## cr1940 ## Source details **Canonical URL:** [cr1940](https://www.imf.org/-/media/files/publications/cr/2019/cr1940.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2019/cr1940.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2019/cr1940.pdf.json) --- ### Executive Board Assessment and Key Messages - Italy’s longstanding structural weaknesses have contributed to sluggish income growth, elevated unemployment, and high public debt. - Directors welcomed the authorities’ focus on supporting growth and improving social outcomes and the recent moderation of the 2019 fiscal plans. - Directors noted the authorities’ intention to put high public debt on a firm downward path but judged the strategy falls short of comprehensive reforms needed to address longstanding structural impediments. - Recommended priorities: - Implement a comprehensive package of structural reforms. - Pursue growth-friendly and inclusive fiscal consolidation. - Further strengthen bank balance sheets. ### Recent Developments and Policy Intentions - A new government took office in June 2018 with policies to facilitate early retirement, tackle poverty, undertake active labor market policies, and increase public investment. - The government’s platform centers on a sizable fiscal stimulus including measures to facilitate earlier retirement, help the poor and unemployed, raise public investment, and reduce tax rates. - Market reaction: - Sovereign spreads vis-à-vis German bunds have jumped to multi-year highs; bank valuations have shrunk by about one third. - Italy and the European Commission are discussing potential revisions of the fiscal plan in relation to the EC’s excessive deficit procedure. ### Outlook and Risks — Growth, Output Gap, and Fiscal Vulnerabilities - Growth projections and key figures: - Growth is projected at 1 percent in 2018, 0.6 percent in 2019, and below 1 percent in 2020 and beyond. - Real GDP (Table projections): 2017: 1.6; 2018: 1.0; 2019: 0.6; 2020: 0.9; 2021: 0.7; 2022: 0.6; 2023: 0.6. - Potential GDP growth and output gap: - Potential GDP growth: 2017: 0.4; 2018: 0.4; 2019: 0.4; 2020: 0.5; 2021: 0.5; 2022: 0.6; 2023: 0.6. - Output gap (percent of potential): 2017: -1.5; 2018: -0.9; 2019: -0.6; 2020: -0.2; 2021: -0.1; 2022: -0.1; 2023: -0.1. - Staff concerns and risk channels: - Planned fiscal stimulus could lift growth temporarily, but rising funding costs for banks and sovereign risk could undermine growth further. - Policies could leave Italy vulnerable to a renewed loss of market confidence even absent further shocks. - Debt could increase sooner and faster if new challenges materialize, potentially forcing notable fiscal contraction and pushing a weakening economy into a recession, with the burden falling disproportionately on the vulnerable. - Financial sector risks: weak profitability and sustained high sovereign yields pose challenges to the banking system. ### Staff Recommendations — Structural, Fiscal, and Financial Policies - Structural reforms (priority actions): - Decentralize wage bargaining to align wages with productivity at the firm level. - Pursue ambitious service market liberalization and liberalize product and service markets (local public services, professions, retail). - Reform the public administration; cut red tape; simplify administrative procedures; streamline procurement; reform local state-owned enterprises. - Modernize the insolvency system; fold the special insolvency regime for large enterprises into the modernized framework. - Fiscal policy (design and sequencing): - Undertake a modest and balanced consolidation to ensure that debt declines—by cutting current spending, modernizing the safety net for the poor, increasing public investment, broadening the tax base, and lowering taxes on labor. - Directors recommended a gradual and balanced adjustment toward a small overall surplus in the medium term; some Directors concurred with a consolidation pace broadly consistent with the preventive arm of the Stability and Growth Pact. - Fiscal measures to protect the poor: introduce a modern guaranteed minimum income program, reduce current spending, avoid reversing past pension reforms, and raise public investment. - Broaden the tax base by addressing large VAT compliance gaps, rationalizing other tax expenditures, avoiding tax amnesties, prioritizing strict enforcement, and introducing a modern property tax on primary residences. - Financial stability: - Continue progress in reducing non-performing loans, increase provisions and build capital buffers. - Strengthen bank governance, reduce costs and non-performing loans, consolidate cooperative banks into three new banking groups and subject them to asset quality reviews. - Swift recapitalization of weaker banks or timely and effective use of the resolution framework to avoid excessive costs to taxpayers. - Restructure operations and improve profitability; consolidate and rationalize smaller banks; build capital buffers that are effective in resolution. ### Selected Quantitative Indicators and Projections (annual percentage change unless noted) - Real domestic demand: 2017: 1.3; 2018: 1.1; 2019: 0.6; 2020: 1.1; 2021: 0.8; 2022: 0.6; 2023: 0.6. - Final domestic demand: 2017: 1.7; 2018: 1.0; 2019: 0.7; 2020: 1.0; 2021: 0.8; 2022: 0.6; 2023: 0.6. - Private consumption: 2017: 1.5; 2018: 0.6; 2019: 0.7; 2020: 1.1; 2021: 0.8; 2022: 0.7; 2023: 0.6. - Public consumption: 2017: -0.1; 2018: 0.3; 2019: -0.1; 2020: 0.9; 2021: 0.6; 2022: 0.5; 2023: 0.5. - Gross fixed capital formation: 2017: 4.3; 2018: 3.2; 2019: 1.4; 2020: 1.0; 2021: 0.6; 2022: 0.6; 2023: 0.7. - Net exports contribution to growth: 2017: 0.3; 2018: -0.1; 2019: 0.0; 2020: -0.1; 2021: -0.1; 2022: 0.0; 2023: 0.0. - Exports of goods and services: 2017: 5.7; 2018: 2.4; 2019: 1.8; 2020: 1.7; 2021: 1.5; 2022: 1.4; 2023: 1.3. - Imports of goods and services: 2017: 5.2; 2018: 3.1; 2019: 2.0; 2020: 2.1; 2021: 2.0; 2022: 1.6; 2023: 1.3. - Savings (percent of GDP): 2017: 20.4; 2018: 20.7; 2019: 20.7; 2020: 20.6; 2021: 20.4; 2022: 20.4; 2023: 20.3. - Investment (percent of GDP): 2017: 17.6; 2018: 18.3; 2019: 18.2; 2020: 18.3; 2021: 18.5; 2022: 18.7; 2023: 18.9. - Employment and labor market: - Employment growth: 2017: 1.2; 2018: 1.2; 2019: 0.6; 2020: 0.7; 2021: 0.6; 2022: 0.5; 2023: 0.4. - Unemployment rate (percent): 2017: 11.3; 2018: 10.7; 2019: 10.5; 2020: 10.3; 2021: 10.1; 2022: 10.0; 2023: 9.9. - Prices and productivity: - GDP deflator: 2017: 0.5; 2018: 1.1; 2019: 1.5; 2020: 1.5; 2021: 1.6; 2022: 1.7; 2023: 1.7. - Consumer prices: 2017: 1.3; 2018: 1.2; 2019: 1.3; 2020: 1.5; 2021: 1.6; 2022: 1.7; 2023: 1.7. - Hourly compensation in industry (including construction): 2017: 1.2; 2018: 1.9; 2019: 1.9; 2020: 1.9; 2021: 2.0; 2022: 2.1; 2023: 2.2. - Productivity in industry (including construction): 2017: 2.1; 2018: 0.3; 2019: 0.2; 2020: 0.5; 2021: 0.3; 2022: 0.4; 2023: 0.4. - Unit labor costs in industry (including construction): 2017: -1.0; 2018: 1.6; 2019: 1.6; 2020: 1.5; 2021: 1.7; 2022: 1.7; 2023: 1.8. - Fiscal indicators: - General government net lending/borrowing (percent of GDP): 2017: -2.4; 2018: -1.9; 2019: -2.1; 2020: -2.9; 2021: -3.0; 2022: -3.0; 2023: -3.0. - General government primary balance (percent of GDP): 2017: 1.3; 2018: 1.6; 2019: 1.4; 2020: 0.7; 2021: 0.7; 2022: 0.8; 2023: 1.0. - Structural overall balance (percent of potential GDP): 2017: -1.6; 2018: -1.5; 2019: -1.8; 2020: -2.8; 2021: -3.0; 2022: -3.0; 2023: -3.0. - Structural primary balance (percent of potential GDP): 2017: 2.0; 2018: 2.0; 2019: 1.7; 2020: 0.9; 2021: 0.8; 2022: 0.9; 2023: 1.1. - General government gross debt (percent of GDP): 2017: 131.2; 2018: 131.4; 2019: 130.9; 2020: 130.7; 2021: 130.9; 2022: 131.0; 2023: 131.1. - External sector: - Current account balance (percent of GDP): 2017: 2.8; 2018: 2.4; 2019: 2.5; 2020: 2.2; 2021: 1.9; 2022: 1.7; 2023: 1.4. - Trade balance (percent of GDP): 2017: 3.2; 2018: 2.5; 2019: 2.7; 2020: 2.5; 2021: 2.2; 2022: 2.0; 2023: 1.8. - Exchange rate (national currency per U.S. dollar): 2017: 0.9; 2018: 0.8. ### Contextual Diagnosis — Long-standing constraints and social outcomes - Key diagnostics: - Real incomes per capita are at the level of two decades ago. - Unemployment has averaged 10 percent since the 1990s. - Over 20 percent of households are at risk of poverty. - Emigration of Italian citizens is near a five-decade high. - Structural weaknesses: - Weak total factor productivity since the 1990s; stagnation in tradable sector and decline in non-tradable sector. - Market inefficiencies, high taxation, and an inefficient public sector; unit labor costs in manufacturing remain well above the euro area average. - Fiscal composition issues: public debt above 130 percent of GDP; primary fiscal surpluses were on average higher than euro area peers but insufficient to lower debt; tax burden skewed toward labor; public investment squeezed; social benefits concentrated on pensions. ### Banking Sector — Exposures, Liquidity, Funding, Asset Quality, and Policy Implications - Sovereign-bank link and market funding: - Italian financial sector bought about €45 billion since April 2018, reinforcing the sovereign-bank link. - From March 2015 to October 2018, the Eurosystem’s net purchases of Italian public debt (QE) were €362 billion, compared to gross medium- to long-term bond issuances of about €600 billion. - Starting January 2019, the market would need