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Italy—1999 Article IV Consultation Preliminary Conclusions of the Mission
March 15, 1999
2. While the benefits of EMU are clear, including an environment of low inflation and interest rates, EMU was not an endpoint for economic policy and may indeed have heightened some challenges within a more competitive euro area. In this context, we are particularly concerned about the weak growth performance of the Italian economy during the 1990s, which can be explained only to a limited extent by the withdrawal of fiscal stimulus (1995–97) and tight monetary conditions (1995–fall of 1998). Against this background, our discussions have focused: (i) on fiscal policy issues (continuation of deficit reduction, but also improvement of the quality of government services and the need to lower the fiscal burden); and (ii) on policies to reignite a dynamic growth process, including in the South. Of course, these two issues are closely linked—a stronger growth performance would alleviate the fiscal constraints, while fiscal policy itself can play an important role in strengthening the growth process.
3. The immediate concern is with the marked cyclical weakness of the economy. At this juncture, most indicators suggest that the economy is stagnating, and the near-term growth outlook remains clouded by the weakness in industrial production and business confidence and by deteriorating growth prospects in important partner countries. Thus—and despite the marked easing of monetary conditions that accompanied entry into monetary union—we share the view of the authorities that growth is likely to remain stuck at just 1½ percent in 1999, again below the euro area average. This would still require a marked acceleration of the economy during the second half of the year, reflecting in part the usual lagged effects of the monetary easing as well as a projected rebound in some major partner countries. There are, therefore, significant downside risks: external demand may well fall short of the currently anticipated level, further aggravating weakness in the export sector; and consumer confidence and spending may ultimately fall back, in particular if growth turns out to be insufficient to sustain current employment levels.
4. With monetary union, the competitive environment has changed fundamentally and requires, inter alia, that nominal wage developments leave unit labor costs in line with those in partner countries. Thus, we very much welcome that the labor agreement of December 1998 refers explicitly to inflation in the euro area as a guidepost for domestic wage negotiations, and we expect that the already observed deceleration in wage increases will lead to closer convergence in inflation rates with the rest of the euro area in 1999. Nevertheless, developments need to be monitored closely, especially if exports were not to rebound following their sharp decline in the second half of 1998.
5. Taking account of the weaker-than-anticipated growth outlook and also of the considerable progress on fiscal consolidation achieved in recent years, we see room—and, indeed, a useful role—for the automatic fiscal stabilizers in 1999. However, they should be used only partially because the underlying budgetary position remains weaker than the objective of a budget in balance or small surplus envisaged by the Stability and Growth Pact. With consumption expected to hold up relatively well, our current projections indicate that even the full budgetary effect of the automatic stabilizers would not exceed 0.3 percent of GDP. Under these circumstances, the revenue shortfall from a partial (albeit substantial) operation of the stabilizers would be fully matched by lower-than-budgeted interest payments, resulting from the observed sharp decline in interest rates. While the weakening of activity justifies, therefore, in our view a small deterioration in the primary balance, it should not result in an increase in the overall budget deficit target of 2.0 percent of GDP in 1999, as long as growth develops in line with current projections.
6. We estimate, however, that there are risks of overshooting the deficit target that are unrelated to the cyclical weakness of the economy, notably due to potential revenue shortfalls on IRAP. In our view, these noncyclical slippages should be fully offset by additional measures. We take note of the Ministry of Finance’s affirmation that this could be done through further improvements in tax administration; but, if necessary, selective cuts in expenditures should also be considered.
7. Beyond the countercyclical role of the stabilizers, fiscal policy can also support activity by setting an ambitious, but realistic and well-specified medium-term agenda. In this context, we were reassured by the continued commitment to the 1.0 percent of GDP deficit target for 2001 and, in our view, budget balance should be achieved by 2002. Nonetheless, with Italy’s high debt burden and longer-run fiscal pressures related to the rapid aging of its population, these targets can only be viewed as a minimum and as intermediate steps. We believe that maintaining the noninterest budget balance around 6 percent of GDP on average over the business cycle would be an appropriate longer-run budget target; even then, public debt is unlikely to decline below the Maastricht reference value of 60 percent of GDP before 2012.
8. We would also see an important benefit if future government programs (including the next DPEF) could lay out a comprehensive and well-specified medium-term adjustment program. Transparency about future expenditure cuts and planned tax measures could provide a pole of stability for private sector expectations, strengthening demand by both firms and households. Specific policy steps should focus on primary expenditure reduction that would have to be sufficiently ambitious to achieve the dual objectives of (i) a durable reduction in the deficit and (ii) a substantial reduction in the tax burden and tax rates on both labor and capital. We also note that some steps in the 1999 budget, including financing from the sale of INPS claims to banks, are of a temporary nature and will need to be replaced later by structural measures. Moreover, the envisaged saving from the internal stability pact is predicated on instituting an effective mechanism that ensures hard budget constraints for local governments.
9. On primary expenditure reduction, steps should be considered in several areas, including: (i) reducing employment in the broader public sector, taking full advantage of recent legal changes to fill, where needed, most vacancies arising from attrition by redeploying people within the public sector; (ii) continuing the reform of health care, in particular through greater accountability of local spending units and raising co-payments for selected services; (iii) improving the operation of the national railways, local transportation, and the postal system, simultaneously reducing budgetary transfers; and (iv) rationalizing welfare expenditure, where better targeting the truly needy should also allow some expenditure saving.
