## 1. Competitiveness and Wage Bargaining (cr17237) ## Source details **Canonical URL:** [1. Competitiveness and Wage Bargaining (cr17237)](https://www.imf.org/-/media/files/publications/cr/2017/cr17237.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2017/cr17237.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2017/cr17237.pdf.json) --- ### Context and macro developments - Modest recovery amid policy support: - Fiscal relaxation: about 2 percent of GDP in structural primary terms since 2013. - Favorable commodity terms of trade: equivalent of transfers of about 1½ percent of GDP since 2013. - Growth and labor: - Growth in 2015–16 averaged just 0.8 percent. - Growth reached 0.9 percent in 2016 and picked up in Q1 2017 to 1.2 percent (year-on-year). - Unemployment: over 11 percent (11.1 percent in April 2017), down from nearly 13 percent peak. - Youth unemployment: about 35 percent. - Regional unemployment Q1: 7.1 percent in the North versus 20.4 percent in the South. - Employment and labor force participation rose by almost 1 p.p. each recently. - Inflation and output gap: - Core inflation: 0.9 percent year-on-year in May 2017. - Headline inflation: 1.6 percent (May 2017). - Output gap for 2016: estimated at 2.7 percent of potential GDP (staff estimate similar to Italian Ministry of Finance, larger than EC estimate of about 1¾ percent). ### Key constraints and vulnerabilities - Structural weaknesses and binding constraints: - Impaired balance sheets and financial fragilities. - High unit labor costs. - High taxation. - Barriers to competition. - Inefficient public sector. - Large share of SMEs struggling to adapt to global technology and trade developments. - Public debt and banking sector: - Public debt: stabilizing around 133 percent of GDP. - NPLs of banks: about 21 percent of GDP (headline); gross NPLs: - €360 billion (18.1 percent of gross loans) at end-2015. - €349 billion (17.3 percent) at end-2016. - Bad loans (sofferenze): about €203 billion (10.9 percent) in April 2017. - Provisions for NPLs improved to over 50 percent. - Real disposable incomes and productivity: - Real disposable incomes per capita below pre-euro accession levels. - On current projections, real incomes per capita expected to return to pre-crisis (2007) levels only a decade from now. - Distributional impacts: - Share of population at risk of poverty has increased. - Emigration remains high, including skilled workers. ### Demand composition and external position - Demand drivers: - Consumption main engine of growth, supported by low oil prices, higher wages and employment, bank credit, and fiscal stimulus. - Investment recovery sluggish and uneven despite fiscal incentives. - Net exports a drag as import growth outpaces export growth. - Competitiveness: - REER overvalued by close to 10 percent (Annex I). - Manufacturing ULC gap vis-à-vis Germany and the euro area: around 30 percent built pre-crisis and sustained since. - Price-based REER measures show enduring gap of about 5–15 percent against Germany and the euro area. - Structural indicators point to low integration with global value chains. - External flows and TARGET2: - TARGET2 net liabilities rose to a record 25 percent of GDP at end-May 2017. - Financial outflows reflect increased Italian residents’ portfolio investments abroad and decreased foreign exposure to Italy’s private and public sectors. ### Urgent policy priorities (staff emphasis) - Raise productivity and growth. - Increase economic resilience. - Protect the vulnerable. - Contain spending pressures from pension and public sector wage measures to preserve fiscal sustainability. --- ### 2. Financial Sector: Banks, NPLs, and Stabilization Actions ### Recent actions and state support - Actions taken: - Precautionary recapitalization for one bank with state aid up to €5.4 billion (bank accounts for about 5 percent of total system assets) including restructuring and disposal of bad loan portfolio. - Two banks (about 2 percent of total assets) deemed failing or likely to fail; liquidation approved with state aid of €4.8 billion and guarantees of up to €12 billion. - Authorities established a backstop of €20 billion (1¼ percent of GDP) to finance rescue or liquidation and to guarantee up to €150 billion of bank liquidity; banks tapped about €20 billion in government-guaranteed bank bonds. - Atlante fund previously invested about €3.5 billion to rescue two banks. - Consolidation and structural change: - Eight of the ten largest popolari banks converted to joint-stock companies by end-2016. - Two large popolari banks merged to create the third-largest banking group in Italy. - Smaller cooperative banks required to consolidate under joint-stock (holding) companies with at least €1 billion in equity by May 2018. - Three new banking groups expected from consolidation of more than 300 cooperative banks by end 2018; two will fall under direct ECB/SSM supervision and be subject to an asset quality review. - Authorities allocated €500 million over the next three years to help banks’ downsizing via early retirement assistance. ### NPLs and provisioning - Stock and sales: - Gross NPLs: €360 billion (18.1 percent) end-2015 → €349 billion (17.3 percent) end-2016. - Bad loans (sofferenze): about €203 billion (10.9 percent) in April 2017. - Bad loan sales of about €8 billion occurred; several large sales—over €60 billion in total—planned. - GACS used in one transaction so far. - Provisioning and coverage: - Provisions for NPLs improved to over 50 percent. - Market participants argue Italian banks need substantial additional reserves; simple estimates suggest capital needs range 2–3 percent of GDP; more rigorous methodologies suggest 6–8 percent of GDP. ### Profitability and capital metrics - Bank profitability: - Bank profitability among the lowest in Europe in 2016—about 14 p.p. below the weighted average in a sample of large European banks compiled by the EBA. - Common equity tier 1 ratio: 10.4 percent in Q4 2016, about 3.7 p.p. below the EBA sample average. - Including a €13 billion capital increase by Unicredit in early 2017, CET1 would stand at about 11.6 percent. - System structure and metrics (Box 2): - Italy had 575 domestic credit institutions in 2015. - Market share of largest 5 credit institutions: 41 percent (EU unweighted average: 63 percent in 2015). - Bottom-up analysis of 386 banks: even if cost-to-income ratios reach EU median, significant parts of sector projected to remain challenged or weak due to legacy NPLs. ### Supervisory, resolution, and governance issues - Supervisory oversight: - SSM issued guidance requiring significant institutions to agree on ambitious NPL reduction targets (sanctions not envisaged for missing targets). - Bank of Italy drafting streamlined NPL guidance for smaller banks and launched a detailed bad loan survey. - Insolvency and enforcement: - Overhaul to replace 1942 insolvency law announced early 2016 has not materialized. - Average time in 2016: enforcement of real estate collateral 4.25 years; insolvency cases 7.5 years. - “Program Strasbourg 2” has not bridged regional duration gaps. - Resolution and burden sharing: - Protracted resolution processes have added costs to the budget and financial system. - Bank of Italy reports over 86 percent by value of non-equity instruments eligible for bail-in are held by the wealthiest 10 percent. - IMF staff: bail-in should be considered from efficiency and equity perspectives; well-targeted safety nets should assist vulnerable households. - Staff recommendations for banks: - Swiftly tackle problem banks cost-effectively; cut costs through strong restructuring; ensure credible NPL reductions; improve governance; engage independent NPL managers; require sales or joint ventures with specialized distressed asset managers where internal capacity weak. - Undertake asset quality review of all emerging consolidated groups; ensure robust governance and risk management. - Close legislative gaps in implementing EU fit and proper rules (CRD-IV) and apply 2015 EBA and 2016 ECB guidance in full. --- ### 3. Fiscal Developments, Debt Sustainability, and Projections ### Recent fiscal outcomes and 2017 measures - Fiscal outcomes: - Overall deficit target achieved: 2.4 percent of GDP in 2016 (improvement of about ¼ percent of GDP over previous year). - Structural primary surplus deteriorated by about ½ percent of GDP when controlling for economic cycle. - Public debt: 132.6 percent of GDP at end-2016. - Privatization proceeds: less than 0.1 percent of GDP in 2016 (target was 0.5 percent). - 2017 budget measures: - Supplementary budget measures: 0.2 percent of GDP largely to tackle tax evasion. - Revised deficit target for 2017: 2.1 percent of GDP. - Budget measures include: - Cuts corporate income tax rate from 27.5 percent to 24 percent. - Introduces a simpler tax (flat rate of 24 percent) for the self-employed. - Targets reduced social security contributions to certain new employees. - Repeals previously legislated increases in the VAT and other taxes. - Offers incentives to boost investment. - Inclusion income law: about €2 billion (0.1 percent of GDP), to be partly implemented by regions. - Budget increases spending on pensioners and facilitates pathways to early retirement, partially reversing objectives of 2011 pension reform. ### Debt trajectories and baseline assumptions - Public debt level and projections: - Debt increased from about 100 percent of GDP in 2007 to 132.6 percent of GDP in 2016. - Debt projected to remain around 133 percent of GDP in 2017 before starting to decline and reach about 120 percent of GDP in 2022 (conditional on assumptions). - Baseline assumptions: - Government assumed to achieve structural balance by 2019 (improvement in primary balance of about 2 percent of GDP). - Real GDP growth projected to average 1 percent annually during 2017–22. - GDP deflator projected to rise from 0.6 percent in 2017 to around 1½ percent over next few years. - Staff projects effective nominal interest rate of about 3 percent over medium term (average interest bill about 3¾ percent of GDP); spreads assumed around 200 bps. - Debt and financing metrics (selected exact figures from DSA tables and text): - General government gross debt: 131.8 (2014), 132.1 (2015), 132.6 (2016), 133.0 (2017), 131.6 (2018), 129.0 (2019), 126.0 (2020), 123.1 (2021), 120.3 (2022) (Percent of GDP). - Gross financing needs: notable, rollover needs of 14–17 percent of GDP. - About two-thirds of debt held by domestic investors. - Average maturity: around 6¾ years. - About 70 percent of debt at fixed interest rates. - ECB net purchases of Italian public debt during 2015–16: about €210 billion. ### Stress tests and downside scenarios (selected outcomes) - Standard growth shock: - Real output growth lower by one standard deviation for two years starting in 2018; average growth –1½ percent in 2018–19. - Primary balance reaches only 1½ percent of GDP by 2022. - Debt increases rapidly to about 140 percent of GDP and fails to come down over projection period. - Interest rate shock: - Increase in spreads of 200 bps. - Implicit average interest rate on debt rises to 3.8 percent by 2022. - Debt declines but only very modestly to around 128 percent by 2022. - Contingent liability shock (financial sector): - One-time increase in non-interest expenditure of about 10 percent of banking sector assets. - Domestic demand depressed; growth lowered by –1½ percentage points for two years; primary balance worsens by 10 percent of GDP in 2018. - Debt rises to 153 percent of GDP by 2022; gross financing needs significantly higher. - No-adjustment scenario: - Steady state real GDP growth of 0.8 percent; structural primary balance of 1¾ percent of GDP; average nominal borrowing cost rising to 6 percent by 2035. - Debt/GDP projected to decline slightly initially (due to exceptional monetary stimulus) then rise, with gross financing needs notably above 20 percent of GDP. --- ### 4. Structural Reforms — Measures, Diagnostics, and Quantified Impacts ### Overview of recent measures and institutional constraints - Recent measures noted: - Jobs Act (addressing labor