Italy -- IMF 2004 Article IV Consultation, Conclusions of the Mission
November 10, 2004
Conclusions of the Mission
1. Near-term economic prospects are improving. We project GDP growth of 1.4 percent in 2004 and 1.7 percent in 2005—the latter broadly in line with our estimate of potential growth—reflecting the stronger external environment and a recovery in investment. The figure for 2005 is lower than the one included in the recent World Economic Outlook, owing to higher oil prices. These, together with a further euro appreciation, continue to involve significant downside risks to the 2005 outlook. Inflationary pressures are modest despite the rise in international oil prices.
2. Notwithstanding the cyclical recovery, without further reform Italy's medium-term outlook remains weak. Since 1994, annual growth has averaged only 1.7 percent. During this period, the cumulative growth gap against the other euro-area countries was 4.1 percent; it was 15.5 percent against the Unites States. Per capita gaps are smaller, but still sizable. Without action, growth is bound to weaken further over time as the population ages.
3. A reform strategy should focus on:
· Containing current primary spending of the government to ensure fiscal sustainability and reduce the tax burden. A more secure fiscal outlook and lower taxation would raise incentives to work and invest. Focusing the adjustment on current spending would also protect public investment.
· Deepening labor market reform. Major reforms since the mid-1990s have yielded good results, but the employment ratio is still the lowest in the euro area.
· Boosting competition in product markets and improving the business climate. These are critical to stimulate investment, innovation, and efficiency, and thus productivity and competitiveness, two areas where Italy's performance has been disappointing. Enhancing the efficiency of the financial sector would also support faster growth.
4. Fiscal developments since last year's Article IV consultation are mixed.
· On the positive side, the recent pension reform is a key step toward long-term fiscal sustainability (although an earlier, phased increase in the retirement age—rather than a step increase in 2008—would have been preferable). Implementation decrees for the pension reform should be introduced as scheduled starting with those related to the reform of the TFR system. From a shorter-term perspective, the government has shown considerable resolve in introducing a mid-year adjustment package to address the weaknesses in the 2004 budget. Some small additional action should be sufficient to keep the deficit (indebitamento netto) below 3 percent of GDP this year.
· On the other hand, the deficit has increased in 2004, one-off measures have remained high (we estimate them at 1.5 percent of GDP), and the debt ratio has declined only marginally, hobbled, once again, by a borrowing requirement (fabbisogno) well above the deficit. The ratio of current primary spending to GDP has failed to decrease, after rising by some 2 percentage points of GDP during 2001-03.
5. Altogether, long-term fiscal sustainability is far from secure. Despite this year's reform, we project annual pension spending to rise by at least 2 percentage points of GDP over the coming decades. Official projections set the growth of health spending over the same period at 2½ percentage points of GDP, but the increase could well be larger. In order to prepare the ground for this aging-related spending increase, it is necessary to move the budget to a small surplus within the next few years. The authorities are encouraged to commit publicly to doing so. In addition, the legally-mandated ten-year adjustments of replacement rates to reflect developments in life expectancy should be implemented on schedule. The first such adjustment is due in 2005.
6. The 2005 budget targets are broadly appropriate. While the deficit is targeted to decline only modestly, to 2.7 percent of GDP, one-off measures would fall substantially. Altogether, the underlying deficit (that is, the deficit net of one-off measures) is targeted to decline from 4.4 percent of GDP to 3.6 percent of GDP, a notable improvement.1 We welcome the focus of the adjustment on containing current spending, to be implemented through a 2 percent cap on the growth of many expenditure items. Incorporating spending growth limits into a system of multiyear spending reviews to develop and protect budget priorities could contribute to improving expenditure management in the next few years.
7. However, the attainment of the targets is subject to substantial risk:
· Even with full implementation of the adjustment package underlying the budget (the manovra correttiva), our revenue estimate falls short of the budget's by 0.2 percent of GDP. This is because our growth projection, which is in line with those of private forecasters, is lower than that in the budget. Moreover, the planned shift of ANAS (the road agency) out of the public sector might again be disallowed by the statistical authorities, increasing the deficit by another 0.2 percent of GDP. In any case, shifting ANAS out of the public sector would be essentially an accounting operation, at least in the short term. Altogether, the shortfall in the budget could be 0.4 percent of GDP (some € 5-6 bl.)
· Other risks relating to the implementation of the manovra correttiva are more difficult to quantify, but are not trivial, particularly on the spending side. The envisaged savings depend in part on the effectiveness of still untested constraints set on regional and local government expenditure, rather than on specific, defined measures. The risks are especially high for health spending.
8. Thus, we recommend introducing additional measures of ½ percent of GDP during the parliamentary debate, in order better to ensure the attainment of the budget targets. Savings could come from broader recourse to user fees for the financing of public services, including in the health sector, with protection for low-income households. Transfers to enterprises could also be cut further, and the public sector wage bill contained more effectively. The latter has risen by some 12 percent in real terms during 2000-2004, reflecting sizable increases in employment (a net 139,000 full-time-equivalent posts were added during 2000-03) and rapid growth of wages (over the same period, gross remuneration per employee grew by a cumulative 4 percent more in the public sector than in the whole economy). If additional resources cannot be found, the measures the government is considering to finance the proposed tax cut could be used instead to reinforce the budget: while tax cuts are important over the medium term to stimulate growth, achieving the 2005 budget targets is the first priority. In any case, it is critical that any tax cut be financed by permanent cuts in expenditure so as to be credible. During 2005, new measures should be introduced if structural slippages emerge.