10. The needed reduction in primary expenditure is only feasible, however, if one of its main components, that is, pension outlays, can be contained. Here, Italy has undertaken important reforms since 1992. However, pension expenditures in percent of GDP remain among the highest in the industrial countries and, coupled with the high stock of public debt and debt service burden, this leaves insufficient room for pursuing other policy objectives. As Italy faces one of the most adverse aging trends among industrial countries, the problem would become even more severe in coming decades without further measures to reduce pension outlays. Implementing policies that reduce unemployment and increase participation rates would help to limit the effects of aging on the employment-population ratio and reduce the needed adjustments in the pension system; but it would not eliminate the need for adjustments. This reality is well understood by the public. The result is that uncertainty about levels of future disposable income is contributing to precautionary saving, and this, combined with uncertainty about the future tax burden, is dampening consumption and investment. Decisive action needs to be taken quickly in order to reduce this uncertainty and increase confidence in the system. In particular, further measures should be taken to accelerate the increase in the effective retirement age.
11. It will also be important to raise the quality and efficacy of government services so that the public sector would contribute to enhancing the country’s growth prospects. In this context, we very much welcome recent legal changes, notably the Bassanini laws. It is now imperative that the changes in the legal framework are quickly translated into concrete actions. One set of measures, which is particularly useful, relates to the one-stop "shop" for investment; if implemented forcefully, this could change the whole environment for investment. We also urge to accelerate the envisaged elimination or simplification of regulations administered at the central and local government level that often hamper private initiative, including in the retail sector (where entry especially by larger entities remains difficult) and in some professions. Some of these reforms will only be effective if the public administration itself is rationalized and if higher-skilled employees are attracted to the public sector.
12. With respect to labor market reform, we were encouraged by the positive results of several earlier initiatives, including the increase in part-time and fixed-term employment. On the other hand, we remain concerned about possible adverse implications for labor costs of a legislated 35-hour week, especially for small- and medium-size firms, and the risk that it would contribute to the growth of the underground economy. While abandoning the initiative would be preferable, in any case the tight fiscal constraint clearly leaves no room for government support in this area; any decline in working hours would need to be offset by a commensurate decrease in labor income. Moreover, further steps are needed to foster employment creation, and the experience elsewhere suggests that limits on dismissal costs, for cases where dismissals reflect economic factors, can play a useful role. There is also a need for a significant increase in the scope and quality of job training and apprenticeship programs to tackle youth unemployment. And wage levels at the entry level may have to decline considerably in the formal economy, especially in the case of on-the-job training. In our view, this is clearly preferable to an alternative where most of the targeted groups would otherwise enter the underground economy without any social protection.
13. The steps to enhance labor market flexibility should be accompanied by the introduction of a broad-based unemployment insurance system. In its design, care needs to be taken to set adequate incentives for employment while providing a true safety net for the unemployed. We also welcome the recently introduced reddito minimo d’inserimento, a social assistance program targeted at the very poor. Provided that it will remain limited to the intended target group, the program could in time become an important element of a more rational welfare system.
14. The weakness in economic activity has been particularly acute in the South and has resulted in unemployment rates well above 20 percent. In our wide-ranging discussions with regional representatives, other government officials, labor unions, and private sector representatives, we found a broad consensus that past policies had generally failed to secure material progress. We consider the government’s recent initiatives, in particular in the context of the contratti d’area and patti territoriali, as important steps forward, even while recognizing that some problems persist at this moment (notably at the local administrative level). Especially the patti territoriali are improving the transparency of the decision process for regional support programs; strengthening competition for public funds; enhancing local responsibilities and "ownership" of projects; and should, as a result, lead to a more efficient use of public resources.
15. The challenges facing the South are enormous, however, and we remain concerned that the steps taken so far will not provide sufficient momentum to secure a rapid economic takeoff in the region and overcome the very high unemployment rates among the young and for women. A comprehensive strategy is required where public support programs have to play an important role, but need to be complemented by steps in other areas, including a further strengthening of public services and of law and order. Moreover, a durable and sharp decline in unemployment in the formal economy will only be possible if relative wages reflect relative productivity levels (including all relevant cost components of operating a business in the South). This is not the case at this juncture; and reaching the necessary flexibility will require adequate regional wage differentiation particularly at the entry level into the labor market. It would be most helpful if this could be incorporated into future labor market agreements. The government could also provide an added incentive in this regard by moving to limit regional support programs to those cases where an extensive derogation from nationally mandated minimum wages has been agreed for the most disadvantaged segments of the labor market.
16. A substantial privatization program and deregulation in several sectors have changed the economic landscape in recent years. Further steps in this area could strengthen the economy’s position in the global market place; these should include, inter alia: (i) a renewed emphasis on privatization, particularly in the energy sector, completion of the state’s divestiture in banks, and liquidation of IRI by mid-2000; (ii) a strict restriction on controlling interests of foundations in the banking sector in the pending implementing regulation; and (iii) a rapid deregulation of the gas market that would introduce effective competition. Important steps have, of course, already been taken; however, they often were overly timid in the face of entrenched interests. A bolder reform of the energy sector with stronger limits on the role of ENEL, for example, would have been preferable, although we acknowledge that reform steps went further than in several partner countries. Concerning the banking sector, the competitive environment has changed fundamentally, in part related to EMU. We recognize that the sector has generally responded well to the new conditions and efficiency has improved, although further reductions in labor costs are still needed. Close and well-coordinated supervision will continue to have an important role to play in safeguarding the stability of the financial sector.