market duality). - Framework law to modernize public administration. - Measures to enhance civil justice efficiency. - Education reform to improve school outcomes. - Industry 4.0 Initiative. - Anti-tax-evasion efforts. - Institutional constraints: - Rejection of December constitutional reform reduced authorities’ ability to streamline legislative structures and transfer competencies from regions to center. - Constitutional Court ruling in November 2016 mandated close coordination with local governments on several public administration items, stalling key implementing actions. ### Product and service market liberalization - Remaining impediments: - Regulatory impediments and barriers to competition in network industries (transport), professional services, retail and local public services, and distribution of permits. - Draft competition law in parliament for over two years; retains pro-competition measures but weakened in insurance, professional services, and fuel distribution; introduces new restrictions in tourism. - Removal of restrictive legislation on energy delayed to mid-2019. - Staff recommendations: - Strengthen draft competition law in line with Competition Authority recommendations and approve expeditiously. - Institute annual process of legislating pro-competition laws and enhance authority to sanction anti-competitive practices. ### Wage bargaining reform and quantified gains - Current system effects: - Sectoral wage bargaining produced persistent wage growth above productivity, binding national wage limits, and compressed wage distribution across regions and firms. - Wage-setting institutions contribute to large regional disparities in unemployment and lagging competitiveness. - Staff-preferred approach: - Decentralize wage bargaining to the firm level, complemented with a minimum wage possibly differentiated across regions. - Give primacy to firm-level contracts within prevailing institutional setup and define stakeholder representation principles. - Quantified impacts (illustrative simulations and models): - Illustrative simulations: almost 5 percent higher employment and 2½ percent improvement in competitiveness indicators in the medium term (Selected Issues Part 1 and Box 1). - DSGE model (Jimeno and Thomas (2013) parameterized to Italy): reduction in steady-state unemployment by 3.5 p.p., translating into almost 4 percent increase in employment. - IMF GIMF equivalence: firm-level bargaining reform equivalent to competitiveness gain of around 2½ percent in the medium term. - Combined reforms scenario: product market, labor market, public administration reforms (illustrative medium-term competitiveness gain of 1½ percent), banking sector cleanup (about 1½ percent), and fiscal reforms (around 2½ percent) together yield an overall competitiveness improvement of around 8 percent over the medium term. ### Other labor market reforms and public administration - Labor market measures recommended: - Lower labor tax wedge on secondary earners and increase childcare to address gender employment gap. - Scale up spending on active labor market policies (ALMPs); Italy spends among lowest in euro area on ALMPs. - Enhance delivery of ALMPs: consider coordinating via a new agency (ANPAL) and delivering ALMPs alongside passive policies through social security agency. - Consider extending new single open-ended contract of Jobs Act to all open-ended private sector arrangements and reduce dismissal compensation as economy strengthens. - Dismissal compensation currently: two monthly wages per year of service with minimum of 4 and maximum of 24 (at 12 years of service); OECD average example: 14 monthly wages at 20 years of service. - Public administration reform issues and recommendations: - Public sector quality ranks among lowest in Europe across multiple metrics. - Problems: high average civil servant age, skills mismatches, low electronic technology use, perceptions of corruption. - Implementation stalled on key actions after Constitutional Court ruling; rationalization of more than 9,000 public enterprises weakened or delayed. - Procurement reform of 2016 simplified procedures but implementation challenges and legal uncertainties lowered volumes. - Staff recommends broadening/completing public sector reform, addressing implementation challenges, and transparent monitoring of outcomes. --- ### 5. Outlook, Risks, and Policy Priorities ### Growth outlook and macro projections - Real GDP growth projections under current policies: - About 1.3 percent in 2017. - About 1 percent in 2018–19. - Growth drivers: - Mainly domestic demand; investment recovering moderately from historically low levels, aided by fiscal incentives. - Contribution of net exports expected to become positive by 2018 as global trade strengthens. - Core inflation expected to rise as output gap closes gradually; slower than key euro area partners due to lagging productivity. ### Market and sovereign developments - Credit rating and market indicators: - Sovereign rating downgraded by Fitch and DBRS by one notch to the “BBB” category. - 10-year sovereign yield doubled to about 2 percent from historic low of 1 percent in August 2016. - DBRS downgrade increased ECB collateral haircuts and bank funding costs. - Risks (tilted to downside): - Upside: stronger European recovery and better-than-anticipated policy effects. - Downside domestic: election uncertainties; setbacks to reform process; financial fragilities. - Policy interaction risks: monetary tightening without fiscal effort could raise debt sustainability and financial stability concerns. - External risks: uncertainty on U.S. policy shifts and Brexit negotiations. - If downside risks materialize, regional and global spillovers could be very significant given size of Italy’s economy and sovereign bond market. ### Policy priority package (staff advice) - Front-loaded, comprehensive reforms while monetary easing and cyclical recovery provide a favorable window: - Implement bolder structural reforms to raise productivity and competitiveness. - Clean up bank balance sheets faster with credible NPL reduction and restructuring. - Adopt growth-friendly fiscal consolidation consistent with multi-year plans: aim for overall deficit of 1.2 percent of GDP in 2018 and broadly balanced budget by 2019; thereafter, a small structural surplus of about ½ percent of GDP as insurance. - Emphasize permanent, growth-friendly fiscal measures: cut current primary spending, broaden tax base, lower gradually tax rates on productive factors, increase capital spending, better-target transfers to low-income groups, improve VAT collection, introduce modern real estate tax. - Ensure burden sharing in bank resolutions with protection for vulnerable retail bondholders and targeted social safety nets. - Accelerate insolvency and civil justice reforms to facilitate NPL resolution and collateral enforcement. - Strengthen competition policy and give primacy to firm-level wage bargaining complemented by a minimum wage possibly differentiated across regions. - Rationale: Combined measures can support near-term job creation, accelerate bank repair, put public debt on firm downward path, and yield notable output gains and competitiveness improvements in medium term. --- *Italic: IMF staff report excerpts (cr17237).* ### 1. Competitiveness and Wage Bargaining _______________________________________________________ 16 ### 1. Competitiveness and Wage Bargaining ### Context: Modest growth amid imbalances - Italy is in the third year of a moderate recovery supported by notable monetary and fiscal stimulus: - Fiscal relaxation has amounted to about 2 percent of GDP in structural primary terms since 2013. - Very favorable commodity terms of trade have been the equivalent of transfers of about 1½ percent of GDP since 2013. - Growth in 2015–16 averaged just 0.8 percent, below euro-area peers. - Binding constraints and structural weaknesses identified: - Impaired balance sheets and financial fragilities. - High unit labor costs. - High taxation. - Barriers to competition. - An inefficient public sector. - A large share of SMEs that have struggled to adapt to global technology and trade developments. - Public debt and banking sector vulnerabilities: - Public debt appears to be stabilizing at around 133 percent of GDP. - Nonperforming loans (NPLs) of banks remain high at about 21 percent of GDP. - Real disposable incomes and productivity: - Real disposable incomes per capita remain below pre-euro accession levels and have fallen behind other euro area countries. - On current projections, real incomes per capita are expected to return to pre-crisis (2007) levels only a decade from now. - Distributional impacts and labor market: - Unemployment is high at over 11 percent (11.1 percent in April 2017), down from a crisis peak of nearly 13 percent. - Youth unemployment is at about 35 percent. - The share of the population at risk of poverty has increased. - Emigration from Italy remains high, including for skilled workers. ### Urgent priorities and policy stance - Urgent priorities stated by IMF staff: - Raise productivity and growth. - Increase economic resilience. - Protect the vulnerable. - Political context: electoral calendar complicates policymaking; the government under Prime Minister Gentiloni maintained the prior policy agenda after Prime Minister Renzi's resignation in December 2016. ### Recent macroeconomic developments (growth, demand, labor, inflation) - Growth: - Growth reached 0.9 percent in 2016 and picked up in Q1 2017 to 1.2 percent (year-on-year). - Demand-side composition (Figure 3 context): - Consumption has been the main engine of growth, supported by low oil prices, higher wages and employment, bank credit, and fiscal stimulus. - Investment recovery has remained sluggish and uneven despite fiscal incentives. - Net exports remain a drag, as import growth outpaces export growth. - Labor market: - Employment and labor force participation rose by almost 1 p.p. each recently. - Regional unemployment variation in Q1: 7.1 percent in the North versus 20.4 percent in the South. - Wage growth has continued to exceed productivity, increasing unit labor costs. - Inflation and output gap: - Core inflation was 0.9 percent year-on-year in May 2017; headline inflation was 1.6 percent. - The output gap for 2016 is estimated at 2.7 percent of potential GDP. - Note: there is uncertainty around the output gap estimate; staff’s estimate for 2016 is similar to that of the Italian Ministry of Finance but larger than the EC’s estimate of about 1¾ percent. ### Financial sector: banks, NPLs, and credit - Banking system health: - Banks’ market capitalizations recovered substantially since November (year not specified in excerpt). - Recent actions dealt with three weak banks via precautionary recapitalization and restructuring of one bank and liquidation of two banks with state aid. - Credit conditions: - Adequate liquidity supported a modest expansion of credit to households. - Credit to the corporate sector was declining at −1.6 percent year-on-year in April 2017. - Corporate leverage fell by about 5 p.p. during 2011–16Q3; share of risky or vulnerable companies fell below 50 percent (source: Cerved). - Nonperforming loans: - Gross NPLs fell marginally from €360 billion (18.1 percent of gross loans) at end-2015 to €349 billion (17.3 percent) at end-2016. - Provisions for NPLs improved to over 50 percent. - Bad loans (sofferenze) remained high at about €203 billion (10.9 percent) in April 2017, despite bad loan sales of about €8 billion. - Several large sales—over €60 billion in total—are planned for the coming months. - GACS (government guarantees for NPL securitization) has been used in one transaction so far. - Profitability and capital: - Bank profitability was among the lowest in Europe in 2016—about 14 p.p. below the weighted average in a sample of large European banks compiled by the EBA, partly due to substantial write-downs. - Common equity tier 1 ratio stood at 10.4 percent in Q4 2016, about 3.7 p.p. below the EBA sample average. - Including a €13 billion capital increase by Unicredit in early 2017, the ratio