to finance about 95 percent of Italy’s annual gross financing needs; the rest is Eurosystem reinvestment. - Funding costs and market access: - Examples: Unicredit privately placed a dollar-denominated 5-year senior note in November 2018 at a coupon of about 7.8 percent (vs. a similar 1 percent coupon euro-denominated bond issued in January 2018). A mid-sized bank issued a 10-year subordinated bond at a coupon of 13 percent in December 2018. - Outstanding bank bonds fell 17 percent year-on-year to €246 billion in September 2018. - Wholesale sources funded about €552 billion of Italian banking system liabilities as of August 2018. - Banks benefit from about €240 billion of TLTRO funds, which fall due in 2020‒21. - Asset quality and capitalization: - Gross NPLs fell from 16½ percent of loans in 2015 to about 10 percent in mid-2018. - NPLs remain well above the 3.6 percent average of the main EU banks. - Provisioning coverage rose to 55 percent, 9 percent above the average of the main EU banks. - In mid-2018, banks reported a CET1 ratio of 13.2 percent, 0.6 percentage points less than at end-2017 and 1.3 percentage points below the average of the main EU banks. - A 100 basis point increase in sovereign spreads could reduce the CET1 ratio of significant banks by 40 basis points and of less significant banks by 90 basis points (Bank of Italy estimate). - Insurance sector holds over ⅓ of their assets in sovereign assets; elevated spreads have resulted in solvency ratios falling by almost 10 percent on average. - Credit trends and vulnerabilities: - Credit to the private sector grew modestly in 2018:Q3; credit to households has grown since 2015; credit to firms started to grow only in 2018. - Among firms, credit has been growing for the strongest firms but shrinking for weaker ones. - Corporate default rates have fallen to pre-crisis levels; nearly ½ of firms are still classified as vulnerable or risky, and profitability of small and medium-sized firms remains 20 percent below pre-crisis levels (Cerved). - Staff financial stability recommendations: - Enhanced monitoring and planning given downside risks from sovereign yields. - Continue NPL reduction, provisioning, and capital buffer build-up. - Consolidate cooperative banks into three new groups and subject them to asset quality reviews. - Ensure swift recapitalization or effective resolution of weak banks; introduce safeguards on MREL issuance and retail investor protection; strengthen governance. ### Debt Sustainability, Shocks, and Scenario Results (Annex III and DSA) - Current level and baseline: - Public debt about 131 percent of GDP; increased from about 100 percent of GDP in 2007 to 131.2 percent of GDP in 2017. - Baseline projects debt broadly stable at about 131 percent of GDP over the next few years, then rising with normalization of interest rates and higher pension spending. - Baseline assumptions (selected): - Real GDP growth projected to average ¾ percent annually during 2018–23 and about 0.7 percent thereafter. - Government assumed to maintain an average structural primary surplus of about 1 percent of GDP over 2018–2023. - Marginal cost of borrowing projected to increase to 2.9 percent in 2019 from 0.7 percent in 2017. - Spreads vis-à-vis German bunds assumed to decline gradually from an average of 225 basis points in 2018 to 205 basis points in 2023. - Shocks and simulated debt outcomes: - Standard growth shock (real output lower by one standard deviation for two years starting in 2019; avg growth -1½ percent in 2019–20): - Primary balance declines to -1.5 percent of GDP by 2023. - Debt increases to 152.5 percent of GDP and fails to come down over the projection period. - Interest rate shock (spreads increase by 205 bps): - Implicit average interest rate on debt rises to 4 percent by 2023. - Debt increases to around 140 percent of GDP by 2023. - Contingent liability shock (one-time non-interest expenditure ~10 percent of banking sector assets plus lower growth and inflation): - Primary balance worsens by 11 percent of GDP in 2019. - Debt rises to 166 percent of GDP by 2023. - Baseline DSA indicators (selected): - Baseline nominal gross public debt (percent of GDP): 118.0 (2016), 131.4 (2017), 131.2 (2018), 131.4 (2019), 131.1 (2020), 131.1 (2021), 131.3 (2022), 131.4 (2023). - Baseline public gross financing needs (percent of GDP): 28.5 (2016), 23.8 (2017), 24.9 (2018), 22.4 (2019), 23.6 (2020), 23.6 (2021), 24.1 (2022), 25.5 (2023). ### Policy Priorities and Implementation Focus (Staff Appraisal) - Overarching objectives: - Make structural reforms to raise productivity the overarching priority. - Emphasize labor and product market reforms, public administration, insolvency, and justice reforms. - Improve fiscal policy quality to be more growth friendly and inclusive and implement credible consolidation to ensure public debt sustainability. - Further strengthen banks’ balance sheets to enhance resilience and support credit provision. - Implementation guidance: - If fiscal stimulus is undertaken, prioritize high-multiplier activities: social benefits to liquidity-constrained households and swift execution of quality public investment projects. - Set ambitious targets and key performance indicators to track reform progress and improve administrative capacity and coordination across levels of government. _Staff Report for the 2018 Article IV Consultation, Italy — December 18, 2018 (cr1940)._ ### 2018. This reflected slower euro area growth, adverse terms of trade, and higher domestic policy ### cr1940 - 2018. This reflected slower euro area growth, adverse terms of trade, and higher domestic policy uncertainty as evidenced in elevated sovereign borrowing costs ### Executive Board Assessment and Key Messages - Italy’s longstanding structural weaknesses have contributed to sluggish income growth, elevated unemployment, and high public debt. - Directors welcomed the authorities’ focus on supporting growth and improving social outcomes and the recent moderation of the 2019 fiscal plans. - Directors noted the authorities’ intention to put high public debt on a firm downward path but judged the strategy falls short of comprehensive reforms needed to address longstanding structural impediments. - Recommended priorities: - Implement a comprehensive package of structural reforms. - Pursue growth-friendly and inclusive fiscal consolidation. - Further strengthen bank balance sheets. ### Recent Developments and Policy Intentions - A new government took office in June 2018 with policies to facilitate early retirement, tackle poverty, undertake active labor market policies, and increase public investment. - The government’s platform centers on a sizable fiscal stimulus including measures to facilitate earlier retirement, help the poor and unemployed, raise public investment, and reduce tax rates. - Recent market reaction: sovereign spreads vis-à-vis German bunds have jumped to multi-year highs while bank valuations have shrunk by about one third. - Italy and the European Commission are discussing potential revisions of the fiscal plan in relation to the EC’s excessive deficit procedure. ### Outlook and Risks - Growth projections: - Growth is projected at 1 percent in 2018, 0.6 percent in 2019, and below 1 percent in 2020 and beyond. - Table projections (Real GDP): 2017: 1.6; 2018: 1.0; 2019: 0.6; 2020: 0.9; 2021: 0.7; 2022: 0.6; 2023: 0.6. - Staff concerns: - The planned stimulus could lift growth temporarily, but rising funding costs for banks and the sovereign risk undermining growth further. - Policies could leave Italy vulnerable to a renewed loss of market confidence, even in the absence of further shocks. - Debt could increase sooner and faster if new challenges materialize, potentially forcing notable fiscal contraction and pushing a weakening economy into a recession, with the burden falling disproportionately on the vulnerable. - Output gap and slack: - Potential GDP growth: 2017: 0.4; 2018: 0.4; 2019: 0.4; 2020: 0.5; 2021: 0.5; 2022: 0.6; 2023: 0.6. - Output gap (percent of potential): 2017: -1.5; 2018: -0.9; 2019: -0.6; 2020: -0.2; 2021: -0.1; 2022: -0.1; 2023: -0.1. - Financial sector risks: weak profitability and sustained high sovereign yields pose challenges to the banking system. ### Staff Recommendations (Policy Package) - Structural reforms: - Decentralize wage bargaining to align wages with productivity at the firm level. - Pursue ambitious service market liberalization. - Reform the public administration. - Modernize the insolvency system. - Cut red tape, simplify administrative procedures, liberalize product and service markets, reduce uncertainty over dismissal costs, decentralize wage bargaining, streamline procurement, and reform local state-owned enterprises. - Fiscal policy: - Undertake a modest and balanced consolidation to ensure that debt declines—by cutting current spending, modernizing the safety net for the poor, increasing public investment, broadening the tax base, and lowering taxes on labor. - Directors recommended a gradual and balanced adjustment toward a small overall surplus in the medium term; some Directors concurred with a consolidation pace broadly consistent with the preventive arm of the Stability and Growth Pact. - Fiscal measures to protect the poor: introduce a modern guaranteed minimum income program, reduce current spending, avoid reversing past pension reforms, and raise public