions, not just by the IMF). In particular, with an estimated potential GDP growth at a barely positive level – 0.2 percent in 2016 – any moderate actual GDP growth – such as the 0.9 percent rate recorded last year – is mistaken for an economic boom. This in turn leads to a presumed rapid closing of the output gap which would imply, for a given reduction in the headline fiscal deficit, a much smaller decline of the calculated structural deficit or even a fiscal expansion.

My authorities underscore that such assessment is clearly inconsistent with a broader view of fiscal data: the Italian headline deficit has been on a steadily declining path since 2010, reaching −2.4 percent of GDP in 2016 (down from −2.7 in 2015), with a projection of a further reduction to −2.1 for this year; the primary balance has been broadly stable in the last few years at about 1½ percent of GDP (and will exceed that level this year); the debt ratio has stabilized and is projected to decline steadily in the coming years. Overall my authorities believe that these numbers describe a path of gradual and growth-friendly fiscal consolidation, rather than one of marked fiscal expansion. Staff acknowledges that measuring potential output growth is subject to much uncertainty in Italy (as mentioned above), but it does not seem to draw the necessary conclusions.

The Italian authorities believe that the appropriate medium-term fiscal objective is a balanced budget, in line with Italy’s commitments under the SGP. They therefore disagree with staff that a surplus of ½ percentage points of GDP would be needed to ensure fiscal sustainability.

As to the long run my authorities believe that the assessment of pension spending trends included in Box 3 of the staff report is too pessimistic. Staff, for example, fails to note that, while immigration is projected to increase, Italy’s fertility rate is projected to remain rather low. Moreover, the more pessimistic view taken in the staff report is not consistent with the projections included in the Fiscal Monitor (according to which Italy’s pension spending is projected to remain stable over the next 15 years, and to decrease by 1.8 percent of GDP by 2050), nor with the 2017 euro area staff report, which shows (Figure 5) that the Italian long- term adjustment needs stemming from aging related spending are among the lowest in Europe. Finally, staff projections are also at odds with those of the European Commission included in the Aging Report, which are close to my authorities’ projections. We also find that Box 3 misses important details, which are only included in the Selected Issues Paper: for example, the Box says that the old defined benefit scheme will be phased out fully only by 2050; it does not say that already by 2030 all new retirees will be fully under the new NDC scheme. But even the selected issues paper is incomplete: for example, it fails to show that the gross replacement rate at retirement is projected to decline, according to the 2015 European Commission Ageing Report, by over 8 percentage points, from 60 per cent of 2013 to 51.8 per cent of 2060. Moreover, the cross-country comparison of replacement ratios is based on gross pension benefits (in Italy pensions are fully taxed, while this is not always the case for other countries); finally, the paper fails to say that, while benefits may be higher, social security contribution rates are also higher than in many other euro area countries. Going back to the staff report, the reference to a partial reversal of the recent pension reform is not justified: the adjustments introduced involved costs to the budget amounting on average to just 0.1 percentage points of GDP over the period 2017-2060, a small fraction of the savings from the Fornero reform.

My authorities also disagree with the characterization of spending trends. The comparison between Italy and other countries is entirely based on the primary spending-to-potential GDP ratios, even if staff acknowledges the uncertainty regarding potential output estimates in Italy (see above). The reality is that between 2010 and 2016 Italy had one of the lowest primary spending increases in the euro area (3.8 percent, compared, for example, to 21.6 percent of Germany, and 15.3 percent of France); indeed, in real terms, primary spending declined by over 4 percent in real terms. This could have been appropriately highlighted in the staff report.

Financial sector policies

The Italian authorities believe that, given the severe shock suffered by the Italian economy during 2008-13 (with a cumulative GDP loss of almost 9 percent), the Italian financial sector proved to be quite resilient: only a handful of banks had to be intervened and we estimate that the taxpayer money used since the global financial crisis is less than 1 percent of GDP including the effect of the most recent decisions (see below), far below the amounts injected by many other advanced economies in their banking systems. It is thus difficult to understand why staff is insisting so much on the burden that the current strategy has involved for the taxpayer. Much higher private and public costs would have been suffered through alternative strategies, including in the area of bank resolution.

More generally, many important recent decisions have addressed tail risks. As described in the staff report, in the last months two important steps have been taken regarding the Italian banking system: (i) the precautionary public recapitalization of Banca Monte dei Paschi di Siena (MPS); (ii) the liquidation of Banca Popolare di Vicenza and Veneto Banca. Moreover, the transfer of the last of the four banks resolved at the end of 2015 (Nuova Carife) has been finalized. These decisions have de facto eliminated the tail risks looming over the Italian banking sector and, together with the substantial impact which is coming from the reforms adopted by my authorities in recent years, set the system on a stronger footing.