would stand at about 11.6 percent. - The latest annual supervisory review resulted in additional capital requirements for a few banks. ### Fiscal developments and policy measures - Fiscal stance and outcomes: - The authorities achieved an overall deficit target of 2.4 percent of GDP in 2016, an improvement of about ¼ percent of GDP over the previous year. - Structural primary surplus deteriorated by about ½ percent of GDP when controlling for the economic cycle. - Public debt edged up to 132.6 percent of GDP at end-2016. - Privatization proceeds were less than 0.1 percent of GDP, below the planned 0.5 percent of GDP. - 2017 budget measures and fiscal direction: - Supplementary budget measures of 0.2 percent of GDP largely to tackle tax evasion. - Revised deficit target of 2.1 percent of GDP for 2017. - Measures in the 2017 budget: - Cuts corporate income tax rate from 27.5 percent to 24 percent. - Introduces a simpler tax (flat rate of 24 percent) for the self-employed. - Targets reduced social security contributions to certain new employees. - Repeals previously legislated increases in the VAT and other taxes. - Offers a range of incentives to boost investment. - Budget increases spending on pensioners and facilitates pathways to early retirement, partially reversing objectives of the 2011 pension reform. - An enabling law on inclusion income was legislated, amounting to about €2 billion (0.1 percent of GDP), to be partly implemented by regions. - Long-run spending pattern: - Current primary spending grew above potential GDP in the years following euro accession, reflecting principally social benefit (pension) spending, and remains above the euro area average. ### Competitiveness and external position - Competitiveness gap: - Efforts to narrow Italy’s competitiveness gap have not yet succeeded. - The real effective exchange rate (REER) is overvalued by close to 10 percent (Annex I). - In manufacturing, a gap in unit labor costs (ULCs) vis-à-vis Germany and the euro area of around 30 percent was built up pre-crisis and has been sustained since. - Price-based REER measures have returned to two-decade-ago levels but show an enduring gap of about 5–15 percent against Germany and the euro area. - Structural indicators point to low integration with global value chains. - External flows and TARGET2: - Italy’s recovery of real exports has lagged European peers. - Investment by non-financial corporations fell below 9 percent of GDP. - TARGET2 net liabilities rose to a record 25 percent of GDP at end-May 2017, mirroring balance-of-payments financial outflows even as Italy runs a current account surplus. - Financial outflows reflect increased Italian residents’ portfolio investments abroad and decreased foreign exposure to Italy’s private and public sectors. ### Key diagnostics and policy implications (drawn from text) - Diagnostics: - Persistent low productivity and high unit labor costs relative to productivity drive competitiveness losses. - High public debt and high NPLs create vulnerabilities as external tailwinds subside. - Weak investment recovery and lagging exports impede stronger growth. - Distributional effects and high youth unemployment threaten social cohesion and human capital retention. - Policy implications and priorities emphasized: - Press ahead with structural reforms to raise productivity and competitiveness. - Strengthen balance sheets (public and private) to reduce financial vulnerabilities. - Protect vulnerable households and improve safety net targeting. - Contain spending pressures from pension and public sector wage measures to preserve fiscal sustainability. - Encourage measures to boost integration with global value chains and investment by non-financial corporations. *Source: IMF staff report excerpt "1. Competitiveness and Wage Bargaining" (cr17237).* ### 10. Citing the weak growth outlook and insufficient ### 10. Citing the weak growth outlook and insufficient progress in fiscal consolidation and addressing banking sector weaknesses, Italy’s credit rating was downgraded recently. ### Outlook and Risks - Real GDP growth projections under current policies: - Real GDP growth is projected at about 1.3 percent this year. - Real GDP growth is projected at about 1 percent in 2018–19. - Growth drivers and dynamics: - Growth is driven mainly by domestic demand, with investment recovering moderately from historically low levels and benefiting somewhat from existing and new fiscal incentives. - The contribution of net exports is slated to become positive by 2018, mirroring the strengthening in global trade. - Core inflation should rise as the output gap closes gradually over the medium term, albeit slower than in key euro area partners, given lagging productivity and thus slower assumed wage increases to maintain competitiveness levels. - Relatively low nominal growth will imply a slower speed at which Italy can grow out of its imbalances, leaving it vulnerable to adverse shocks over a protracted period. - Market and sovereign developments: - Italy’s sovereign rating was downgraded by Fitch and DBRS by one notch to the “BBB” category. - DBRS’ downgrade resulted in an increase in the ECB’s collateral haircuts and in bank funding costs as it had previously been the only agency rating Italy as “A”. - Reflecting subdued market sentiment and increased uncertainty, the 10-year sovereign yield has doubled to about 2 percent from its historic low of 1 percent in August 2016. - Risks (significant and tilted to the downside): - Upside possibility: stronger European recovery and better-than-anticipated effects of monetary and fiscal easing could lift growth in the near term. - Downside domestic risks: uncertainties surrounding forthcoming general elections, possible setbacks to the reform process, and financial fragilities. - Policy interaction risks: monetary tightening, in the absence of fiscal effort, could raise debt sustainability and financial stability concerns. - External risks: uncertainty on the scope of U.S. policy shifts and Brexit negotiations. - If downside risks materialize, regional and global spillovers could be very significant, given the size of Italy’s economy and sovereign bond market and the prospect of renewed sovereign-bank strains. - The urgency of addressing Italy’s imbalances is amplified; further strengthening euro area policies and architecture would be helpful. ### Policy Discussions — Overview - Authorities' stance: - Authorities considered growth to be catching up to the rest of the euro area and are revising forecasts after a better-than-expected first quarter outcome. - They anticipate growth to exceed staff’s projections, including over the medium term, boosted not least by investment. - They view risks as notable, stemming largely from external factors but also from political uncertainty domestically. - They disagreed with staff’s change in external assessment relative to last year, pointing to a structural improvement in the external position and better growth outlook; they considered the REER to be in line with fundamentals. - Staff advice: - As monetary tightening approaches and while conditions remain favorable, staff argued for implementing bolder and comprehensive structural reforms, cleaning up bank balance sheets faster, and adopting a growth-friendly fiscal adjustment. - Staff simulations suggest front-loaded implementation of such a reform package can support the economy in the near term, put public debt on a firm downward trajectory, and achieve an overall gain in competitiveness of around 8 percent over the medium term. - Implementing reforms as a package is mutually reinforcing, enhancing the yield of individual efforts, raising growth, and facilitating adjustment. - Authorities’ commitment: - Authorities emphasized commitment to their current strategy and noted plans to implement further reforms in coming months should the current legislature reach its scheduled end in early 2018. ### Structural Reforms — Objectives and Recent Measures - Recent measures noted: - Jobs Act (addressing labor market duality among other objectives). - A framework law to modernize the public administration. - Measures to enhance efficiency of civil justice. - An education reform to improve school outcomes. - Institutional and political constraints: - Rejection of the December constitutional reform reduced the authorities’ ability to streamline legislative structures and transfer competencies from regions to the center. - New government focused on implementing already legislated reforms, addressing challenges raised by the constitutional court to some of them. - Staff recommendation: - Broaden and deepen reform efforts to create critical mass to address inter-related structural challenges. - Bolder reforms are needed to: open product and service markets; modernize the wage bargaining framework to align wages with productivity at the firm level; implement additional measures to support labor market functioning; broaden public administration reform; and strengthen civil justice performance. ### Liberalizing Product and Service Markets - Remaining impediments: - Regulatory impediments and barriers to competition remain significant in some sectors: network industries (e.g., transport), professional services, retail and local public services, and distribution of permits. - Despite a requirement to legislate annually a competition law since 2009, none has yet been approved. - Draft competition law status: - Authorities have progressed on a draft law that has been in parliament for over two years. - The draft retains pro-competition measures in sectors such as communication and energy but has been weakened in areas including insurance, professional services, and fuel distribution, and introduces new restrictions in tourism. - Removal of restrictive legislation on the energy sector is delayed further to mid-2019. - Staff recommendations: - The draft should be strengthened in line with the recommendations of the Competition Authority and approved expeditiously. - An annual process of legislating pro-competition laws and enhancing the authority to sanction anti-competitive practices is essential. ### Reforming Wage Bargaining - Current system and effects: - Current sectoral wage bargaining has resulted in persistent wage growth above productivity, binding national wage limits, and compressed wage distribution across regions and firms despite productivity differentials. - Wage-setting institutions contribute to large regional disparities in unemployment and lagging competitiveness. - Staff-preferred approach: - Decentralize wage bargaining to the firm level, complemented with a minimum wage that could be differentiated across regions. - Within the prevailing institutional setup, giving primacy to firm-level contracts and clearly defining principles for stakeholder representation is likely required. - Quantified impacts (illustrative simulations and model results): - Illustrative simulations point to the potential for almost 5 percent higher employment and 2½ percent improvement in competitiveness indicators in the medium term (Selected Issues Part 1 and Box 1). - Box 1 model results: a search-and-match DSGE model parameterized to Italy predicts a reduction in the steady-state unemployment rate by 3.5 p.p., translating into an almost 4 percent increase in employment; within the IMF’s GIMF, this is equivalent to a competitiveness gain in the medium term of around 2½ percent. - When combined with other structural reforms (product market, other labor market, public administration reforms—for an illustrative medium-term competitiveness gain of 1½ percent), banking sector cleanup (about 1½ percent), and fiscal reforms (around 2½ percent), Italy can achieve an overall competitiveness improvement of around 8 percent over the medium term. ### Advancing Other Supportive Labor Market Reforms - Recommendations and measures: - To address high gender employment gap: lower the labor tax wedge on secondary earners and increase supply of childcare. - Scale up spending on active labor market policies (ALMPs): Italy spends among the lowest in the euro area on ALMPs. - Enhance