investment. - Broaden the tax base by addressing large VAT compliance gaps, rationalizing other tax expenditures, avoiding tax amnesties, prioritizing strict enforcement, and introducing a modern property tax on primary residences. - Financial stability: - Continue progress in reducing non-performing loans, increasing provisions and building capital buffers. - Strengthen bank governance, reduce costs and non-performing loans, consolidate cooperative banks into three new banking groups and subject them to asset quality reviews. - Swift recapitalization of weaker banks or timely and effective use of the resolution framework to avoid excessive costs to taxpayers and the rest of the banking system. - Restructure operations and improve profitability; consolidate and rationalize smaller banks; build capital buffers that are effective in resolution. ### Selected Quantitative Indicators and Projections (annual percentage change unless noted) - Real domestic demand: 2017: 1.3; 2018: 1.1; 2019: 0.6; 2020: 1.1; 2021: 0.8; 2022: 0.6; 2023: 0.6. - Final domestic demand: 2017: 1.7; 2018: 1.0; 2019: 0.7; 2020: 1.0; 2021: 0.8; 2022: 0.6; 2023: 0.6. - Private consumption: 2017: 1.5; 2018: 0.6; 2019: 0.7; 2020: 1.1; 2021: 0.8; 2022: 0.7; 2023: 0.6. - Public consumption: 2017: -0.1; 2018: 0.3; 2019: -0.1; 2020: 0.9; 2021: 0.6; 2022: 0.5; 2023: 0.5. - Gross fixed capital formation: 2017: 4.3; 2018: 3.2; 2019: 1.4; 2020: 1.0; 2021: 0.6; 2022: 0.6; 2023: 0.7. - Net exports contribution to growth: 2017: 0.3; 2018: -0.1; 2019: 0.0; 2020: -0.1; 2021: -0.1; 2022: 0.0; 2023: 0.0. - Exports of goods and services: 2017: 5.7; 2018: 2.4; 2019: 1.8; 2020: 1.7; 2021: 1.5; 2022: 1.4; 2023: 1.3. - Imports of goods and services: 2017: 5.2; 2018: 3.1; 2019: 2.0; 2020: 2.1; 2021: 2.0; 2022: 1.6; 2023: 1.3. - Savings (percent of GDP): 2017: 20.4; 2018: 20.7; 2019: 20.7; 2020: 20.6; 2021: 20.4; 2022: 20.4; 2023: 20.3. - Investment (percent of GDP): 2017: 17.6; 2018: 18.3; 2019: 18.2; 2020: 18.3; 2021: 18.5; 2022: 18.7; 2023: 18.9. - Employment and labor market: - Employment growth: 2017: 1.2; 2018: 1.2; 2019: 0.6; 2020: 0.7; 2021: 0.6; 2022: 0.5; 2023: 0.4. - Unemployment rate (percent): 2017: 11.3; 2018: 10.7; 2019: 10.5; 2020: 10.3; 2021: 10.1; 2022: 10.0; 2023: 9.9. - Prices and productivity: - GDP deflator: 2017: 0.5; 2018: 1.1; 2019: 1.5; 2020: 1.5; 2021: 1.6; 2022: 1.7; 2023: 1.7. - Consumer prices: 2017: 1.3; 2018: 1.2; 2019: 1.3; 2020: 1.5; 2021: 1.6; 2022: 1.7; 2023: 1.7. - Hourly compensation in industry (including construction): 2017: 1.2; 2018: 1.9; 2019: 1.9; 2020: 1.9; 2021: 2.0; 2022: 2.1; 2023: 2.2. - Productivity in industry (including construction): 2017: 2.1; 2018: 0.3; 2019: 0.2; 2020: 0.5; 2021: 0.3; 2022: 0.4; 2023: 0.4. - Unit labor costs in industry (including construction): 2017: -1.0; 2018: 1.6; 2019: 1.6; 2020: 1.5; 2021: 1.7; 2022: 1.7; 2023: 1.8. - Fiscal indicators: - General government net lending/borrowing (percent of GDP): 2017: -2.4; 2018: -1.9; 2019: -2.1; 2020: -2.9; 2021: -3.0; 2022: -3.0; 2023: -3.0. - General government primary balance (percent of GDP): 2017: 1.3; 2018: 1.6; 2019: 1.4; 2020: 0.7; 2021: 0.7; 2022: 0.8; 2023: 1.0. - Structural overall balance (percent of potential GDP): 2017: -1.6; 2018: -1.5; 2019: -1.8; 2020: -2.8; 2021: -3.0; 2022: -3.0; 2023: -3.0. - Structural primary balance (percent of potential GDP): 2017: 2.0; 2018: 2.0; 2019: 1.7; 2020: 0.9; 2021: 0.8; 2022: 0.9; 2023: 1.1. - General government gross debt (percent of GDP): 2017: 131.2; 2018: 131.4; 2019: 130.9; 2020: 130.7; 2021: 130.9; 2022: 131.0; 2023: 131.1. - External sector: - Current account balance (percent of GDP): 2017: 2.8; 2018: 2.4; 2019: 2.5; 2020: 2.2; 2021: 1.9; 2022: 1.7; 2023: 1.4. - Trade balance (percent of GDP): 2017: 3.2; 2018: 2.5; 2019: 2.7; 2020: 2.5; 2021: 2.2; 2022: 2.0; 2023: 1.8. - Exchange rate (national currency per U.S. dollar): 2017: 0.9; 2018: 0.8. ### Contextual Diagnosis - Italy has low economic growth and poor social outcomes: real incomes per capita are at the level of two decades ago; unemployment has averaged 10 percent since the 1990s; over 20 percent of households are at risk of poverty; emigration of Italian citizens is near a five-decade high. - Structural weaknesses: weak total factor productivity since the 1990s; stagnation in tradable sector and decline in non-tradable sector; market inefficiencies, high taxation, and an inefficient public sector; unit labor costs in manufacturing remain well above the euro area average. - Fiscal composition issues: public debt above 130 percent of GDP; primary fiscal surpluses were on average higher than euro area peers but insufficient to lower debt; tax burden skewed toward labor; public investment squeezed; social benefits concentrated on pensions. *Staff Report for the 2018 Article IV Consultation, Italy — December 18, 2018.* ### 5. The economy grew relatively quickly in 2017 but has slowed since then. It grew by ### cr1940 - 5. The economy grew relatively quickly in 2017 but has slowed since then. It grew by ### Recent growth and short-term outlook - Growth: - Grew by 1.6 percent in 2017, the fastest in nearly a decade. - Slowed thereafter, contracting slightly on a sequential basis in 2018:Q3. - Growth is projected to decline from 1.6 percent in 2017 to 1 percent in 2018, about ¾ percent in 2019‒20, and 0.6 percent beyond. - Drivers and headwinds: - 2017 growth driven by robust euro area growth and accommodative monetary conditions. - Slowing linked to policy uncertainty (reflected in elevated sovereign spreads), weaker external demand, and high oil prices. - High-frequency indicators: purchasing managers’ indices signal contraction ahead, while consumer confidence indicators remain near post-crisis highs so far. - Fiscal policy and stimulus: - Fiscal policy is set to expand sizably in 2019. - Draft budget plan of November 2018 estimated the structural primary surplus will deteriorate by ¾ percent of GDP next year and be constant thereafter. - Corresponding headline deficit target is 2.4 percent of GDP in 2019, falling slowly to 1.8 percent in 2021. - Staff and most external analysts’ deficit/impact estimates are higher (¶30). - Staff uses multipliers of 0.5–0.7 in the first year and 0.7–0.9 in the second year; planned fiscal impulse translates into higher real GDP (relative to the baseline) by 0.4–0.6 percent in the first two years. Persistent rise in sovereign spreads is projected to lower GDP by about 0.2–0.4 percent in those years, while hurting growth further in the period beyond. ### Labor market, inflation, and output gap - Labor market: - Employment and labor force participation are at historical peaks. - Unemployment fell to 10.2 percent in 2018:Q3, close to its historical average. - Involuntary part-time employment remains elevated. - Contractual wages grew by 2 percent led by the public sector. - Inflation: - Headline inflation rose to 1.6 percent driven by higher energy prices. - Core inflation was subdued at 0.7 percent in November 2018. - Output gap and slack: - With economic growth outpacing potential, the output gap has narrowed. - Staff estimates a gap of about -1 percent for 2018. - Indicators suggesting remaining slack: subdued core inflation and increased involuntary part-time employment. - Indicators suggesting closing gaps: job vacancy rate at its pre-crisis average, capacity utilization near historical peaks, high structural unemployment. ### Fiscal trajectory, markets, and sovereign risk - Market developments: - Since early May, the benchmark 10-year sovereign yield increased to around 3–3 ½ percent. - Spreads vis-à-vis German bunds were near their highest levels since early 2013. - Moody’s downgraded Italy to one notch above junk (with stable outlook); Fitch and S&P rate Italy at two notches above junk but have placed it on a negative outlook. DBRS rates the Italian sovereign at three notches above junk. - Banks’ market valuations have declined by ⅓ in recent months. - Financing and ECB context: - From March 2015 to October 2018, the Eurosystem’s net purchases of Italian public debt (QE) were €362 billion, compared to gross medium- to long-term bond issuances of about €600 billion. - Starting January 2019, the market would need to finance about 95 percent of Italy’s annual gross financing needs; the rest is Eurosystem reinvestment. - Fiscal risks: - Authorities’ planned fiscal stimulus carries substantial downside risks given fiscal space at risk. - In staff’s projections, debt would remain at around 131 percent of GDP over the next few years absent additional fiscal measures; then it would rise with increasing interest rates during monetary policy normalization and higher pension spending (Annex III). - Materialization of modest adverse shocks (slowing growth or rising spreads) would increase debt further, raising the risk of a market-forced sharp fiscal consolidation. ### External flows and real exchange rate - Portfolio flows and TARGET2: - Portfolio outflows in Q2–Q3 totaled €72 billion, about 80 percent of which were related to government securities. - These outflows contributed to widening Italy’s Target 2 balance to over €490 billion, an all-time high. - Current account and valuation: - External current account surplus declined somewhat after reaching 2.7 percent of GDP in 2017. - With unit labor costs above euro area peers, the real effective exchange rate is moderately overvalued