IMF Executive Board Concludes 2005 Article IV Consultation with Italy

Public Information Notice (PIN) No. 06/13
February 7, 2006

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

On February 6, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Italy.1

Background

A consolidation of the cyclical recovery that began in mid-2005 is expected this year, with growth rising from close to zero last year to about 1½ percent in 2006. Net exports and investment should benefit from sustained demand in partner countries, while consumption growth is forecast to remain within the narrow range witnessed in recent years. Despite high international energy prices, inflationary pressures should remain modest, at just over 2 percent in 2006. Despite the better cyclical outlook, medium-term trends remain troubling: potential growth is estimated at just 1¼ percent, as low productivity growth and high domestic costs have led to a steady erosion of competitiveness and export market share.

The 2005 fiscal deficit target of 4.3 percent of GDP is estimated to have been met, thanks in part to measures introduced by the authorities late last year, though current expenditure dynamics remained strong. For 2006, the authorities have committed to a deficit target of 3.5 percent of GDP. To this end, they strengthened the budget substantially in various steps. Sustaining the envisaged deep expenditure cuts will require strict implementation of the budget's enhanced control and sanction mechanisms.

Labor market reforms and wage moderation have led to a substantial increase in employment in recent years, although the employment ratio remains very low. In other areas, some key structural measures were approved in late 2005, including a long-overdue reform of the bankruptcy code, an updating of civil procedures, and a "savings law" that enhances corporate governance, disclosure, and coordination among regulators. Nevertheless, a number of cross-country indicators point to the presence of rigidities and inefficiencies in the economic environment that constrain Italy's growth potential.

The 2005 Financial Sector Assessment Program (FSAP) found that Italy's financial system is generally sound and well regulated. The banking sector has proven resilient to slow growth, and stress tests revealed little vulnerability going forward. However, the FSAP identified issues related to market contestability, loan classification standards, and lending to related parties, and noted that the cost of core bank services was relatively high. The mission also raised concerns about the Bank of Italy's governance structure and about potential conflicts of interest arising from the Bank's joint mandates for banking sector stability and competition, but these have substantially been addressed by reforms approved in late-December 2005.

Executive Board Assessment

Executive Directors welcomed the expected consolidation of the recovery of the Italian economy that began in mid-2005 following several years of slow growth. Against this backdrop, Directors commended the authorities' commitment to the agreed fiscal targets, as reflected in the additional measures taken to strengthen the 2006 budget. They also welcomed the recent progress in passing some long-standing structural reforms, including an overhaul of the bankruptcy code, new and accelerated civil procedures, and a savings law that strengthens corporate governance and coordination among regulatory agencies—all of which constitute important steps forward on needed reforms.

At the same time, Directors stressed that Italy faces difficult policy challenges going forward. Italy's medium-term prospects are troubling, as slow productivity growth has significantly eroded its competitive position and export market share. In addition, pervasive rigidities and inefficiencies in the domestic economy are restraining growth more generally, with potential growth now estimated at just 1¼ percent annually. The large public debt also remains a drag on the economy. Against this background, Directors considered that Italy must undertake significant fiscal consolidation over the medium term to reduce the high public debt and fiscal deficit, while widening and deepening structural reforms. Directors believed that progress on both fronts will help the Italian economy adapt better to external challenges, and more generally, to better compete in an increasingly globalized world and in the context of the single currency.

Directors stressed that, in the present pre-electoral period, the economic policy priority is to ensure the credibility of the fiscal adjustment targets agreed to under the Excessive Deficit Procedure (EDP). In view of Italy's recent history of missed fiscal targets, they viewed the recent steps taken to strengthen the 2006 budget as a welcome sign of the authorities' commitment both to consolidation and to the EDP fiscal targets. While endorsing the budget's reliance mainly on expenditure restraint, Directors emphasized the importance of cautious execution of spending plans, together with timely monitoring and strict implementation of the strengthened control and sanction mechanisms. They welcomed the authorities' assurance that corrective measures will be implemented promptly if slippages emerge. Several Directors also emphasized that recourse to amnesties and one-off measures should be discontinued, in order to enhance the durability of fiscal adjustment. Directors noted that in the medium term—and in the absence of a reform of the fundamental determinants of spending—the underlying expenditure dynamics could put significant pressure on the budget.

Directors stressed the need for a strong commitment to a program of liberalization and deregulation going forward, based on reforms that will enhance competition, eliminate economic rents, and promote freedom of choice for consumers. With past reforms having prioritized labor markets, the main focus should be on liberalizing product and services markets. Directors recommended several measures: freeing professional services of the array of rules that inhibit competition, including via rapid implementation of the EU services directive, when finalized; using the central government's responsibilities over retail trade to promote consumer welfare through greater competition; further deregulating network sectors, with a reduction in the government's predominant interest in privatized firms; and enhancing the powers of the antitrust and sectoral authorities. Another key priority is to improve Italy's business environment, including by reducing bureaucratic burdens and accelerating legal processes. Directors welcomed the National Action Plan for Innovation, Growth, and Employment, and urged the authorities to implement it in a comprehensive and timely manner to make progress toward the Lisbon Agenda targets. Early implementation of a broad package of such reforms will be essential to create a more competitive Italy and boost medium-term performance.

Directors welcomed the strong growth of employment of recent years, which is largely attributable to past reforms that reduced employment protection and introduced new, flexible forms of contracting. Nonetheless, the employment rate remains very low, indicating a need for further action. While the recent initiatives to improve the unemployment compensation system are a positive development, Directors suggested that these be seen as the first steps toward a more thorough overhaul of the system that should aim to offer better and properly-conditional unemployment support along with more flexible labor legislation. Furthermore, greater variation of wages in line with productivity differences is critical to redress competitiveness losses in the short term, while more fundamental reforms take hold. Greater wage flexibility across regions could also help improve the high regional disparity in employment rates. Directors also encouraged the authorities to strengthen education and training.