delivery of ALMPs: a new agency to coordinate ALMPs and the new system of unemployment benefits across regions was set up, but coordination and enforcement vis-à-vis local authorities remains limited; consideration could be given to delivering ALMPs alongside passive labor market policies through the social security agency. - Consider extending the new single open-ended contract of the Jobs Act to all existing open-ended work arrangements in the private sector and reducing compensation for dismissals as the economy strengthens. - Dismissal compensation specifics: - Compensation for dismissals: two monthly wages per year of service with a minimum of 4 and a maximum of 24 (at 12 years of service), compared with the OECD average of 14 monthly wages at 20 years of service. ### Reforming Public Administration - Performance and challenges: - Italy’s public sector quality ranks among the lowest in Europe across multiple metrics (World Bank governance indicators, World Economic Forum indicators, EC Eurobarometer, European Quality of Government Index). - Issues: high average age of civil servants, skills mismatches, low use of electronic technology, notable perceptions of corruption. - Public sector inefficiencies and pushback from local vested interests hinder productivity and the materialization of gains from reforms, especially where central policy design is delegated to regions. - Reforms adopted and implementation status: - Enabling reform of the public administration adopted in 2015 to simplify procedures, streamline decision making, rationalize local public enterprises, and improve recruitment/management of staff. - Several implementing decrees have been issued, but key actions have effectively stalled after a Constitutional Court ruling in November 2016 mandating close coordination and agreement with local governments on several issues (public employment, disciplinary dismissals, state owned enterprises, local public services). - No progress in reorganizing public sector management and regulating local public services (except transport). - Rationalizing of more than 9,000 public enterprises has been weakened or delayed; many are shielded from competition, receive service contracts without open tender, and more than one-third operate with losses despite substantial state transfers. - Procurement reform of 2016 simplifies procedures and lowers administrative burden but has been hampered by implementation challenges and legal uncertainties, resulting in lowered volumes. - Staff recommendation: - Broadening and completing public sector reform, addressing implementation challenges, and transparent and detailed monitoring of outcomes to facilitate assessment and accountability. ### Box 1 — Competitiveness and Wage Bargaining (Key Points) - Historic ULC (unit labor cost) gap with Germany: - The ULC gap grew rapidly prior to the crisis and has since stabilized but not meaningfully reversed. - Around 45 percent of the widening ULC gap in the manufacturing sector over the past two decades is attributable to hourly wages, with the rest largely due to lagging productivity. - Adjustment has occurred in quantities—cuts in labor and investment—rather than by reducing relative wages and prices. - Institutional constraints: - Wage-setting institutions impose strong rigidities: sector-level bargaining extended nationally, with second-tier (firm-level) bargaining subordinated to national contracts. - Only 12 percent of companies show interest in derogative options provided by the 2011 law owing to prevailing legal uncertainty. - Resistance by unions to firm-level bargaining is strong; level of cooperation in labor-employer relations is the lowest in the euro area. - Quantified gains from decentralization: - Moving from sector- to firm-level bargaining can reduce steady-state unemployment by 3.5 p.p. and increase employment by almost 4 percent (DSGE model by Jimeno and Thomas (2013) parameterized to Italy). - In GIMF terms, this is equivalent to a competitiveness gain of around 2½ percent. - Combined with other reforms (product market, labor market, public administration: illustrative 1½ percent), banking sector cleanup (about 1½ percent), and fiscal reforms (around 2½ percent), the overall competitiveness improvement could be around 8 percent over the medium term. ### Financial Stability - Opening note: - The assessment of financial stability concerns is emphasized throughout the document as a core reason for urgency in reforms; specific financial stability recommendations and diagnostics follow in the subsequent section. *International Monetary Fund staff report excerpt* ### 25. Against the backdrop of high NPLs and weak profitability, the authorities have been ### Against the backdrop of high NPLs and weak profitability, the authorities have been taking actions to stabilize the banking sector. ### Actions to stabilize the banking sector - Dealing with weak banks: - Three banks failed to raise sufficient capital after poor performance in the 2016 EBA and ECB stress tests; each bank has undergone multiple recapitalizations in recent years. - Two banks were rescued early last year by Atlante, which invested about €3.5 billion. - Authorities established a backstop of €20 billion (1¼ percent of GDP) to finance rescue or liquidation and to guarantee up to €150 billion of bank liquidity; banks tapped about €20 billion in government-guaranteed bank bonds. - Precautionary recapitalization agreement reached for one bank (accounting for about 5 percent of total system assets) with state aid up to €5.4 billion, including restructuring and disposal of its bad loan portfolio. - Two other banks (accounting for about 2 percent of total assets) were deemed failing or likely to fail and will be liquidated under Italian insolvency legislation (not subject to BRRD bail-in). European Commission approved state aid of €4.8 billion, with guarantees of up to €12 billion, to avoid regional economic disruptions. - Both operations would add to public debt. - Consolidating banks: - Eight of the ten largest popolari banks converted to joint-stock companies by end-2016; court challenges stalled the conversion of the remaining two. - Two large popolari banks merged to create the third-largest banking group in Italy. - Smaller cooperative banks are required to consolidate under joint-stock (holding) companies with at least €1 billion in equity by May 2018. - Three new banking groups are expected to emerge from consolidation of more than 300 cooperative banks by end 2018; two will fall under direct ECB/SSM supervision and be subject to an asset quality review. - Authorities allocated €500 million over the next three years to help banks’ downsizing via early retirement assistance. - Tackling NPLs: - Supervisory oversight: - SSM issued guidance to significant institutions for strategies to tackle high NPLs; such banks need to agree with the SSM on ambitious NPL reduction targets in the coming months (sanctions not envisaged for missing targets). - Bank of Italy is drafting streamlined NPL guidance for smaller banks and launched a survey requiring detailed reporting on bad loans, collateral, and recovery procedures. - Insolvency, debt enforcement, and civil justice: - Overhaul announced early in 2016 to replace the 1942 insolvency law has not materialized. - Limited progress reducing backlog and length of commercial and civil litigation (European Justice Scoreboard, 2017). - Average time in 2016 for enforcement of real estate collateral was 4.25 years and for insolvency cases 7.5 years (Consiglio Superiore della Magistratura and Ministry of Justice). - “Program Strasbourg 2” has not bridged regional duration gaps, which remain up to six times between best and worst performers. - Authorities aim for a unified comprehensive reform to rationalize insolvency framework, increase restructuring options, address procedural inefficiencies and excessive creditor priorities, and adopt rules for insolvency of enterprise groups and consumers. ### Key assessment of progress and urgency - Repair of the banking system is proceeding very slowly, permitting vulnerabilities to linger and hindering monetary transmission. - Much of the banking system has profitability persistently below the cost of equity (staff calculations; Box 2). - Cyclical recovery alone is unlikely to restore large parts of the sector to healthy profitability given projected modest growth. - Timely steps are needed as part of a comprehensive and proactive strategy to: - Swiftly tackle challenges in problem banks in a cost-effective manner. - Cut costs through strong restructuring plans. - Ensure banks lower NPLs credibly and decisively over the medium term. - Improve governance so banks can fully support the economic recovery. ### Resolution and burden sharing (findings and implications) - Effective resolution: - Timely and cost-effective solutions to problem banks have proven difficult, adding costs to the budget and financial system. - Protracted processes reflect domestic reluctance to resolve banks and apply bail-in, need to clarify new resolution framework, and coordination challenges across authorities. - Example: two banks being liquidated imposed notable taxpayer costs—government-guaranteed bank bonds that replaced fleeing private investors, and state aid in liquidation (about €5 billion in cash support and up to €12 billion in guarantees, for a total of up to 1 percent of GDP). - Investments via the Atlante fund are being wiped out months after encouragement to invest. - For problem banks, swift recapitalization or timely and effective use of resolution framework is essential to avoid lingering weaknesses and costs. - Burden sharing: - Bank of Italy reports vast majority of non-equity instruments eligible for bail-in (over 86 percent by value) are held by the wealthiest 10 percent (Financial Stability Report 1/2016). - Italian households have among the highest ratios of net wealth internationally. - Bail-in should be considered from efficiency and equity perspectives and to break sovereign-bank links and minimize budget costs. - Well-targeted social safety nets should assist vulnerable households. - Cases of mis-selling should be addressed ex-ante by regulators, supervisors, and banks. ### Restructuring and efficiency (recommendations) - Rationalization: - Other banks could benefit from recognizing losses, raising capital, and rationalizing operations, following the example of Italy’s largest bank. - Intensive and assertive supervisory challenge would promote realistic business modeling to recognize and then streamline, divest, or wind down capital-destructive business lines. - Banks’ industrial and formal restructuring plans should face similar supervisory challenge to ensure realism and durability. - Consolidation: - Consolidation can increase efficiency but must be accompanied by proactive supervision. - Supervisors should rigorously ensure the three emerging banking groups start with a clean bill of health and long-term profitability: - Undertake an asset quality review of all emerging groups. - Ensure robust governance and risk management structures. - Follow up on issues in remaining smaller banks. - Each bank should set ambitious and credible targets for risk management and branch/staff rationalization, with viability assessments to ensure sufficient income-generating capacity to build capital through retained earnings, even in a downside scenario. ### Lowering NPLs (recommendations and considerations) - Supervisory oversight: - Supervisor must ensure NPL reduction strategies and targets are ambitious and credible by assessing banks’ capacity to resolve NPLs using internal tools and resources. - Engage independent NPL management experts; require banks with weak internal capacity to engage specialist collection and workout firms, sell NPLs in the open market, and/or enter joint ventures with specialized distressed asset managers. - Loan loss buffers: - Market participants argue Italian banks need substantial additional reserves to tackle NPLs. - Several banks have booked heavy provisions to effect NPL portfolio sales; supervisors should review internal