by 0–10 percent. - External position assessment: - The external position is assessed to be broadly in line with fundamentals (Annex I). ### Banking sector: exposures, liquidity, funding, and asset quality - Sovereign-bank link: - Italian financial sector bought about €45 billion since April 2018, reinforcing the sovereign-bank link. - Banks’ sovereign exposures and rising spreads have adversely impacted banks’ capital and insurance companies’ solvency ratios. - Funding costs and market access: - Banks’ costs of tapping wholesale funding have risen sharply; access to bond markets has been limited. - Examples: In November 2018, Unicredit privately placed a dollar-denominated 5-year senior note at a coupon of about 7.8 percent, compared with a similar 1 percent coupon euro-denominated bond issued in January 2018. In December 2018, a mid-sized bank issued a 10-year subordinated bond at a coupon of 13 percent. - Outstanding bank bonds fell 17 percent year-on-year to €246 billion in September 2018. Wholesale sources funded about €552 billion of Italian banking system liabilities as of August 2018. - Banks benefit from about €240 billion of TLTRO funds, which fall due in 2020‒21. - Deposits have been stable; passthrough to private sector borrowing rates has been relatively contained so far. - Asset quality and capitalization: - Gross nonperforming loans (NPLs) fell from 16½ percent of loans in 2015 to about 10 percent in mid-2018, mainly through sales. - NPLs remain well above the 3.6 percent average of the main EU banks. - Provisioning coverage rose to 55 percent, 9 percent above the average of the main EU banks. - In mid-2018, banks reported a CET1 ratio of 13.2 percent, 0.6 percentage points less than at end-2017 and 1.3 percentage points below the average of the main EU banks. - The rise in sovereign yields contributed to a fall in tier 1 capital ratio of the banking sector by 40 basis points in 2018:Q2. - According to the Bank of Italy, a 100 basis point increase in sovereign spreads could reduce the CET1 ratio of significant banks by 40 basis points and of less significant banks by 90 basis points. - Insurance sector holds over ⅓ of their assets in sovereign assets; elevated spreads have resulted in solvency ratios falling by almost 10 percent on average. - Credit trends: - Credit to the private sector continued to grow modestly, including in 2018:Q3. - Credit to households has grown since 2015; credit to firms started to grow only in 2018. - Among firms, credit has been growing for the strongest firms but shrinking for weaker ones. - Corporate default rates have fallen to pre-crisis levels; however, nearly ½ of firms are still classified as vulnerable or risky, and profitability of small and medium-sized firms remains 20 percent below pre-crisis levels (Cerved). ### Outlook, risks, and spillovers - Outlook summary: - Growth projected to slow; risk of recession has risen. - Without accounting for the rise in sovereign spreads, well-targeted fiscal stimulus could temporarily boost growth by supporting liquidity-constrained households and quality public investment projects. - Sharp rise in sovereign spreads would mitigate temporary benefits and, if persistent, risk undermining medium-term growth. - Downside risks (selected): - Elevated sovereign spreads weighing further on domestic demand. - Sizable gross fiscal financing needs—above 20 percent of GDP annually—require regular market access at sustainable yields. - Persistently elevated spreads would exacerbate pressures on banks’ funding costs and profitability, accelerate passthrough to private borrowing costs, complicate replacement of TLTRO funding due in 2020‒21, raise MREL, and curtail credit provision. - Liquidity outflows, higher probability of bank failures, unfavorable government bond auctions, and rating downgrades of sovereign and banks are key risks. - Persistence of international trade tensions could weigh on investment. - Upside scenario: - Earlier and more rapid easing of financial conditions or larger-than-expected demand effects from planned fiscal easing and monetary policy would boost growth. - Global spillovers: - Spillovers from heightened stress in Italy would be global and significant; transmit through higher risk aversion and repricing of risky assets. - Late May 2018 saw largest safe-haven related intra-day yield declines in U.S. Treasuries and German bunds since 2010 and contagion to Greek, Portuguese, and Spanish yields. - Acute stress or an unprecedented downgrade to junk status of a very large advanced sovereign issuer could trigger broad-based reversal of portfolio flows, including from emerging markets. - French, Spanish, Portuguese, and Belgian banks have sizable exposures to Italy; Italian bank subsidiaries are systemically important in some Central and Eastern Europe countries such as Croatia and Serbia. ### Authorities’ views and policy discussion - Authorities’ stance: - Confident growth would over-perform expectations; stood by growth targets of about 1½ percent in 2019–21 while acknowledging higher downside risks. - Attributed higher spreads and weaker sentiment to temporary uncertainty; affirmed commitment to pursue prudent policies and not to exceed deficit targets. - Highlighted persistent fiscal primary and external current account surpluses, nearly balanced net international investor position, sizable household savings, and long maturity of government bonds. - Emphasized banks’ abundant liquidity, stable deposits, and limited pass-through of sovereign spreads to private borrowing costs. Viewed protectionism as main downside risk to growth. - Policy debates and risks: - Authorities feel fiscal stimulus is needed to promote growth and improve social outcomes; plan to raise public investment to pre-crisis level, increase pension and social benefit spending, facilitate early retirement, and introduce a citizenship income program with job training. - Staff view: higher potential growth through structural reforms is the only durable way to improve outcomes and resilience, not fiscal stimulus or reform reversals. - Staff recommends credible consolidation to put debt-to-GDP on a firm downward trajectory and further strengthen banks’ balance sheets. - Staff simulations suggest implementation of reforms could, over the next decade, close competitiveness gaps, boost Italy’s real GDP by about 13 percent, and lower public debt by about 20 percent of GDP. ### Policy recommendations (staff) - Priorities: - Make structural reforms to raise productivity the overarching priority. - Emphasize labor and product market reforms in addition to public administration, insolvency, and justice reforms. - Improve quality of fiscal policy to be more growth friendly and inclusive. - Implement credible consolidation to ensure public debt sustainability and put debt on a firm downward path. - Further strengthen banks’ balance sheets to enhance resilience and support credit provision. - Implementation focus: - If fiscal stimulus is undertaken, prioritize high-multiplier activities: social benefits to liquidity-constrained households and swift execution of quality public investment projects, supported by well-designed social welfare and public investment management systems. *Source: IMF staff report excerpt (cr1940).* ### 22. The authorities are seeking to reduce temporary employment and support job search. ### 22. The authorities are seeking to reduce temporary employment and support job search. ### Labor market measures and recent developments - The “Dignity Decree” increases job protection by making it costlier to dismiss workers and limits incentives to use temporary contracts by requiring employers to justify extending such contracts beyond one year. - A recent constitutional court ruling delinked dismissal costs from the length of employment. - These changes have increased the uncertainty over, and costs of, dismissals, thus reversing a key benefit of the 2015 Jobs Act. - As part of the budget, the authorities plan to allocate 0.1 percent of GDP in additional resources for unemployment centers. - A minimum wage in sectors not subject to collective wage bargaining could be envisaged. ### Staff recommendations on wage bargaining and labor policies - Staff recommends decentralizing wage bargaining as a reform of first-order importance (IMF working paper 18/61). - Rationale: Decentralization would facilitate re-alignment of wages with productivity at the firm and regional levels, reducing Italy’s high structural unemployment and the heavy resort to temporary employment. - Consideration could be given to introducing a minimum wage, differentiated by regions to account for differing labor productivity levels, unemployment rates, and living costs. - The uncertainty over, and the costs of, dismissals, which are high in international comparison, should be lowered to encourage hiring and preserve key benefits of the Jobs Act. - To raise Italy’s labor force participation (the lowest among euro area countries), consideration should be given to well-designed reductions in the tax wedge on secondary earners. - Enhanced active labor market policies are welcome; cross-country experience suggests effective local administration is essential for success. - Note: Employment centers operate under competences of different levels of government; in 2017, just over 25 percent of job seekers had contacts with an employment center