Restoring the sustainability of the fiscal accounts will also be essential for stronger medium-term growth. While welcoming the authorities' commitment to reduce the fiscal deficit to below 3 percent of GDP in 2007, Directors cautioned that this will be insufficient to ensure the sustainability of the public debt, especially in light of the pressures that will arise from population aging. They therefore called on the authorities to commit to a path of medium-term deficit reduction sufficient to achieve overall balance by 2010, before the end of the next legislature. Directors stressed that, to be credible, such an adjustment will need an ambitious and targeted approach to expenditure containment, relating in particular to subsidies, public employment, and health care. As the steady rise of primary current spending underlies the country's fiscal fragility, several Directors underscored the importance of strengthening the primary balance. Directors also noted the contribution that sales of public assets could make to reducing the public debt and enhancing economic efficiency. Directors urged that the adjustment of pension replacement rates—mandated to take place every decade in line with developments in life expectancy but delayed—now be effected promptly. Directors also stressed the importance of a properly designed system of fiscal federalism to maintain budget discipline in the presence of ongoing devolution.

Directors stressed the need to enhance the transparency of Italy's budget presentation, which falls short of international best practices. Directors commended the work that has helped to narrow the gap between the cash and accrual deficits. They called for following this up with efforts to increase the transparency of budget preparation; ensure the timely availability of key budget documents; and disseminate up-to-date financial data on key state enterprises. Directors supported the authorities' intention to strengthen the role of the Court of Auditors (Corte dei Conti) in budget monitoring and in providing independent evaluations of fiscal proposals and trends.

Directors welcomed the opportunity to consider the key findings of the Financial System Stability Assessment (FSSA) in the context of this discussion, and expressed their broad agreement with them. They welcomed the finding that Italy's financial system appears to be generally sound and well regulated, and encouraged the authorities to deal expeditiously with the issues identified in the FSSA. These include limited market contestability, high fees and commissions, and regulations covering loan classification and lending to related parties. Directors welcomed the steps underway to deal with some of these matters. A number of Directors noted the need for further improvement in efficiency and competition in the financial sector, including that which would result from increased participation by foreign banks. This would contribute to raising Italy's growth potential. Several Directors also encouraged Italy to move to a 90-day classification rule for non-performing loans.

Directors supported recent changes in the Bank of Italy's governance structure and the institutional arrangements for the oversight of banking competition. They welcomed the transfer of responsibility for anticompetitive behavior to the antitrust authority, which will help address the potential conflict between stability and competition in previous arrangements. Directors stressed the importance of ensuring that the new arrangements safeguard fully both the Bank of Italy's and the antitrust authority's high levels of independence, and establish the division of responsibilities between the two institutions along clear lines with distinct accountability.

Directors welcomed Italy's commitment to raise its relatively low level of development assistance. They also welcomed the authorities' commitment to continue to promote trade liberalization through a multilateral approach.

Directors noted that Italy's statistics are adequate for surveillance, and welcomed recent steps to address weaknesses identified in the 2002 Report on the Observance of Standards and Codes. They underscored the need to address remaining issues regarding the transparency and timeliness of some fiscal data and documentation.


Italy: Selected Economic Indicators

 

2001 2002 2003 2004 2005 1/

Real economy (change in percent)

 

 

 

 

 

Real GDP

1.8 0.4 0.3 1.2 0.1

Total domestic demand

1.4 1.2 1.2 1.0 0.7

CPI (average)

2.3 2.6 2.8 2.3 2.3

Unemployment rate (in percent)

9.5 9.0 8.7 8.5 8.1

Public finance (in percent of GDP)

 

 

 

 

 

Overall balance

-3.0 -2.9 -2.7 -2.6 -3.2

General government balance

-3.2 -2.7 -3.2 -3.2 -4.3

General government debt

110.9 108.3 106.8 106.5 108.7

Money and credit (end of year, percent change)

 

 

 

 

 

Private sector credit 2/

7.0 6.2 7.0 5.9 8.8

National contribution to euro area M3 3/

6.0 8.1 6.7 8.1 8.7

Interest rates (in percent)

 

 

 

 

 

6-month interbank rate 4/

4.3 3.3 2.3 2.1 2.5

Government bond rate, 10-year 5/

5.2 5.0 4.2 4.3 3.6

Trade balance

1.4 1.1 0.8 0.7 -0.4

Current account balance

-0.1 -0.8 -1.3 -0.9 -1.9

Fund position (as of December 31, 2005)

 

 

 

 

 

Holdings of currency (percent of quota)

 

 

 

 

82.6

Holdings of SDRs (percent of allocation)

 

 

 

 

22.8

Quota (millions of SDRs)

 

 

 

 

7,055.5

Exchange rates

 

 

 

 

 

Exchange rate regime

 

Member

of EMU

 

 

Euro per U.S. dollar (January 30, 2006)

 

 

 

0.85

 

Nominal effective rate (2000=100) 4/

100.4 101.6 105.8 107.2 106.5

Real effective rate (2000=100) 4/ 6/

101.1 104.2 111.4 113.7 110.1

Sources: Italian authorities; IMF, International Financial Statistics; World Bank, World Development Indicators; Bloomberg; Eurostat; and Fund staff estimates and projections.

1/ Staff estimates and projections, unless otherwise noted.

2/ Twelve-month credit growth, adjusted for securitizations. Data for 2005 refer to July.

3/ Excludes currency in circulation held by non-bank private sector. 2005 data refer to October.

4/ Data for 2005 refer to November.

5/ Data for 2005 refer to December.

6/ Based on CPI.


1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.



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