workout capacity and provide feedback on provisioning and loan restructuring practices. - Insolvency, debt enforcement, and out-of-court restructuring: - Authorities’ timeframe for adopting comprehensive insolvency reforms is not commensurate with urgency to address the stock of NPLs. - Proposed reforms should be adopted promptly while maintaining ambitious goals for corporate debt restructuring rationalization and special procedures for large enterprises. - Implementation requires improving court functioning, qualifying insolvency administrators, and developing registries and platforms for collateral sales. - Reform of civil procedures needs acceleration to simplify processes, facilitate collateral sales, and incentivize courts to reduce backlogs. - Consistent implementation across Italy requires uniform practices and attention to resource allocation. - Reforms should be complemented with more intensive use of out-of-court restructuring. - Estimates of capital needs to address NPLs (literature): - Simple back-of-the-envelope calculations based on pricing gaps suggest a range of 2–3 percent of GDP. - More rigorous methodologies suggest 6–8 percent of GDP. ### Improving governance - Close legislative gaps in Italy’s implementation of EU fit and proper rules for bank management (CRD-IV). - When implemented, apply 2015 EBA and 2016 ECB guidance relating to fit and proper assessments in full. ### Authorities’ perspective and recent developments - Authorities noted progress in safeguarding financial stability and broad agreement on need for timely solutions to problem banks; they acknowledged the process for the three problem banks had been protracted. - In the liquidation case of two banks, authorities noted swift weekend decisions within state aid framework once banks were deemed failing or likely to fail. - Italian authorities argued that, having found a solution for the three banks, tail risks in the banking sector have largely been addressed. - Authorities claimed costs to taxpayers were limited through burden sharing involving shareholders and subordinated debt holders; state aid in liquidation avoided notable economic and financial costs, including on the deposit guarantee scheme. - They expressed optimism that the liquidation vehicle will further reduce taxpayer costs by enhancing value recovered from NPLs through a patient approach. - Authorities viewed bail-in as exacerbating systemic risk until MREL is fully met and see the 2018 BRRD review as an opportunity to assess and improve effectiveness. - On NPL guidance, authorities consider planned measures to improve banks’ NPL focus and pointed to aggressive NPL sales plans in several banks, but cautioned that NPL overhang risk is generally overstated given provisioning, collateral and guarantees, and warned against too rapid reductions that could cause fire sales and destroy value. - Authorities argued credit to sound firms is not hampered by high NPLs. - Regarding consolidation of small cooperative banks, authorities considered it sufficient to apply an asset quality review to the two largest groups, citing their small share of the sector. *International Monetary Fund. From IMF country report text.* ### Box 2. Bank Consolidation and Efficiency ### Box 2. Bank Consolidation and Efficiency ### Banking system structure and health - Italy had 575 domestic credit institutions in 2015. - Market concentration is lower than in most other euro area countries: the market share of the largest 5 credit institutions was 41 percent, compared to an EU unweighted average of 63 percent in 2015. - The system is fragmented and in varying states of health; parts of the system—both large and small banks—are lagging on profitability and many are suffering from high NPLs. ### Profitability, efficiency, and balance-sheet impediments - Bottom-up analysis of 386 Italian banks indicates: - Profitability improves as the economy recovers, but operational efficiency gains are needed to restore large parts of the banking system to healthy profitability. - Even if all banks achieve cost-to-income ratios in line with the EU median, significant parts of the banking sector are still projected to be challenged or weak. - This implies that other factors dragging down profitability—such as the high stock of legacy NPLs—also need to be addressed. ### Consolidation as a pathway to efficiency gains - Bank consolidation can facilitate efficiency gains. - Cross-country experience suggests efficiency gains from consolidation are more likely when decisive actions accompany consolidation, specifically: - Improving governance (including addressing ownership structure issues). - Tackling entrenched vested interests opposed to rationalization. - Strengthening supervisory oversight and taking prompt corrective action when needed. - Addressing structural rigidities that could limit efficiency gains. ### Cross-border M&A, policy role, and Italy-specific notes - Literature and experience highlight that cross-border M&As are often more efficiency enhancing than domestic M&As. - There is a role for policies at the EU level to facilitate an equal playing field for cross-border M&As. - Cross-border M&As remain very rare in Italy. - Significant consolidation is planned in Italy, but realization of efficiency gains will depend on implementing the governance, supervisory, and rigidities-related measures above. *Source: Box 2. Bank Consolidation and Efficiency, cr17237 - Box 2. Bank Consolidation and Efficiency* ### 36. The current backdrop of cyclical recovery and exceptional monetary easing provides a ### 36. The current backdrop of cyclical recovery and exceptional monetary easing provides a ### Overview - The cyclical recovery and exceptional monetary easing create a favorable, if narrowing, window to press forward urgently with reforms and adjustment. - Front-loaded implementation of a comprehensive and more ambitious program, alongside a credible and growth-friendly fiscal consolidation, can: - support the economy and job creation in the near term, - create room for measures to accelerate bank repair, - put public debt on a firm downward path. - In the medium term, such actions would yield notable output gains and narrow significantly competitiveness gaps. ### Structural reforms to boost growth - Authorities’ existing efforts include: - the Jobs Act, - decrees to modernize the public administration, - measures to accelerate insolvency and debt enforcement procedures as well as civil justice, - an education reform to improve school outcomes. - These measures should be implemented fully and backtracking or weakening resisted firmly. - Further reforms needed: - enhance competition in product and service markets, - align wages with productivity at the firm level, - broaden public sector reform. - Specific recommendations: - Strengthen and approve expeditiously the draft annual competition law, and adhere to the requirement of legislating annual pro-competition laws. - Enhance the wage bargaining system by giving clear primacy to firm-level contracts and introducing a minimum wage, possibly differentiated across regions. - Broaden public sector reform by regulating local public services, rationalizing state-owned enterprises, improving the skill mix of employees, tackling corruption, and widening the scope of procurement reform. ### Accelerating bank balance sheet repair - Progress underway includes actions to strengthen capital buffers of some large banks, plans for sizable NPL sales, and bank consolidation. - These should be complemented with additional measures to materially tackle NPLs and enhance banks’ operational efficiency. - Key principles and actions: - Take prompt actions to address problems in banks with appropriate burden sharing involving banks’ shareholders and creditors, and protection as needed for the most vulnerable retail bondholders. - Ensure measures minimize costs to taxpayers, recognizing Italy’s limited fiscal space. - Banks’ NPL reduction strategies and targets must be ambitious and credible, aided by supervisory assessments of banks’ capacity to resolve NPLs in a timely manner. - Supervisors should ensure banks have realistic and coherent business model assumptions so that capital destructive practices are streamlined, divested, or closed. - Undertake an asset quality review of all emerging consolidated groups and ensure robust governance and risk management structures. - Close legislative gaps in Italy’s implementation of the EU fit and proper rules for bank management. ### Fiscal consolidation: trajectory and rationale - Rationale: - High public debt leaves Italy exposed to shocks, with little room to respond and at risk of a sharp, pro-cyclical correction. - Recommended fiscal path: - A gradual adjustment, as announced in the authorities’ multi-year budget plans in April and aiming to achieve an overall deficit of 1.2 percent of GDP in 2018 and a broadly balanced budget by 2019, is appropriate to ensure debt is on a firmly declining trajectory. - Thereafter, a small structural surplus of about ½ percent of GDP would provide valuable insurance for a declining debt path against shocks. ### Priorities for growth-friendly fiscal consolidation - Emphasize permanent, growth-friendly measures including: - cutting current primary spending, - broadening the tax base, - lowering gradually tax rates on productive factors. - Specific fiscal measures: - Reduce high pension spending over the medium term to address persistent fiscal pressures before very long-run pension reform savings materialize. - Increase capital spending. - Increase transfers to those with low incomes through better targeting and rationalizing social protection programs. - Improve VAT collection and emphasize enforcement of taxes. - Introduce a modern real estate tax. *IMF Country Report excerpt.* ### 41. It is recommended that the next Article IV consultation be held in the usual ### 41. It is recommended that the next Article IV consultation be held in the usual ### High-Frequency and Real Economy Developments - A modest recovery continues, driven mainly by consumption. - Real GDP (annual rate shown in figures): recent annual growth rates depicted (no new numeric summary beyond charts provided). - Contribution to GDP growth components shown: Private consumption, Public consumption, Foreign balance, Investment. - Industrial production and retail sales remain quite muted (indices reported with 2010=100 baseline in charts). - Unemployment has declined but remains very high; unemployment rate series by region shown in chart. - Headline inflation recently picked up but core inflation remains subdued; HICP inflation (Headline and Core) series shown. - Confidence indicators: PMI manufacturing output, Business confidence, Consumer confidence remain relatively strong in chart series. ### Financial Sector Developments - Italy continues to lag behind other EU countries despite capital increases by some significant banks. - Nonperforming loans (NPLs) fell marginally in 2016, while the coverage ratio improved (chart: NPLs and Coverage Ratio in billions of euros). - The banking system as a whole has adequate liquidity and collateral; net liquidity position and ECB liquidity support series shown. - As the stock of bank bonds reduces, deposits and ECB support have increased (ECB Liquidity Support and Bank Financing chart, Billions of euros). - Bank equity prices have recently started to recover, in line with developments elsewhere (Price to Book Value Ratios of Banks chart). - CDS spreads signaling default risks continue to diverge from other countries (European Banks' CDS Spreads in basis points). - CET1 (Fully Loaded) by country shown for 2016Q4 with EU average noted; Italy's CET1 level appears below many peers in chart. - Key textual recommendations for banking sector: - Supervisors should set ambitious targets for reducing the stock of impaired assets in identified banks. - Fast-track insolvency procedures to reduce the large stock of nonperforming loans, encourage bank consolidation and better governance to improve profitability, and resolve weak banks in a timely manner. - Repair bank and corporate