while the share of the unemployed who found a job in the private sector through employment centers was just 2 percent, with wide regional differences. Even in France and Germany in 2016, the probability that an unemployed person would find a job through an employment center was 7 percent. ### Promoting competition - Progress in improving competition has been weak over the past year. - August 2017: parliament approved the Annual Competition Law for the first time since 2009, but emphasis was more on consumer protection and pro-competition measures were weakened during parliamentary debates. - Implementation of various provisions has been weakened or delayed further (examples include liberalization of energy tariffs, reform of local state-owned enterprises, and minimum fees for professionals). - Authorities are considering whether to reverse the 2011 reform on liberalized retail hours. - Importance: Promoting competition is critically important for raising productivity—greater competition allows more productive firms to enter and grow and less productive ones to diminish or exit. - Staff recommends: - Tackling barriers to competition that are high in sectors such as local services, professions, and retail. - Consideration of a new competition law to decisively address regulatory impediments and barriers. - Strengthening the enforcement powers of the Competition Authority. ### Improving the business environment and insolvency framework - Long-standing issues: Public sector inefficiencies and a slow justice system; Italy ranks well on de jure indicators but poorly on perception-based ones (third-last among euro area countries in the World Bank’s Doing Business indicators). - Specific barriers: High regulatory burden, weak governance, inefficient legal framework where bankruptcy procedures take about 6 years on average. - Authorities’ planned initiatives: - Cut red tape and simplify procedures through digitization. - Reform managerial roles and fight absenteeism. - Tackle corruption through preventive and punitive measures. - Rationalize and simplify procurement; streamline, consolidate or privatize local state-owned enterprises. - Improve managerial and administrative capacity and coordination between the center and regions; publish ambitious targets (key performance indicators) to track progress. - Insolvency reform: - A delegating law approved in October 2017 establishes high-level principles to modernize the framework. - Prompt adoption and implementation of legislative decrees, adhering to international best practice, is advisable. - The special insolvency regime for large enterprises is excluded from the reform; staff finds this special regime inefficient and costly (IMF working paper 18/218) and advises folding it into the modernized framework with well-defined circumstances for potential state intervention. - Complementary efforts: improve court functioning, ensure qualified insolvency administrators, reform civil procedures to simplify processes and facilitate collateral sales, develop uniform practices, and make more intensive use of out-of-court restructuring. ### Authorities’ views on reforms - The authorities agree on the need to increase potential growth but consider demand-side policies to be of primary importance. - On labor market policies: - They do not consider decentralizing wage bargaining a priority and view the current two-tier bargaining system (which provides for productivity bonuses) as sufficient to link wages with productivity. - They expressed confidence in their active labor market plans to generate substantial positive impacts on training and employment. - On competition policy: - They clarified some reversals occurred before they took office and argued delays or changes were necessary to address employment and compensation concerns. - The possible introduction of limits on large retailers is seen as a means to support smaller shops. - On the business environment: - They questioned the methodology of the World Bank’s Doing Business indicators but acknowledged domestic surveys highlighting weaknesses in the justice system, public administration, and business regulation. - They emphasized public administration initiatives focused on managers as enablers and close monitoring of regional implementation. - Insolvency reform timing: - They intend to issue all the decrees for their insolvency reform by mid-January 2019 and continue civil justice reforms to reduce the backlog in courts and length of commercial and civil litigations. *Source: cr1940 - 22. The authorities are seeking to reduce temporary employment and support job search.* ### 33. The authorities considered their fiscal stimulus plans to be appropriate for supporting ### The authorities considered their fiscal stimulus plans to be appropriate for supporting growth and social inclusion. ### Fiscal stimulus, timing, and public investment - Authorities view pension and citizenship income measures as urgent to tackle social strains, promote turnover in the workforce, create jobs for the young, and rejuvenate the public sector skill base. - Time required to design measures; they could be introduced in 2019:Q2. - Draft budget plan based on prudent macroeconomic projections and does not include effects of higher GDP growth targets on government revenues. - Deficit level for 2019 of 2.4 percent of GDP viewed as an upper bound. - Privatization receipts expected to be 1 percent of GDP. - Critical pillar: revitalization of public investment accompanied by streamlined administrative procedures and enhanced technical capacity to accelerate implementation of sound projects. ### Financial sector stability: tail risks and monitoring - Tail risks re-emerging with the recent rise in sovereign yields: - Sustained high yields could reduce banks’ capital, raise funding costs, and increase liquidity pressures related to maturing bank bonds and TLTROs that fall due in 2020–21. - High yields would complicate plans to raise substantial volumes of MREL (minimum requirements for own funds and eligible liabilities). - Higher yields would lower investor interest and increase cleanup costs of NPL disposals, weigh on bank profitability and credit provision. - Banks with concentrated sovereign exposures and less diverse funding are more at risk. - Enhanced monitoring and planning is advisable given downside risks. ### Bank balance-sheet repair, NPLs, and supervisory oversight - Important progress on asset quality and economic recovery has produced positive results (¶12 referenced). - Significant banks (supervised directly by the SSM) are seeking to reduce NPLs to 7 percent of loans by end-2020. - Intensive supervisory oversight of NPL reduction should continue for significant banks and be extended fully to smaller banks with high NPLs. - SSM thematic review found no systemic issues for Italian banks but identified opportunities for individual banks to improve business models and processes; assertive supervisory oversight recommended to address capital-depleting business lines. - Supervisory benchmarking and guidance to promote risk-based pricing, cost allocation, and scenario analysis frameworks. ### Consolidation, problem banks, MREL, and governance - About 270 cooperative banks are expected to consolidate into three new banking groups; two of these would be supervised directly by the SSM and subject to an asset quality review in 2019. - Proceeding quickly with consolidations and subjecting all three groups to asset quality reviews would help address concerns over smaller banks’ health and viability. - Dealing with weak banks remains a challenge: - Two medium-sized banks required fresh capital in 2018; one could meet requirements only after a private rescue fund (financed by contributions from other Italian private banks) purchased subordinated debt and committed to underwrite a share capital increase scheduled for April 2019. - Swift recapitalization or timely and effective use of the resolution framework is essential to avoid lingering weaknesses and excessive burden on taxpayers and the system. - Ensuring adequate bail-in-able instruments: - Bail-in of retail subordinated debt previously created substantial challenges and led to costly taxpayer and private interventions (IMF working paper 18/196 referenced). - Large volume of fresh bail-in-able debt is needed; banks required to increase MREL buffers in coming years. - Introducing safeguards recommended, including limiting proportions of MREL allowed to be held by retail investors and rigorous public enforcement of MiFID rules. - Governance needs strengthening: - Legislative gaps in Italy’s implementation of the EU fit and proper rules for bank management need to be closed. - When implemented, 2015 EBA and 2016 ECB fit-and-proper guidance can be applied in full. ### Authorities’ views (as reported) - Broad agreement that sustained elevated sovereign yields will have increasingly negative consequences for the financial sector; authorities noted: - Pass-through has been limited so far; deposits stable; banks have sufficient capital headroom to withstand some further increase in sovereign yields; adverse effects expected over the medium term if elevated yields are sustained. - Expiration of TLTROs could adversely impact banks’ liability term structure; liquidity rules including the net stable funding ratio are being decided at the European level and would not come into force