Mission Concluding Statement 

May 11, 2011

Italy’s economy continues to recover. Fiscal consolidation and strengthened financial stability are making the economy more resilient and are prerequisites for growth. The mission supports the goal of reaching a near-balanced budget by 2014. The adjustment should be based on public expenditure rationalization. Italian banks weathered the crisis better than most peers, partly helped by a prior consolidation process. The recently announced recapitalizations will further strengthen banks’ balance sheets. Growth is mainly driven by exports, but remains modest; only a bold and comprehensive structural reform program will unleash Italy’s growth potential.

A weak recovery is underway

1. Italy is experiencing a weak recovery, mainly driven by exports. The economy grew by 1.3 percent in 2010, less than the euro area average and despite a larger than average fall in 2009. Domestic demand remained weak. Employment fell, pushing up unemployment. However, the unemployment rate was still below the euro area average, also owing to the state-funded wage supplementation program (Cassa Integrazione Guadagni). The current account widened reflecting high import growth and rising energy prices.

2. Growth is likely to remain weak. Staff projects output to grow modestly and in line with the authorities’ forecast, driven by exports and the resumption of investment. However, it will be held back by subdued private consumption and fiscal consolidation. Such a modest pace of activity will not allow a significant recovery in employment. Persistently high youth unemployment will result in a long-term loss in human capital. Consumer price inflation is projected to increase somewhat, owing to rising energy and commodity prices.

3. Structural bottlenecks will continue to impede growth. Italy’s chronically weak growth performance has deep-rooted causes, including 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 policy agenda: unleash growth potential through structural reforms while pursuing fiscal consolidation and boosting bank capital buffers

4. Italy needs to move onto a higher growth path. Italy’s GDP per capita has not grown in the last ten years, one of the worst performances among advanced economies. Prompt and decisive actions should be taken to avoid another decade of stagnation.

5. Structural reforms and fiscal consolidation are both necessary. Structural reforms and fiscal consolidation can reinforce each other. Structural reforms could mitigate the contractionary effects of fiscal consolidation, by boosting investor confidence and supporting private investment. Without the growth enhancing effect of structural reforms, durable fiscal consolidation is difficult to achieve.

Fiscal consolidation: a necessary (but not sufficient) condition for sustained growth

6. The 2010 fiscal target was comfortably achieved. In 2010, the fiscal deficit declined to 4.5 percent of GDP. The deficit was smaller than expected and one of the lowest in the euro area. Public expenditure growth was contained by phasing out the 2009 anti-crisis measures, cutting capital spending, and reducing the wage bill. The fight against tax evasion sustained revenues. Real primary current expenditure grew at the lowest rate since the mid-1990s. The structural balance improved, accounting for most of the change in the headline balance. The positive budgetary trends continued in the first months of 2011. However, public debt reached 119 percent of GDP at end-2010, the second highest in the euro area.

7. The mission welcomes the authorities’ commitment to reduce the fiscal deficit to below 3 percent of GDP by 2012 and close to zero by 2014. The envisaged consolidation implies an annual improvement of the structural primary balance by about 1 percentage point of GDP until 2014. The consolidation plan is appropriately based on sustained real expenditure contraction. However, under less optimistic revenue assumptions, the fiscal deficit in 2012 would be slightly above the target of 3 percent of GDP. The authorities’ plan appears optimistic on the income effect of the envisaged fiscal consolidation. Furthermore, the authorities have so far resorted to across-the-board cuts and have not specified measures to achieve consolidation beyond 2012.

8. A sustainable fiscal consolidation should rely on expenditure rationalization based on clear priorities. This would mitigate the effect of fiscal retrenchment on growth. Containing public sector wages within a broader public administration reform could generate positive spillovers for the private sector. Important pension reforms have already been implemented. Further measures, including 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. More generally, the large size of the fiscal retrenchment envisaged by the authorities requires structural changes in public expenditure, which must be designed well in advance. The prompt announcement of measures will also have a positive effect on market sentiment.

9. 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. The mission welcomes this initiative and sees it as an important component of the fiscal consolidation plan.

10. Further decentralization should not undermine fiscal discipline.  Reducing transfer dependency at the sub-national level should improve public expenditure efficiency, fiscal performance, and accountability. To this end, local authorities should be allowed to tax all real estate properties. Clear safeguards need to be established to guarantee deficit neutrality and avoid an increase in the tax burden. The ongoing fiscal federalism reform should be integrated with the envisaged fiscal consolidation. Federalism at variable speeds should be considered, reflecting the regional differences in administrative capacity.

Financial sector: boosting capital buffers

11. Italian banks have been adversely affected by the recession. Over the last two years, banks’ asset quality worsened due to the economic slowdown, and earnings were hampered by low net interest income and high loan-loss provisions. However, banks remained profitable. The previous consolidation contributed to bank resilience.. Going forward, they will continue to face challenges. While the deterioration in credit quality is likely to slow, loan-loss provision costs will remain elevated, given the high level of accumulated non-performing loans. Profitability will also be undermined by rising funding costs.

12. Italian banks have a solid funding and liquidity profile. A large and stable retail funding base and ample collateral to access Eurosystem refinancing help Italian banks to face liquidity and funding risks, which have intensified with the euro area sovereign crisis. However, Italian banks’ funding costs remain sensitive to market sentiment about the Italian sovereign.

13. The recently announced recapitalizations go a long way towards the goal of strengthening banks’ position. 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. Staff thus welcomes the authorities’ preemptive and strong call for capital increases and the banks’ prompt response. 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, and by raising capital from the market. Further bank mergers should also be part of the recapitalization strategy, as they are often the most effective and quickest way to address weaknesses. 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.

14. Further recapitalization or restructuring of enterprises may be necessary. The anti-crisis measures to sustain small and medium enterprises (SME) 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.

Structural reforms: the cornerstone of a growth strategy

15. Progress on structural reforms has been mixed. Measures implemented in 2010 include reducing the bureaucratic burden for starting a business, facilitating out-of-court bankruptcy procedures, and introducing a requirement for competitive tendering for local public service contracts. The EU Service Directive was implemented with delay. However, some measures related to product market liberalization were reversed, for instance, by reintroducing minimum tariffs for lawyers’ services.

16. The National Reform Plan 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. But further labor and product market reforms are necessary to address long-lasting structural problems.

17. Further product market reforms are needed. Measures should aim at establishing a more efficient regulatory environment, promoting a higher degree of competition by opening up further services and network industries, and reducing public ownership, especially at local level. The conflict of interest deriving from local authorities’ dual role as regulators and shareholders should be resolved. Foreign direct investment is an important channel to improve efficiency and should be boosted from its chronically low level.

18. Policies should address labor market duality and the low participation rate. The labor market is characterized by duality with a protected group of permanent workers and a relatively less protected group of temporary ones. 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 these two categories can boost employment and social cohesion. Employment rates, especially among women, youth, and older workers remain significantly below the euro area average, with large regional disparities. Reducing the labor tax burden, in a fiscally prudent way, could boost employment.

19. Wage setting needs to promote job creation. In the private sector, more decentralized bargaining would better align wages with productivity and boost competitiveness. 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.

20. 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.