balance sheets to enhance monetary transmission. - Faster progress on banking union—clarify backstops. ### Fiscal Developments and Issues - There has been a sizable fiscal relaxation in recent years (charts show expenditures and deficits). - While interest expense has declined, the fiscal burden has been reduced only modestly. - Social benefits continue to increase as a share of GDP (Expenditures by Category: Social benefits, Wage bill, Public investment, Other primary spending; series for 2001, 2007, 2016). - Bond redemptions coming due over the next 12 months are notable (Central Government Bond Operations, Upcoming Redemptions chart, Billions of euros). - Government bond yields have risen since mid-2016, but still remain low (Government Bond Yields; 1-year and 10-year yields; 10-year spread over Bunds in basis points). - Tax wedge on low-wage earners, 2015: Italy shown among highest in chart comparing countries. - Fiscal indicators from tables (selected): - General government gross debt: 131.8 (2014), 132.1 (2015), 132.6 (2016), 133.0 (2017), 131.6 (2018), 129.0 (2019), 126.0 (2020), 123.1 (2021), 120.3 (2022) (Percent of GDP). - General government net lending/borrowing: -3.0 (2014), -2.7 (2015), -2.4 (2016), -2.2 (2017), -1.3 (2018), -0.3 (2019), -0.1 (2020), 0.0 (2021), 0.0 (2022) (Percent of GDP). - General government primary balance: 1.4 (2014), 1.3 (2015), 1.4 (2016), 1.4 (2017), 2.3 (2018), 3.3 (2019), 3.6 (2020), 3.7 (2021), 3.7 (2022) (Percent of GDP). - Interest expense (% of GDP) series shown in Table 1. - Policy implication: Observe structural fiscal targets to boost credibility; run higher fiscal surpluses to reduce public debt; let automatic stabilizers work to support growth. ### External Developments - Current account and trade: - Current account balance (Percent of GDP): 1.9 (2014), 1.4 (2015), 2.6 (2016), 1.9 (2017), 1.6 (2018), 1.4 (2019), 1.2 (2020), 0.9 (2021), 0.5 (2022). - Trade balance (Percent of GDP): 2.8 (2014), 3.0 (2015), 3.6 (2016), 3.1 (2017), 2.9 (2018), 2.8 (2019), 2.6 (2020), 2.4 (2021), 2.1 (2022). - Exports (Billions of euros): 389.5 (2014), 405.4 (2015), 410.4 (2016), 429.8 (2017), 451.5 (2018), 473.4 (2019), 495.8 (2020), 519.3 (2021), 544.0 (2022). - Imports (Billions of euros): 429.0 (2014), 446.0 (2015), 444.8 (2016), 478.5 (2017), 509.1 (2018), 537.7 (2019), 568.2 (2020), 602.5 (2021), 639.2 (2022). - TARGET2 net liabilities have rapidly risen to a record level of 25 percent of GDP (text and chart). - Italy REER (HICP- and ULC-deflated) series shown; ULC-gap vis-a-vis Germany remains very large. - Financial account flows and composition presented (Billions of euros and percent of GDP) across 2011–17 with projections to 2022 in Table 3. - Gross external debt (Billions of euros): 124.3 (2014), 126.0 (2015), 125.7 (2016), 124.6 (2017), 122.5 (2018), 119.6 (2019), 116.5 (2020), 114.5 (2021), 112.7 (2022). - Public sector share of gross external debt (Billions of euros): 63.8 (2014), 66.6 (2015), 69.8 (2016), 68.5 (2017), 66.3 (2018), 63.3 (2019), 60.2 (2020), 58.3 (2021), 56.5 (2022). - Private sector share: 60.5 (2014), 59.4 (2015), 55.9 (2016), 56.1 (2017), 56.2 (2018), 56.3 (2019), 56.2 (2020), 56.2 (2021), 56.2 (2022). - Assessment: TARGET2 liabilities and residents' net purchases of foreign assets have driven large increases in net liabilities; real exports have not led the recovery; a growing trade surplus has supported the improved current account. - Policy responses suggested: - Strong implementation of structural reforms to improve competitiveness and boost potential growth. - Progress in fiscal consolidation to narrow the external gap and maintain investor confidence. ### Risk Assessment Matrix (RAM) — Key Risks, Impacts, and Policy Responses - Major identified vulnerabilities: - Fiscal: High public debt and gross financing needs. - Banks: High NPLs and sovereign exposure; low profitability. - Real economy: Large corporate debt overhang; chronically weak productivity; cumbersome business environment. - Trigger events and impacts: - Investors reassessing policy fundamentals, term premia decompression, or more rapid Fed normalization could put lower-rated sovereigns under pressure—higher financing costs and concerns over fiscal sustainability could push Italy into a bad equilibrium. - Strained bank balance sheets amid weak profitability could lead to financial distress in one or more major banks—tighter financial conditions, weakened bank solvency, potential loss of market confidence, widening sovereign yields, and an inability to support recovery. - Political fragmentation and uncertainty surrounding forthcoming general elections could lead to rising financial stress. - Global risks: slowdown in China and other large EMs, protectionism, regional security dislocations, and post-Brexit negotiation uncertainty could harm confidence and private investment. - Policy responses listed in RAM: - Observe structural fiscal targets to boost credibility. - Activate OMT if needed. - Supervisors to set ambitious targets for reducing impaired assets. - Fast-track insolvency procedures, encourage bank consolidation and governance improvements, and resolve weak banks timely. - Faster progress on banking union—clarify backstops. - Implement and deepen structural reforms to spur investment, productivity, and competitiveness; repair bank and corporate balance sheets; run higher fiscal surpluses. ### Summary of Economic Indicators and Projections (Selected Table 1 Highlights) - Real GDP (annual percent change): 0.1 (2014), 0.8 (2015), 0.9 (2016), 1.3 (2017), 1.0 (2018), 0.9 (2019), 1.0 (2020), 0.9 (2021), 0.8 (2022). - Output gap (percent of potential): -4.1 (2014), -3.3 (2015), -2.7 (2016), -1.7 (2017), -1.2 (2018), -0.8 (2019), -0.4 (2020), -0.1 (2021), 0.0 (2022). - Unemployment rate (percent): 12.6 (2014), 11.9 (2015), 11.7 (2016), 11.4 (2017), 11.0 (2018), 10.6 (2019), 10.3 (2020), 10.0 (2021), 9.7 (2022). - Consumer prices (percent): 0.2 (2014), 0.1 (2015), -0.1 (2016), 1.4 (2017), 1.2 (2018), 1.4 (2019), 1.4 (2020), 1.4 (2021), 1.4 (2022). - Savings (percent of GDP): 18.9 (2014), 18.8 (2015), 19.6 (2016), 19.0 (2017), 19.2 (2018), 19.3 (2019), 19.3 (2020), 19.2 (2021), 19.3 (2022). - Investment (percent of GDP): 17.0 (2014), 17.3 (2015), 17.0 (2016), 17.2 (2017), 17.6 (2018), 17.9 (2019), 18.1 (2020), 18.4 (2021), 18.7 (2022). ### Statement of Operations — General Government (Selected Table 2 Figures) - Revenue (Billions of euros): 721.8 (2009), 732.4 (2010), 747.8 (2011), 771.7 (2012), 772.6 (2013), 776.7 (2014), 785.9 (2015), 789.0 (2016), 796.4 (2017), 808.7 (2018). - Expenditure (Billions of euros): 804.7 (2009), 800.5 (2010), 808.6 (2011), 818.9 (2012), 819.1 (2013), 825.5 (2014), 830.1 (2015), 829.7 (2016), 834.5 (2017), 851.2 (2018). - Net lending/borrowing (Billions of euros): -82.9 (2009), -68.1 (2010), -60.8 (2011), -47.2 (2012), -46.5 (2013), -48.8 (2014), -44.3 (2015), -40.7 (2016), -38.2 (2017), -23.4 (2018). - Net lending/borrowing (Percent of GDP): -5.3 (2009), -4.2 (2010), -3.7 (2011), -2.9 (2012), -2.9 (2013), -3.0 (2014), -2.7 (2015), -2.4 (2016), -2.2 (2017), -1.3 (2018). - Memorandum item: General government gross debt (Percent of GDP): 112.5 (2009), 115.4 (2010), 116.5 (2011), 123.4 (2012), 129.0 (2013), 131.8 (2014), 132.1 (2015), 132.6 (2016), 133.0 (2017), 131.6 (2018). ### Balance of Payments (Selected Table 3 Figures) - Current account balance (Billions of euros): 30.5 (2014), 23.7 (2015), 42.8 (2016), 31.5 (2017), 27.3 (2018), 25.2 (2019), 21.9 (2020), 16.1 (2021), 10.2 (2022). - Financial account (Billions of euros): 43.8 (2014), 27.4 (2015), 63.9 (2016), 33.2 (2017), 29.0 (2018), 27.0 (2019), 23.7 (2020), 17.9 (2021), 12.1 (2022). - Portfolio investment (Billions of euros): -3.6 (2014), 89.5 (2015), 153.9 (2016), 35.8 (2017), 28.5 (2018), 41.9 (2019), 35.8 (2020), 40.2 (2021), 28.9 (2022). - Gross external debt (Billions of euros): 124.3 (2014), 126.0 (2015), 125.7 (2016), 124.6 (2017), 122.5 (2018), 119.6 (2019), 116.5 (2020), 114.5 (2021), 112.7 (2022). ### Financial Soundness Indicators (Selected Table 4 Figures) - Regulatory capital to risk-weighted assets: 12.7 (2011), 13.4 (2012), 13.7 (2013), 14.3 (2014), 14.8 (2015), 15.0 (2016) (Percent). - Nonperforming loans to total gross loans: 11.7 (2011), 13.7 (2012), 16.5 (2013), 18.0 (2014), 18.1 (2015), 17.5 (2016) (Percent). - Nonperforming loans net of provisions to capital: 64.6 (2011), 79.7 (2012), 89.9 (2013), 93.4 (2014), 89.0 (2015), 84.3 (2016) (Percent). - Return on assets: -0.9 (2011), -0.1 (2012), -0.8 (2013), -0.2 (2014), 0.3 (2015), 0.1 (2016) (Percent). - Customer deposits to total (noninterbank) loans: 58.2 (2011), 67.9 (2012), 70.5 (2013), 70.6 (2014), 75.2 (2015), 77.7 (2016) (Percent). - Foreign-currency-denominated liabilities to total liabilities: 30.7 (2011), 27.8 (2012), 28.7 (2013), 32.0 (2014), 34.4 (2015), 39.1 (2016) (Percent). ### External Position Assessment (Narrative) - Background: Italy’s NIIP deteriorated from -6 percent of GDP at end-2000 to about -25 percent of GDP in 2013, recovering to around -15 percent of GDP by end-2016. Gross assets and liabilities reached 149 and 164 percent of GDP respectively. - TARGET2 liabilities rose from about 15 to 25 percent of GDP between end-2015 and May 2017, reflecting residents' net purchases of foreign assets and Eurosystem asset purchase program liquidity creation. - External debt composition: about ¾ of gross external liabilities; half is owed by the public sector, underscoring vulnerabilities related to high government debt. - Assessment: The external position in 2016 was in the upper range of moderately weaker than suggested by medium-term fundamentals and desirable policy settings. - Policy recommendations: - Strong implementation of structural reforms, including improving wage bargaining mechanisms to better align wages with productivity at the firm level. - Strengthen bank balance sheets. - Progress in fiscal consolidation to help narrow the external gap and maintain investor confidence. - Combined measures to support growth and employment over the medium term. *Italic: Sources: ISTAT; Bloomberg Finance L.P.; IMF staff estimates; Bank of Italy; S&P Global Market Intelligence; ECB; European Banking Authority; Eurostat; Haver; National Authorities.* ### 2.5 percent of GDP below the EBA norm implied by medium-term fundamentals and desirable ### 2.5 percent of GDP below the EBA norm implied by medium-term fundamentals and desirable policy settings. Demographics is the largest contributor to the CA norm of 4 percent of GDP and its increase by about one percentage point relative to 2015 (reflecting faster-than-previously-expected population aging). Given these estimates and the need for stronger growth to reduce public debt and unemployment over the medium term, while improving the external balance sheet, staff assesses a CA gap of about -3 to -1 percent of GDP for 2016. ### Current account norm and gap - Staff assesses the current account (CA) norm at 3.5 percent of GDP.1/ - Demographics is the largest contributor to the CA norm of 4 percent of GDP and its increase by about one percentage point relative to 2015. - Staff assesses a CA gap of about -3 to -1 percent of GDP for 2016. ### Real exchange rate (REER) - Background: - The CPI-based REER appreciated by about 1 percent from 2015 to 2016. - The ULC-based REER appreciated by about 0.4 percent from 2015 to 2016. - Since joining the Euro area, the REER appreciated in absolute terms and relative to the euro area average by about 0 to 10 percent using price-based REER indices. - As of May 2017, the REER is unchanged relative to 2016 average. - Assessment: - EBA regression methods suggest REER gaps in 2016 of: - –3.1 percent (EBA Level REER model) - -0.2 percent (EBA Index REER model) - The CA regression method implies an overvaluation of about 10 percent. - Staff assesses an REER gap of 6–12 percent. - ULC-based indicators point to sizable and persistent wage-productivity differentials vis-à-vis key trading partners, contributing to slower recovery of real exports and investment. ### Capital and financial accounts; FX intervention