before 2021. - Intensive oversight of NPL reduction has resulted in notable improvements: new NPL formation below pre-crisis levels, provisioning coverage above the average of the main euro area banks, and NPLs net of provisions are 5 percent of loans compared to 2.3 percent among the main euro area banks. Authorities noted credit supply is not hindered by NPLs. - Agreed on need for continued improvements in bank efficiency and profitability; questioned the extent supervisors should challenge bank business strategy but affirmed consolidation of small cooperative banks is necessary with only minor delays. - Agreed on need for timely solutions for problem banks and building MREL buffers; acknowledged low appetite in wholesale markets could lead some banks to rely on local retail market but emphasized diminishing future risks as existing instruments mature and MiFID evolution addresses mis-selling risks. ### Staff appraisal: diagnosis and recommended priorities - Welcome emphasis on growth and social inclusion given Italy’s long-standing low growth and weak social outcomes: - Real personal incomes at the level of two decades ago; unemployment averaged close to 10 percent over this period; emigration of Italian citizens near a five-decade high. - Key structural weaknesses inherited by authorities: - Anemic productivity growth since the mid-1990s; prior reform efforts not comprehensive or sustained. - Weak quality of fiscal policy: high and increasing pension spending; tax burden on narrow base; high labor taxation while wealth lightly taxed; social safety net not well targeted; falling public investment. - Public debt remains very high and a perennial vulnerability despite larger fiscal primary surpluses than euro area peers at times. - Concerns about authorities’ strategy: - Strategy focuses mainly on insufficient demand; structural reform content needs strengthening. - Reversals or weakening of reforms in labor, product markets, and pensions could be costly (example: facilitating early retirements may create short-term jobs for the young but increase pension costs and burdens on younger generations). - Quality of proposed fiscal policy needs strengthening; limited progress on broadening the tax base or lowering the labor tax wedge. - Risks if sovereign spreads remain elevated: - Higher costs pass through to firms and households; banks deleverage; financial stability concerns rise; growth falls. - Even if stimulus delivers short-term boost, public debt likely to remain at its current high level for the next three years, after which it is projected to rise; it would rise sooner and faster if modest adverse shocks materialize. - Potential loss of market confidence could force sharp fiscal consolidation and a deeper recession. - Recommended comprehensive package: - Structural reforms to raise productivity and unlock potential should be overarching priority. - Improve quality of fiscal policy to be more growth friendly and inclusive; credible consolidation to put public debt sustainability concerns to rest. - Further strengthen banks’ balance sheets to enhance resilience and support the economy. - Firm implementation would reduce risks, bolster investor confidence, and enhance resilience, yielding medium-term gains by closing competitiveness gaps, boosting real incomes, and lowering public debt. ### Specific policy recommendations - Consider broadening structural reforms to include significant labor and product market reforms: - Decentralize wage bargaining to reduce structural unemployment and informality. - Reduce size and uncertainty over dismissal costs to foster job creation. - Liberalize product and service markets (local public services, professions, retail) to raise productivity, investment, and employment. - Fold Italy’s special regime for large enterprises into the general insolvency regime. - Tackle corruption, cut red tape, simplify administrative procedures, streamline procurement, and reform local state-owned enterprises. - Establish ambitious targets or key performance indicators to track progress. - Undertake credible fiscal consolidation while external conditions are favorable: - Aim for a small overall surplus in 4–5 years via a balanced adjustment to ensure debt declines firmly and automatic stabilizers can operate when shocks occur. - Shift policy composition to be growth-friendly and inclusive: - Introduce a modern, guaranteed minimum income scheme targeted to the poor; avoid welfare dependence and disincentives to work; consider gradual scaling up of the inclusion income program and rationalization of other income support programs. - Avoid pension reform reversals that reduce the effective retirement age; rationalize excesses in the pension system, ensure actuarial fairness, and adjust pension parameters to secure affordability given spending pressures over the next 2–3 decades. - Gradually increase public investment supported by improved public investment management and strengthened implementation capacity; offsetting budgetary measures needed to remain consistent with the consolidation path. - Comprehensive tax reform to broaden the tax base, lower the tax wedge on labor, promote efficiency, and support fairness: address VAT compliance and policy gaps, rationalize tax expenditures, introduce a modern property tax on primary residences, prioritize stricter enforcement, and avoid tax amnesties. - Financial sector recommendations reiterated: - Enhanced monitoring/planning to address sovereign yield risks. - Continue and extend close supervisory oversight of NPL reduction strategies for significant and less significant banks. - Consolidation of cooperative banks into three new groups should not be delayed; asset quality reviews for all three groups recommended. - Strengthen governance and ensure swift recapitalization or timely resolution of problem banks. - Implement safeguards for MREL issuance and retail investor protection; enforce MiFID rules. *Source: https://www.imf.org/-/media/files/publications/cr/2019/cr1940.pdf* ### 52. It is recommended that the next Article IV consultation be held in the usual 12-month ### 52. It is recommended that the next Article IV consultation be held in the usual 12-month cycle. ### Recommendation - It is recommended that the next Article IV consultation be held in the usual 12-month cycle. ### Box 1. Italy’s Output Gap — Key findings and staff assessment - Real GDP is about 4 percent below its pre-crisis peak in 2007. - Domestic demand is about 7 percent below its pre-crisis peak in 2007. - Unemployment is well above its pre-crisis low of 6 percent. - Involuntary part-time employment has risen to 10 percent of the labor force. - Core inflation remains subdued. - Indicators suggesting narrower slack: - Capacity utilization in industry and job vacancy rates are near historical peaks. - The share of long-term unemployed has remained persistently high. - Total unemployment is close to its historical average. - Emigration has reached its highest levels in nearly five decades. - Structural factors affecting potential and slack: - Low potential growth (including pre-crisis) complicates comparisons with pre-crisis outcomes. - Productivity depressed by long-standing structural rigidities and balance sheet strains. - The double-dip recession has weighed on investment (IMF working paper 15/230). - Staff quantitative estimates and judgment: - Staff uses the multi-variate filter of the April 2015 WEO (Phillips curve and Okun’s law) which points to a gap that is almost closed in 2019. - Staff imposes judgment favoring arguments for greater slack. - Staff’s estimate for 2018: about -1 percent of potential GDP. - This lies between the authorities’ estimate of -1.9 percent and the EC estimate of -0.3 percent. - Caution on negative bias in real-time estimates: - Historical real-time estimates by staff from 1994 through 2017 systematically estimated Italy’s output gap for that year to be significantly negative, averaging -2¾ percent of potential GDP. - Staff notes real-time negative bias tends to be more pronounced for highly indebted countries and at relatively good times, caused by inability to predict recessions and judgment that may over-estimate potential output. ### Box 2. Fiscal Multipliers — Assessment and simulations - Structural determinants imply multipliers in the medium range in normal times owing to: - Labor market rigidities, weak social safety net, relatively low propensity to import, and monetary union membership (which tend to increase multipliers). - High-level of public debt, expenditure inefficiencies, and sizable tax evasion (which tend to decrease multipliers). - Conjunctural factors that increase multipliers: - Negative output gap and constrained interest rates at the effective lower bound. - Staff and guidance-based medium-range multiplier assessment: - First year: 0.5–0.7. - Second year: 0.7–0.9. - Reference: IMF, “Fiscal Multipliers: Size, Determinants, and Use in Macroeconomic Projections,” Technical Notes and Manuals 14/04. - Authorities’ and other estimates: - Bank of Italy estimates: - A 1 percent of GDP increase in social transfers → 0.1–0.3 percent increase in real GDP (over the first two years, relative to baseline). - A 1 percent of GDP increase in public investment → 0.9–1.1 percent increase in real GDP (over the first two years, relative to baseline). - A 1 percent of GDP reduction in employers’ social