My authorities believe that some additional information is important to complement that provided in the staff report:

  • - All the above decisions have been taken in strict coordination with the European institutions and are fully compliant with the European rules, including the BRRD and state-aid rules as also acknowledged in the summing up of the most recent Eurogroup meeting of July 10. In the case of the two banks in Veneto, the Single Resolution Board considered that a resolution was not justified by the existence of a public interest; this implied that their liquidation had to be implemented under Italian solvency legislation.

  • - Both for MPS and for the two banks in Veneto a substantial share of the needed financial resources has come from burden sharing. Specifically, €4.3 bn in MPS subordinated debt will be converted in shares and MPS’ shareholders will be heavily diluted; €5.2 bn in shares and subordinated bonds of the two banks in Veneto were de facto obliterated.

  • - There are reasonable expectations that in both cases most – if not all – tax-payer money will be recovered. As for MPS, the stake owned by the Government will be sold once the implementation of the restructuring plan agreed upon with the Italian and European authorities is completed, no later than 2021. In the case of the two banks in Veneto, should the recovery rate of the NPLs transferred to the state-owned specialized vehicle be in line with the average recovery rate recorded by the Italian banking system in the years 2006-2015, public resources would be fully recovered.

The solution adopted for the two banks in Veneto, which includes the sale of the good assets and some liabilities to Intesa San Paolo, allows to preserve client relationships with around 100,000 SMEs and 200,000 households. This shows the deep rooting of the two banks in the economy of the Veneto region, whose GDP size is just a little smaller than that of countries such as Portugal or Greece, and is thus of critical importance for the recovery of the broader Italian economy.

The ongoing reduction of the stock of NPLs is expected to accelerate sharply in the coming months. The operations with MPS and the two banks in Veneto will have a notable impact also on the stock of NPLs. As a consequence, and considering other NPL market disposals that are being finalized, the ratio of net NPLs to total loans – which at the end of Q1-2017 stood at 9.2 percent for significant institutions – could decline below 8 percent in the next twelve months.

Furthermore, the strengthening of the economic recovery will continue to play a critical role. The flow of new NPLs is gradually declining from the peak reached in 2013 (5.9 percent per year); in the first quarter of 2017 it was 2.4 percent, a value that is close to the one observed before the crisis.

Following this improvement, my authorities will continue tackling the NPL issue with firm determination and accelerate its solution in line with the “Council Conclusions” in developing a European Action Plan to tackle NPLs approved by the Ecofin Council on July 11. To this aim, they agree on the importance of enhancing the banks’ internal management of NPLs, pursuing prudent provisioning, and achieving further efficiency gains in the judicial system. My authorities remain also mindful of the need to avoid generalized fire sales of NPLs, which would likely result in an unwelcome transfer of resources from Italian banks to a few specialized investors which are operating – de facto – in an oligopolistic regime, thereby leading to an erosion of banks’ capital at a time when raising it remains important.

Besides the operations mentioned above, the broader restructuring of the Italian banking system is advancing steadily, also as a reflection of the reforms adopted by my authorities in recent years. As recalled by staff, since end-2015 eight of the ten largest cooperative banks (‘banche popolari’) have been transformed into joint-stock companies with the aim of improving – inter alia – their corporate management and capacity to tap the capital markets. Furthermore, the reform of the mutual banks (‘banche di credito cooperativo’) is being implemented and is expected to lead – by May 2018 at the latest – to the formation of three larger groups which will consolidate around 300 mutual banks currently operating on the territory; for the two largest groups – whose supervision will be carried out directly by the SSM – a comprehensive assessment (like that held in 2014) will be conducted in 2018 by the ECB together with the Bank of Italy.

Looking ahead, the elimination of the tail risks that were looming over the banking sector and the progress with the ongoing restructuring – which my authorities consider as substantial advancements, rather than ‘very slow repair’ as qualified in the staff report – will now allow banks to step-up efforts on the critical objective of upgrading their business model and shoring up profitability. In my authorities’ views, while there is no such thing as a ‘one- size-fits-all’ banking business model, there are ample margins across the banking system to streamline operating costs, enhance efficiency and productivity, better leverage technology and human capital. Banks have already been taking measures to reduce costs and rationalize branch networks, but more needs to be done, particularly in small and medium-size banks. My authorities assign high priority to achieving further progress along these fronts.