and reserves - Capital and financial accounts: flows and policy measures - Background: - Portfolio and other-investment inflows typically financed past current account deficits despite a modest net FDI outflow. - Italy’s financial account posted net outflows of about 3 percent of GDP in 2016, largely reflecting residents’ net purchases of foreign assets. - Assessment: - Italy remains vulnerable to market volatility owing to large refinancing needs of the sovereign and banking sectors and potentially tight credit conditions from the high stock of NPLs in the banking sector. - Support provided by exceptional ECB monetary accommodation. - FX intervention and reserves level - Background: The euro has the status of a global reserve currency. - Assessment: Reserves held by the euro area are typically low relative to standard metrics, but the currency is free floating. ### Debt Sustainability Analysis — overview - Italy’s public debt is very high at about 133 percent of GDP and subject to notable risks. - Debt trajectory summary: - Debt increased from about 100 percent of GDP in 2007 to 132.6 percent of GDP in 2016. - Debt is projected to remain around 133 percent of GDP in 2017 before starting to decline in 2018 and reach about 120 percent of GDP in 2022, conditional on assumptions below. - Gross financing and debt structure: - Gross financing needs: sizable, with rollover needs of 14–17 percent of GDP. - About two-thirds of debt is held by domestic investors. - Average maturity: around 6¾ years. - About 70 percent of debt is at fixed interest rates. - ECB net purchases of Italian public debt during 2015–16 were about €210 billion, compared with rollover needs on medium- to long-term debt of about €400 billion; purchases continued in 2017 albeit by a smaller amount from April to December. ### Baseline assumptions underpinning projections - Fiscal: - Government assumed to achieve structural balance by 2019, corresponding to an improvement in the primary balance of about 2 percent of GDP. - Growth and inflation: - Real GDP growth projected to average 1 percent annually during 2017–22. - GDP deflator projected to rise from 0.6 percent in 2017 to around 1½ percent over the next few years. - Interest rates and costs: - Staff projects an effective nominal interest rate of about 3 percent over the medium term, or an average interest bill of about 3¾ percent of GDP. - Spreads assumed at around 200 bps. - Effective nominal interest rate increasing to around 5 percent by 2035 (about 3½ percent in real terms). - An effective real interest rate of 3½ percent with real GDP growth of 1 percent implies a debt stabilizing primary balance of 3¼ percent of GDP. - Privatization: - In 2016, privatization proceeds were about 0.1 percent of GDP, compared to a target of 0.5 percent of GDP. - No projection made for 2017–22 given uncertainties. ### Fiscal balances and sustainability insights - Sizable primary surpluses of about 3¾ percent of GDP will be needed in the baseline to maintain structural balance for several years. - Historical context: - Primary surpluses averaged 1¼ percent of GDP during 2001–16. - No-adjustment scenario: - If the primary balance remains around 1¾ percent of GDP, public debt would decline very modestly and be 10 percentage points higher by 2022 than in the baseline. ### Material risks and shock scenarios - Standard growth shock: - Assumption: real output growth lower by one standard deviation for two years starting in 2018, resulting in an average growth of –1½ percent in 2018–19. - For every 1 percentage point decline in growth, inflation is assumed to decline by 25 bps. - Primary balance reaches only 1½ percent of GDP by 2022. - Debt increases rapidly to about 140 percent of GDP and fails to come down over the projection period. - Interest rate shock: - Assumption: an increase in spreads of 200 bps (moderate relative to the 2011–12 episode when spreads increased above 500 bps). - Higher borrowing costs depress growth by 0.4 p.p. for every 100 bps increase in spreads. - Implicit average interest rate on debt rises to 3.8 percent by 2022. - Debt declines but only very modestly to around 128 percent by 2022. - Contingent liability shock (financial sector): - Assumption: one-time increase in non-interest expenditure of about 10 percent of banking sector assets. - Assumed effects: depress domestic demand, lower growth for two consecutive years by –1½ percentage points, and lower inflation by ½ percent. - Primary balance assumed to worsen by 10 percent of GDP in 2018. - Debt rises to 153 percent of GDP by 2022; gross financing needs would be significantly higher. *Annex I–II, Italy: External Sector Assessment and Debt Sustainability Analysis (excerpts).* ### 5. In a no-adjustment scenario, Italy’s public debt would rise over the long term once ### 5. In a no-adjustment scenario, Italy’s public debt would rise over the long term once ### No-adjustment scenario: key assumptions and trajectory - Steady state real GDP growth of 0.8 percent. - Structural primary balance of 1¾ percent of GDP. - Gradually increasing average cost of borrowing, reaching a nominal rate of 6 percent in 2035 or about 4½ percent in real terms. - Debt/GDP is projected to decline slightly to about 130 percent in the coming years, owing to exceptional monetary stimulus reducing the interest bill; thereafter, as monetary conditions normalize, debt/GDP keeps rising. - Gross financing needs would remain notably above 20 percent of GDP, above the threshold considered safe under the MAC-DSA. ### Baseline DSA projections and indicators (selected exact figures) - Nominal gross public debt (percent of GDP): 2015: 114.8; 2016: 132.0; 2017: 132.6; 2018: 133.0; 2019: 131.6; 2020: 129.0; 2021: 126.0; 2022: 123.1; 2022 (later row): 120.3. - Public gross financing needs (percent of GDP): 2015: 28.5; 2016: 26.5; 2017: 23.9; 2018: 20.9; 2019: 20.4; 2020: 19.6; 2021: 18.2; 2022: 19.1; 2022 (later row): 18.8. - Net public debt (percent of GDP): 2015: 98.2; 2016: 112.5; 2017: 113.3; 2018: 114.1; 2019: 113.1; 2020: 110.9; 2021: 108.3; 2022: 105.8; 2022 (later row): 103.4. - Real GDP growth (in percent): 2015: -0.6; 2016: 0.8; 2017: 0.9; 2018: 1.3; 2019: 1.0; 2020: 0.9; 2021: 1.0; 2022: 0.9; 2022 (later row): 0.8. - Inflation (GDP deflator, in percent): 2015: 1.6; 2016: 0.7; 2017: 0.8; 2018: 0.6; 2019: 1.2; 2020: 1.4; 2021: 1.4; 2022: 1.4; 2022 (later row): 1.4. - Nominal GDP growth (in percent): 2015: 1.0; 2016: 1.5; 2017: 1.6; 2018: 1.9; 2019: 2.1; 2020: 2.3; 2021: 2.4; 2022: 2.4; 2022 (later row): 2.3. - Effective interest rate (in percent) (defined as interest payments divided by debt stock at the end of previous year): 2015: 4.3; 2016: 3.2; 2017: 3.1; 2018: 2.9; 2019: 2.9; 2020: 2.9; 2021: 3.0; 2022: 3.1; 2022 (later row): 3.2. - Change in gross public sector debt (cumulative): 2015: 3.3; 2016: 0.3; 2017: 0.6; 2018: 0.4; 2019: -1.4; 2020: -2.7; 2021: -3.0; 2022: -2.9; 2022 (later row): -2.7; cumulative to 2022: -12.3. - Identified debt-creating flows (cumulative): 2015: 2.0; 2016: 0.4; 2017: 0.3; 2018: 0.4; 2019: -1.4; 2020: -2.7; 2021: -3.0; 2022: -2.9; 2022 (later row): -2.7; cumulative to 2022: -12.3. - Primary deficit (percent of GDP): 2015: -1.4; 2016: -1.4; 2017: -1.5; 2018: -1.6; 2019: -2.4; 2020: -3.4; 2021: -3.7; 2022: -3.8; 2022 (later row): -3.8; cumulative to 2022: -18.9. - Primary (noninterest) revenue and grants (percent of GDP): 2015: 46.2; 2016: 47.8; 2017: 47.2; 2018: 46.7; 2019: 46.5; 2020: 46.8; 2021: 46.7; 2022: 46.7; cumulative to 2022: 280.1. - Primary (noninterest) expenditure (percent of GDP): 2015: 44.8; 2016: 46.3; 2017: 45.6; 2018: 45.1; 2019: 44.0; 2020: 43.3; 2021: 43.0; 2022: 42.9; cumulative to 2022: 261.3. - Automatic debt dynamics (percent): 2015: 3.7; 2016: 2.3; 2017: 1.8; 2018: 1.4; 2019: 1.0; 2020: 0.8; 2021: 0.8; 2022: 0.9; 2022 (later row): 1.1; cumulative to 2022: 6.0. - Real interest rate contribution (percent): 2015: 3.0; 2016: 3.3; 2017: 3.0; 2018: 3.1; 2019: 2.3; 2020: 1.9; 2021: 2.0; 2022: 2.0; 2022 (later row): 2.1; cumulative to 2022: 3.5. - Real GDP growth contribution (percent): 2015: 0.7; 2016: -1.0; 2017: -1.1; 2018: -1.7; 2019: -1.2; 2020: -1.2; 2021: -1.3; 2022: -1.2; 2022 (later row): -1.0; cumulative to 2022: -7.5. - Other identified debt-creating flows (percent): 2015: -0.4; 2016: -0.4; 2017: -0.1; 2018: 0.6; 2019: 0.0; 2020: 0.0; 2021: 0.0; 2022: 0.0; cumulative to 2022: 0.6. - Privatization receipts (negative, percent): 2015: -0.1; 2016: -0.4; 2017: -0.1; 2018: 0.6; 2019–2022: 0.00; cumulative to 2022: 0.6. - Residual, including asset changes (percent): 2015: 1.4; 2016: -0.2; 2017: 0.3; 2018: 0.0; 2019–2022: 0.00. - Sovereign spreads (EMBIG, bp): 178 (as of As of March 03, 2017). - 5Y CDS (bp): 160 (as of As of March 03, 2017). ### Scenario comparisons and composition insights - Under alternative scenarios presented (Baseline, Historical, Constant Primary Balance), key underlying assumptions differ in real GDP growth, inflation, primary balance, and effective interest rate for 2017–2022. For example: - Baseline Primary Balance path (percent of GDP): 2017: 1.6; 2018: 2.4; 2019: 3.4; 2020: 3.7; 2021: 3.8; 2022: 3.8. - Historical Primary Balance path (percent of GDP): 2017: 1.6; 2018: 1.4; 2019: 1.4; 2020: 1.4; 2021: 1.4; 2022: 1.4. - Constant Primary Balance scenario keeps the primary balance at 1.6 percent across 2017–2022. - Composition charts indicate the stock of gross nominal public debt and net debt, by maturity (medium and long-term vs short-term) and by currency (local vs foreign), evolving across 2015–2022 under baseline projections. ### Stress test results (selected themes) - Stress tests shown include: Primary Balance Shock; Real GDP Growth Shock; Real Interest Rate Shock; Real Exchange Rate Shock; Combined Shock; Contingent Liability Shock. - Example baseline and shock parameter snapshots (2017–2022) show precise yearly values for Real GDP growth, Inflation, Primary balance, and Effective interest rate under each stress test (see figures for exact annual sequences). - Charts show gross nominal public debt and public gross financing needs under baseline and stress scenarios, with debt peaking higher under adverse shocks and financing needs rising well above safe benchmarks in several stress cases. ### Identified risks and vulnerabilities - Debt profile vulnerabilities include gross financing needs persistently high (notably above 20 percent of GDP in the no-adjustment scenario). - Market perception indicators and heat-map benchmarks flagged areas of concern (e.g., bond spread, external financing requirement, public debt held by non-residents) — specific numeric benchmarks referenced include 400 and 600 basis points for bond spreads; 17 and 25 percent of GDP for external financing requirement; 1 and 1.5 percent for change in share of short-term debt; and 30 and 45 percent for public debt held by non-residents. ### Policy recommendations and next steps (from IMF advice and progress annex) - Implement and strengthen structural reforms to boost growth: adopt/strengthen Annual Competition Law provisions, eliminate regulatory barriers, fully implement legislated reforms at all government levels. - Public administration and services: implement public administration reform fully, rationalize local public services and state-owned enterprises, improve procurement and anti-corruption measures. - Labor market reforms: modernize wage bargaining to give primacy to firm-level contracts; consider establishing a differentiated minimum wage; scale up and better coordinate active labor market policies via ANPAL; monitor take-up of new open-ended contracts. - Fiscal adjustment: implement plans aiming for overall deficit of 1.2 percent of GDP in 2018 and broad budget balance by 2019 (April 2017 plan); build a structural primary surplus buffer of about ½ percent of GDP over the medium term. - Growth-friendly fiscal policy mix: cut current primary spending where possible, raise and better-target capital spending, rationalize social protection, broaden the tax base, reduce VAT compliance and policy gaps, review tax expenditures, introduce a modern real estate tax, and lower tax rates on productive factors while reducing labor tax wedge. - Banking sector and financial stability: accelerate NPL resolution with credible bank strategies and supervisory follow-up; adopt a comprehensive insolvency overhaul and fast-track restructuring options; ensure consolidation of cooperative banks yields sound, profitable groups via asset quality reviews; use resolution framework effectively and protect vulnerable households when burden sharing or bail-in occurs. - Specific next steps highlighted include strengthening several provisions of draft ACL per Competition Authority recommendations; fully implementing procurement and public sector reform decrees; monitoring ANPAL effectiveness and scaling up ALMPs; and promptly adopting insolvency reforms with supporting implementation measures. *Source: IMF staff.