contributions → 0.4–1.2 percent increase in real GDP (over the first two years, relative to baseline). - Ministry of Finance estimates: - Spending multipliers: 0.9–1.1 in both years. - Revenue multipliers: 0.2–0.4 in the first year and 0.6–0.8 in the second year (Economic and Financial Update Document, 2017). - Authorities’ 2019 draft budget plan estimate: average multiplier of 0.5 in the first year. - Simulations of the authorities’ fiscal expansion (staff assumptions and results): - Discretionary measures scaled to 1.1–1.3 percent of GDP relative to the baseline: - Increases in social spending: 0.9 percent of GDP. - Public investment: 0.2–0.3 percent of GDP. - Reduction in personal income taxes: 0.1 percent of GDP. - Using IMF’s G20 model, simulation indicates: - First-year real GDP impact of about 0.7 percent in normal times. - Peak impact increases to about 1 percent. - Risks from sovereign spreads and net impact dynamics: - If sovereign spreads increase and persist, they can shrink Italy’s GDP by offsetting stimulus effects. - Example simulation: an increase in sovereign spreads of 50 basis points (relative to the October 2018 WEO projections) yields a range of outcomes between: - No-adjustment scenario: increase in spreads not expected to persist → no offset from the rise in spreads. - Immediate/complete-adjustment scenario: increase in spreads immediately recognized as permanent → stimulus more than fully offset (contractionary fiscal expansion occurs immediately). - Staff’s near-term assumption: a small net positive impact of the stimulus based on an intermediate case where expectations adjust gradually and pass-through to private sector borrowing costs occurs with a lag. - Over the medium term: as the stimulus fades, the negative effect of persistently high spreads dominates. - Policy implication: lowering spreads—by pursuing staff’s recommended policies and reducing risks—would boost growth. *Source: cr1940 — https://www.imf.org/-/media/files/publications/cr/2019/cr1940.pdf* ### Box 3. Propagation of Sovereign Spreads to Bank Funding, Lending Costs, and Credit ### Box 3. Propagation of Sovereign Spreads to Bank Funding, Lending Costs, and Credit ### Transmission from sovereign spreads to bank funding costs - Increased sovereign spreads generally imply higher funding costs for banks. - Italy exhibits a stronger correlation of sovereign and bank credit default spreads than other advanced economies. - Empirical analysis shows that a 100 basis point increase in sovereign spreads translates swiftly to a 15–20 basis points rise in large Italian bank bond yields relative to other euro area banks. - The impact is stronger for newly-issued bonds, with a contemporaneous response of 80–100 basis points. - Banks typically increase their deposit rates by 20–40 basis points in the quarter of the spread increase. - Passthrough in recent months has been limited as banks have: - converted maturing bonds to deposits, - drawn down excess deposits at the central bank to finance increased holdings of government bonds, - and used other measures to keep overall funding costs down. ### Evidence of market stress and re-access risks - Sustained high sovereign spreads would make banks’ funding environment very challenging. - As noted in ¶11, Unicredit’s private placement of a 5-year note in November 2018 at a coupon above 7.8 percent (compared to 1 percent in January 2018) confirms the significant difficulties banks have been facing and explains their limited access to markets since early 2018. - Banks’ debt amortization profile includes substantial redemptions in 2020–21, related to the ECB’s long-term refinancing operations—banks will eventually need to re-access markets. - Sustained high sovereign spreads imply significant, and in some cases prohibitive, cost pressures for banks, which would not only impair funding but also lead to deleveraging, impacting growth. ### Pass-through to lending costs and credit quantities - The cost and availability of credit to firms and households would be negatively affected. - During the 2011–12 confidence crisis, Italian banks tightened lending conditions to firms and households considerably, increased lending rates, and reduced credit. - Empirical analyses suggest that a 100 basis point increase in sovereign yields passes through, within a quarter, to: - bank lending rates to the private sector of 25–70 basis points, and - lower bank lending by 0.4–3 percentage points annually. - The impact is higher and faster in stressful times. - Consequently, domestic demand and economic growth would suffer. ### Key empirical magnitudes and mechanisms - Sovereign-to-bank bond yield pass-through for large Italian banks: 15–20 basis points per 100 basis point sovereign shock (relative to other euro area banks). - Newly-issued bank bond yields: 80–100 basis points contemporaneous response per 100 basis point sovereign shock. - Deposit rate response: 20–40 basis points in the quarter of the spread increase. - Lending-rate pass-through to private sector: 25–70 basis points within a quarter per 100 basis point sovereign yield increase. - Reduction in bank lending: 0.4–3 percentage points annually per 100 basis point sovereign yield increase. - Noted market episode: Unicredit 5-year note in November 2018 issued at coupon above 7.8 percent versus 1 percent in January 2018. - Banks’ debt redemptions concentrated in 2020–21 (linked to ECB long-term refinancing operations). ### Policy implications and vulnerabilities - Large exposure of Italian banks to the sovereign amplifies the transmission of sovereign spreads to bank funding costs. - Limited market access and heightened funding costs can force banks into deleveraging, reducing credit supply and weighing on growth. - Measures that have mitigated near-term passthrough (converting maturing bonds to deposits, drawing down excess central bank deposits, increasing sovereign holdings) may not suffice if spreads remain elevated. - The faster and larger pass-through during stress episodes underscores the importance of addressing sovereign-bank linkages to avoid adverse macro-financial feedback loops. *cr1940 - Box 3. Propagation of Sovereign Spreads to Bank Funding, Lending Costs, and Credit* ### 2.8 Cycl. Adj. CA 2.1 EBA CA Norm 2.5 EBA CA Gap -0.3 Staff Adj. 0.0 Staff CA Gap -0.3 ### 2.8 Cycl. Adj. CA 2.1 EBA CA Norm 2.5 EBA CA Gap -0.3 Staff Adj. 0.0 Staff CA Gap -0.3 ### Real exchange rate - Background: - From 2016 to 2017, the CPI-based real effective exchange rate (REER) appreciated by 0.8 percent while the ULC-based REER was unchanged. - From a longer perspective, stagnant productivity and rising labor costs have led to a gradual appreciation of the REER since Italy joined the euro area, both in absolute terms and relative to the euro area average (by about 10 percent using ULC-based indices). - As of November 2018, the REER appreciated by a further 3.9 percent relative to the 2017 average. - Assessment: - The EBA level and index REER models suggest a modest overvaluation of 5.4 percent and 7.2 percent, respectively. - This is generally consistent with, but slightly below, the persistent wage-productivity differentials vis-à-vis key partners, and it corresponds to a CA gap in the lower end of the staff-assessed CA gap range. - Staff assesses a REER gap of 0–10 percent. - Technical note: - The elasticity of the REER to the CA gap is estimated to be 0.26. ### Capital and financial accounts: flows and policy measures - Background: - Portfolio and other-investment inflows typically have financed the CA deficits of the past, despite a modest net FDI outflow. - Italy’s financial account posted net outflows of about 3 percent of GDP in 2017, largely reflecting residents’ net purchases of foreign assets, even as foreign investment in Italian portfolio securities continued. - Assessment: - While supported by monetary accommodation by the ECB, Italy remains vulnerable to market volatility, owing to the large refinancing needs of the sovereign and banking sectors, and the potentially tight credit conditions from the still high stock of NPLs in the banking sector. ### 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. ### Technical background notes (EBA CA norm and refinements) - The CA norm for 2017 (2.5 percent) is lower than in 2016 (4.4 percent), reflecting methodological refinements to the EBA framework, particularly as it pertains to capturing demographic effects and credit cycles. - For Italy, the refined model indicates: - a positive, but smaller, contribution of demographics (1.7 instead of 3.4 percent), - and a small positive contribution of policies (including credit) of 0.3 percent (instead of -0.5 percent as in 2016). ### Risk Assessment Matrix — excerpts of vulnerabilities, triggers, impacts, and policy responses - Key vulnerabilities and triggers: - Fiscal: High public debt and gross financing needs. - Banks: High NPLs and sovereign exposure; higher funding costs, low profitability; crowding out credit to private sector. - Real sector: Chronically weak productivity; large corporate debt overhang. - External: Weaker-than-expected global growth; falling external demand; trade actions and isolationism. - Potential adverse evolutions and impacts: - Strained bank balance sheets amid legacy problems and weak profitability could lead to financial distress in one or more major banks. - Widening of sovereign yields, higher