9. The government's divestment program is appropriately ambitious, but its implications for future budgets should be carefully assessed. Privatization should proceed speedily, and we welcome the recent successful ENEL operation. Divestment of enterprises owned by local governments remains critical. Sales of real estate have contributed to lowering public debt and improving allocative efficiency. However, the sale of part of the road network envisaged in the budget will require the state to make payments to the purchaser in subsequent years, creating a burden for future budgets. The sale of buildings used by the public administration would have the same effect. The merit of these operations is unclear. In addition, it is necessary to ensure full transparency in the operations of the institutions in charge of facilitating investments in infrastructure outside the general government, particularly in relation to possible contingent liabilities for the state.
10. Other aspects of fiscal transparency need to be improved further. The reconciliation of the deficit with the borrowing requirement is not yet sufficiently transparent, but we welcome the effort made in clarifying some issues. Budget documents could be streamlined and more emphasis given to an economic, rather than legal, formulation. A pilot project to create a standardized reporting system for cash transactions of government units (SIOPE), to be implemented in 2005, is a welcome step to monitor treasury operations.
11. Implementing fiscal federalism remains challenging. The further extension of the mandate of the High Commission is indicative of the considerable political and technical difficulties in this area. The degree and design of the spending and tax autonomy of the various levels of government, the appropriate equalization system, and mechanisms for monitoring and enforcing budgetary implementation are key issues to be resolved. Norms and regulations have changed frequently in recent years. Greater stability would strengthen compliance and contribute to fiscal discipline.
Labor and Product Market Reforms
12. Increasing wage flexibility and reducing the tax wedge over time are key to raising employment. Greater decentralization of the wage bargaining process, to ensure that wages adequately reflect differences in productivity and cost of living, can help narrow disparities in employment rates. Production by ISTAT of regional price indices would assist these efforts and should be a priority. The second stage of the Biagi Reform should be approved.
13. The decline in potential growth in the last decade despite the improving labor market shows that other structural weaknesses have increasingly impeded innovation and efficiency. We draw attention to three priorities:
· Enhancing competition. In key sectors—wholesale and retail trade, energy, and professional services—a lack of competition continues to impose costs on other firms, hampering their competitiveness and stifling investment. Reforms to subject key sectors to increased competition should not be further delayed. In addition, the powers of the anti-trust authority to penalize anticompetitive behavior should be enhanced. The introduction of the electric power exchange in April was a welcome step.
· Improving the business environment. Data from the World Bank and other sources document that Italy's business environment lags those of other advanced economies by many standards. The legal processes involved in enforcing a contract take six times longer to complete than in the average industrial country. In addition, the costs of opening and closing a business are—despite recent improvements—still well above the OECD average. The World Economic Forum's Global Competitiveness Report ranks Italy 47th in the world in terms of the support its business environment provides for growth. While surveys have a subjective component, the low level of foreign direct investment (FDI) is an objective indication of the need for improvement. Problems in this area are also critical in explaining regional differences (tellingly, FDI is virtually nonexistent in the South). As a first step, the long-delayed reform of bankruptcy legislation needs to be approved as soon as possible. Reforms are also urgently needed to accelerate legal processes and reduce red tape.
· Removing inefficiencies that inhibit the growth of firms. The small size of Italian companies tends to reduce risk-taking and investment in R&D—private spending on R&D as a share of business sector GDP is one third of the OECD average. To some extent, the prevalence of small firms is due to cultural factors, but other matters are also at work, such as high tax rates that are more easily avoided by small firms, labor laws that discriminate against larger entities, regulatory barriers to the consolidation of firms, and problems with creditor protection that discourage the flow of capital to smaller enterprises.
Financial Sector Stability and Efficiency
14. The profitability of Italian banks has improved significantly in 2004. Return on equity is expected to rebound to 10 percent. The capital adequacy ratio (almost 11 percent at end-June 2004) is comfortably above the Basel minimum. Over the last few years, improved profitability has been achieved through gradual cuts in costs and increases in non-interest income, but expenditure control remains a priority. Despite a significant improvement in the quality of the loan portfolio over the last few years, NPL levels remain relatively high. Some restatement of balance sheets could occur with the transition to International Financial Reporting Standards in 2005, in part related to the treatment of NPLs. The large banking groups continue their efforts to improve risk management through risk-based pricing in the context of their preparation for Basel II.
15. Since the last Article IV consultation, the Parmalat scandal has again focused policy makers' attention on the importance of further financial sector reform. CONSOB's oversight of the auditing profession and its powers over disclosures are adequate. However, concentrated ownership and cross-shareholding may complicate the monitoring of the independence of corporate board members. The draft law on market abuse currently in Parliament appropriately gives CONSOB more resources, strengthens its ability to exercise key functions independently, and raises the sanctions that can be imposed on wrongdoing. Consideration could also be given to mandating that corporate boards contain a majority of independent directors; incorporating some of the provisions of the Preda Code into legal or regulatory requirements; and stipulating that corporate boards include a representative of minority shareholders. CONSOB should also consider taking further steps to ensure financial intermediaries fulfill requirements related to matching customers with appropriate investments.
16. A comprehensive review of the Italian financial system, as part of the IMF's Financial Sector Assessment Program (FSAP), is underway. The review will cover both Italy's compliance with a number of international standards and codes and the resilience of banks to shocks. This work follows the two assessments conducted last year in the area of payments systems and the Basel core principles of bank supervision. These found a high degree of compliance, with some improvements needed in a few areas (such as the classification of NPLs). The FSAP work is expected to be completed in 2005.
1 Using the official definition, one-off measures are estimated at €7 bl in 2005. Our estimate is higher (€ 12½ bl), as we include other non-recurrent components of the budget: some tax measures will have a bigger yield in 2005 than in later years (0.3 percent of GDP) and interest savings from restructuring government assets (0.1 percent of GDP) will occur only in 2005. In our definition, the one-off measures would decline from 1.5 percent of GDP in 2004 to 0.9 percent of GDP in 2005.