* ### 2014. Non-financial firms are overcoming the deep and prolonged crisis while reaping the ### 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. ### Macroeconomic outlook, the real sector and the external sector - Staff projects GDP growth at 1.3 percent this year, broadly in line with the current projection of the Italian authorities. - Budget assumption: 1.0 percent. - Staff projection comparisons: - Almost twice as large as projected by staff in the January WEO update. - ½ percentage points of GDP higher than projected in the more recent April WEO. - Growth remains below the euro area average; the growth differential projected by staff for 2017 is the lowest since 2010. - Medium-term outlook: under continuation of the reform effort, Italy’s growth rate is likely to surpass IMF staff projections. - Uncertainty: estimates of potential output and the output gap are subject to a high degree of uncertainty (footnote 2 on page 7 referenced). - External sector developments and competitiveness: - 2016 Italian current account (CA) surplus: 2.6 percent of GDP (the fourth in a row and almost doubled compared to 2015). - NIIP: -15 percent of GDP at end-2016 (down from -23.5 at end-2015), with further improvement to -13.5 percent in the first quarter of this year. - Staff assessment moved from “broadly in line” to “moderately weaker” than fundamentals and desirable policies. - CA norm per EBA-model: 4 percent of GDP (corrected to 3.5 by staff judgment); described as 2 percentage points higher than in 2014 and 4 compared to 2013. - Authorities consider the staff’s estimated CA norm too high and question the reliability and robustness of the model revisions. - EBA REER models indicate a slight undervaluation of Italy’s REER. - Authorities argue staff did not fully account for impacts of labor market reform and increased retirement age (67 years as of 2019, with subsequent upward revisions based on increases in life expectancy) on the CA norm. - Authorities conclude the external position is in line with fundamentals. - Cost competitiveness debate: - Authorities contend ULC indicators overestimate manpower costs because many formally self-employed workers are de facto employees with more flexible, lower wage growth. - PPI-based competitiveness indicators show a less gloomy outlook. - Italy’s export share in world trade has remained broadly stable. ### Structural policies - Authorities agree on need to advance reforms in product and service markets, labor market, public administration, judicial system, and strengthen the banking sector. - Notable initiatives and achievements: - Industry 4.0 Initiative to support technological upgrade of the productive system. - Stepped up fight against tax evasion. - Judicial efficiency improvements: pending cases in civil courts declined by 25 percent between 2010 and 2015 (with further progress needed). - Refinements to the insolvency framework. - Completed reforms: budget reform (aimed at improving efficiency and effectiveness of public resources) and tax administration reform (delivering substantial improvements in relations with taxpayers). - Introduction of the first universal anti-poverty instrument to improve living conditions of vulnerable households. - Areas of disagreement with staff: - Draft competition law already includes important measures across many sectors (insurance, banking, pension funds, communications, utilities, regulated professions). - Authorities support a more decentralized wage bargaining system but note tax incentives in the 2017 budget to enhance plant-level decentralization; final choice rests with social partners. - Public administration reform: authorities dispute staff’s description as incomplete; most implementing acts deriving from the 2015 reform have been adopted. - Decree on rationalization of publicly-owned enterprises: implementation delayed by Constitutional Court ruling, but authorities disagree that provisions have been weakened. ### Fiscal policy - Authorities agree on need for further fiscal consolidation consistent with EU fiscal rules and on balancing stability and sustainability. - Key fiscal metrics and positions: - Italy’s high public debt must be put on a firmly declining path. - Public debt ratio has stabilized despite modest growth rates, attributed to continued fiscal effort and among the highest primary surpluses in the EU. - Authorities’ strategy (in line with European Commission 2017 EU Semester Package published on May 22) aims at gradual fiscal adjustment to ensure debt reduction while not hindering recovery. - Authorities informed the European Commission of intention to implement a structural fiscal adjustment in 2018 equal to 0.3 percentage point of GDP. - Authorities’ view: the strategy balances fiscal consolidation and economic recovery; European Commission’s recent reply confirms the appropriateness of the strategy. - Disagreement on fiscal stance characterization: - Staff labels Italian fiscal stance as “markedly expansionary” in 2014-17 based on change in structural primary balance; authorities contest this methodology given uncertainty in potential output estimates. - Example: estimated potential GDP growth at 0.2 percent in 2016; actual GDP growth 0.9 percent last year—authorities argue this can mislead structural balance measures. - Broader fiscal data highlighted by authorities: - Headline deficit trend: -2.4 percent of GDP in 2016 (down from -2.7 in 2015); projection of -2.1 for this year. - Primary balance: broadly stable in recent years at about 1½ percent of GDP (and will exceed that level this year). - Debt ratio: stabilized and projected to decline steadily. - Authorities characterize these as gradual, growth-friendly fiscal consolidation rather than marked expansion. - Medium- and long-term fiscal positions: - Authorities believe appropriate medium-term fiscal objective is a balanced budget, in line with SGP commitments; they disagree staff’s claim that a surplus of ½ percentage points of GDP is needed for fiscal sustainability. - Pension spending assessment: - Authorities view staff Box 3 as too pessimistic. - Notes: immigration projected to increase; fertility rate projected to remain rather low. - Fiscal Monitor projection cited: Italy’s pension spending projected to remain stable over next 15 years, and to decrease by 1.8 percent of GDP by 2050. - 2015 European Commission Ageing Report projection: gross replacement rate at retirement projected to decline by over 8 percentage points, from 60 per cent of 2013 to 51.8 per cent of 2060. - Authorities note differences in cross-country comparisons (gross pension benefits taxed in Italy; social security contribution rates higher in Italy than in many euro area countries). - Cost of partial reversals of recent pension reform: adjustments introduced involve costs averaging 0.1 percentage points of GDP over 2017-2060, described as a small fraction of savings from the Fornero reform. - Spending trends comparison: - Between 2010 and 2016 Italy had one of the lowest primary spending increases in the euro area: 3.8 percent (compared to 21.6 percent for Germany and 15.3 percent for France). - Primary spending declined by over 4 percent in real terms. ### Financial sector policies - Authorities’ perspective on banking sector resilience: - Given the 2008-13 shock with cumulative GDP loss of almost 9 percent, the financial sector proved resilient: only a handful of banks required intervention. - Estimated taxpayer money used since the global financial crisis is less than 1 percent of GDP (including effect of most recent decisions). - Recent decisive actions addressing tail risks: - Precautionary public recapitalization of Banca Monte dei Paschi di Siena (MPS). - Liquidation of Banca Popolare di Vicenza and Veneto Banca. - Finalization of transfer of Nuova Carife (one of four banks resolved at end-2015). - Additional clarifying points emphasized by authorities: - All above decisions coordinated with European institutions and compliant with European rules, including BRRD and state-aid rules; acknowledged in Eurogroup summing up of July 10. - For the two banks in Veneto, the Single Resolution Board found resolution not justified by public interest, leading to liquidation under Italian solvency legislation. - Burden sharing contributions: - MPS: €4.3 bn in subordinated debt will be converted into shares and shareholders will be heavily diluted. - Two Veneto banks: €5.2 bn in shares and subordinated bonds were de facto obliterated. - Reasonable expectations that most – if not all – taxpayer money will be recovered: - MPS: government stake to be sold once restructuring plan is completed, no later than 2021. - Veneto banks: if NPL recovery rates of state-owned specialized vehicle align with Italian banking system average in 2006-2015, public resources would be fully recovered. - Solution for the two Veneto banks includes sale of good assets and some liabilities to Intesa San Paolo, preserving client relationships with around 100,000 SMEs and 200,000 households. - Veneto region GDP size described as a little smaller than Portugal or Greece, highlighting regional economic importance. - NPL dynamics and outlook: - Impact of MPS and Veneto operations, plus other market disposals, expected to accelerate reduction of NPL stock. - Net NPLs to total loans for significant institutions at end of Q1-2017: 9.2 percent; could decline below 8 percent in the next twelve months. - Flow of new NPLs: peaked in 2013 at 5.9 percent per year; in Q1-2017 it was 2.4 percent (close to pre-crisis levels). - Policy approach to NPL resolution: - Continue tackling NPLs with firm determination and accelerate solutions in line with “Council Conclusions” on a European Action Plan to tackle NPLs approved by the Ecofin Council on July 11. - Emphasis on enhancing banks’ internal NPL management, prudent provisioning, and efficiency gains in the judicial system. - Authorities warn against generalized fire sales of NPLs that could transfer resources to a few specialized investors operating de facto in an oligopolistic regime, eroding banks’ capital when raising it remains important. - Banking structural reforms: - Since end-2015, eight of the ten largest cooperative banks (‘banche popolari’) transformed into joint-stock companies to improve corporate management and capital market access. - Reform of mutual banks (‘banche di credito cooperativo’) ongoing; expected by May 2018 at the latest to form three larger groups consolidating around 300 mutual banks. - For the two largest groups, ECB and Bank of Italy to conduct a comprehensive assessment in 2018, similar to that held in 2014. - Looking ahead: - Elimination of tail risks and ongoing restructuring considered substantial advancements that will enable banks to upgrade business models and improve profitability. - Authorities underscore no “one-size-fits-all” banking model but see ample margins to: - streamline operating costs, - enhance efficiency and productivity, - better leverage technology and human capital. - Banks are already reducing costs and rationalizing branch networks; further progress, particularly in small and medium-size banks, is assigned high priority. *Source: cr17237 - 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.* --- _Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17237.pdf_