financing costs, and concerns over fiscal sustainability could push Italy into a bad equilibrium—tighter financial conditions, higher debt service and refinancing risks, weakening of bank balance sheets and solvency positions, potential loss of market confidence. - Lower growth potential, weaker investment and employment, deterioration in public debt sustainability and private balance sheets. - Policy responses and recommendations highlighted: - Undertake credible fiscal consolidation to achieve small structural surplus with pro-growth measures. - Implement and deepen structural reforms to spur investment, productivity and competitiveness, advance rebalancing. - Let automatic stabilizers work to support growth. - Repair bank and corporate balance sheets to enhance monetary transmission. - Run higher fiscal surpluses to reduce public debt. - Implement bold structural reforms and restore market confidence through corrective fiscal and financial policies. - Supervisors should continue to set ambitious targets for reducing NPLs in identified banks. - Reform insolvency to facilitate reduction in NPLs, encourage bank consolidation and better governance to improve profitability, and resolve weak banks in a timely manner. - Faster progress on banking union—clarify backstops. - Activate OMT if needed. ### Annex III — Debt Sustainability Analysis (key findings and projections) - Current level and recent history: - Italy’s public debt is very high at about 131 percent of GDP. - Debt increased from about 100 percent of GDP in 2007 to 131.2 percent of GDP in 2017. - In percent of GDP, it is the second highest in the euro area, after Greece. - Structure and refinancing context: - About two-thirds of debt is held by domestic investors. - Average residual maturity is around 7½ years and about 75 percent of debt is at fixed interest rates. - Since March 2015, the Eurosystem’s net purchases of Italian public debt were €362 billion, compared with gross medium- to long-term bond issuances of about €600 billion. - Baseline projection: - In the baseline, debt is projected to remain broadly stable at about 131 percent of GDP over the next few years, owing to the historically subdued interest rates, but then rise under staff’s projection of rising interest rates as monetary conditions normalize and higher pension spending. - Baseline assumptions: - Real GDP growth is projected to average ¾ percent annually during 2018–23 and about 0.7 percent thereafter. - The GDP deflator is projected to rise from 0.5 percent in 2017 to a steady state of around 1¾ percent over the next few years. - The government is assumed to maintain an average structural primary surplus of about 1 percent of GDP over the period 2018–2023. Thereafter, the primary balance would deteriorate with higher pension spending (by about 3 percent of GDP above the authorities’ projections over the period 2017–2035, cumulatively). - The proposed reversal of pension reforms would increase pension spending by a further 1 percent of GDP. - Over the medium term, staff projects an effective nominal interest rate of about 3 percent, or an average interest bill of about 3.9 percent of GDP. - The marginal cost of borrowing is projected to increase to 2.9 percent in 2019 from a low of 0.7 percent in 2017. - Spreads vis-à-vis German bunds are assumed to decline gradually from an average of 225 basis points in 2018 to 205 basis points in 2023. - The average cost of debt rises gradually with monetary normalization, with the effective nominal interest rate increasing to around 5 percent by 2035 (3½ percent in real terms). - An effective real interest rate of 3½ percent (about 50 basis points higher than the average over 1996–2017), with real GDP growth of ⅔ percent, implies a debt stabilizing primary balance of about 3½ percent of GDP. - The authorities have indicated potential privatization receipts of 1 percent of GDP in 2019. - Risks to baseline: - Important risks are embedded in the baseline assumptions; Italy’s projected fiscal stance is subject to significant downside risks. - Sizable and sustained primary surpluses of about 4 percent of GDP will be needed to put debt on a firm downward trajectory. - Italy’s history: primary surpluses averaged 1¼ percent of GDP during 2001–17. - A more expansionary fiscal stance than in the baseline—for example, further tax cuts in 2020 and beyond or raising public investment to 3 percent of GDP by 2023—would further increase debt. *Source: Annex I–III, Italy: External Sector Assessment and Debt Sustainability Analysis (cr1940).* ### 4. Materialization of moderate shocks would result in debt rising earlier and faster, e.g.: ### 4. Materialization of moderate shocks would result in debt rising earlier and faster, e.g.: ### Standard growth shock - Assumption: Real output growth rates are lower by one standard deviation for two years starting in 2019, resulting in an average growth of -1½ percent in 2019–20. - For every 1 percentage point decline in growth, inflation is assumed to decline by 25 bps. - Fiscal impact: The primary balance would decline, reaching -1.5 percent of GDP by 2023. - Debt outcome: Debt increases to 152.5 percent of GDP and fails to come down over the projection period. ### Interest rate shock - Assumption: Spreads could increase further; a further increase in spreads of 205 bps is assumed. - Context: during the 2011–12 episode, spreads increased above 500 bps. - Transmission: Higher borrowing costs are passed on to the real economy, depressing growth by 0.4 p.p. for every 100 bps increase in spreads. - Interest rate outcome: The implicit average interest rate on debt rises to 4 percent by 2023. - Debt outcome: Debt increases to around 140 percent of GDP by 2023. ### Contingent liability shock - Assumption: A one-time increase in non-interest expenditure standardized to about 10 percent of banking sector assets, accompanied by lower growth for two consecutive years by -1½ percentage points, and lower inflation by ½ percent. - Fiscal impact: The primary balance is assumed to worsen by 11 percent of GDP in 2019 (e.g., from costs to recapitalize the banking system or of other contingent fiscal liabilities as reported by Eurostat). - Debt outcome: Debt rises to 166 percent of GDP by 2023. - Additional effect: Gross financing needs would be significantly higher. ### Baseline and DSA-related indicators (selected figures from the Public DSA) - Baseline nominal gross public debt (in percent of GDP): 118.0 (2016), 131.4 (2017), 131.2 (2018), projections 131.4 (2019), 131.1 (2020), 131.1 (2021), 131.3 (2022), 131.4 (2023). - Baseline public gross financing needs (in percent of GDP): 28.5 (2016), 23.8 (2017), 24.9 (2018), 22.4 (2019), 23.6 (2020), 23.6 (2021), 24.1 (2022), 25.5 (2023). - Net public debt (in percent of GDP): 107.5 (2016), 118.9 (2017), 119.0 (2018), 119.4 (2019), 119.4 (2020), 119.6 (2021), 120.1 (2022), 120.4 (2023). - Real GDP growth (in percent): -0.7 (2016), 1.1 (2017), 1.6 (2018), 1.0 (2019), 0.8 (2020), 0.7 (2021), 0.6 (2022), 0.6 (2023). - Inflation (GDP deflator, in percent): 1.5 (2016), 1.1 (2017), 0.5 (2018), 1.1 (2019), 1.5 (2020), 1.5 (2021), 1.6 (2022), 1.7 (2023). - Nominal GDP growth (in percent): 0.7 (2016), 2.3 (2017), 2.1 (2018), 2.1 (2019), 2.3 (2020), 2.2 (2021), 2.2 (2022), 2.3 (2023). - Effective interest rate (in percent): 4.1 (2016), 3.1 (2017), 3.0 (2018), 2.8 (2019), 2.9 (2020), 3.0 (2021), 3.1 (2022), 3.3 (2023). - Cumulative change in gross public sector debt (percent of GDP): 3.2 (2016), -0.2 (2017), -0.1 (2018), 0.2 (2019), -0.3 (2020), 0.0 (2021), 0.2 (2022), 0.1 (2023), 0.0 (cumulative). - Identified debt-creating flows and components (selected): Primary deficit contributions, automatic debt dynamics, privatization receipts, contingent liabilities, other debt flows, residuals as detailed in the DSA tables. *Source: IMF staff (Public DSA, Italy).* ### Annex IV. Progress Against IMF Recommendations ### Annex IV. Progress Against IMF Recommendations ### I. Structural Reforms — Labor Markets - 2017 Article IV policy advice: - Modernize wage bargaining by giving primacy to firm-level contracts, clarifying rules on representativeness, and possibly establishing a minimum wage that is differentiated across regions. - Monitor take-up of new open-ended contract. Consider extending the new open-ended contract to all existing work arrangements in the private sector and reduce dismissal costs, which is high in OECD comparison. - Scale up spending on ALMPs. Enhance coordination with local authorities and improve centralized data collection and job matching. Monitor effectiveness of delivery, or consider providing ALMPs alongside passive labor market policies. - Actions since 2017 Article IV: - A “Dignity Decree” was approved in mid-2018 which increases dismissal costs and reduces incentives to use temporary contracts by requiring employers to justify extending such contracts beyond one year. - A recent constitutional court ruling delinked dismissal costs from the length of employment, increasing uncertainty over such costs. - On ALMPs, the authorities plan to allocate 0.1 percent of GDP in 2019 in additional resources for unemployment centers. - Next steps recommended: - Decentralize wage bargaining as a measure of first-order importance to facilitate the re-alignment of wages with productivity at the firm and regional levels. In this context, consider introducing a minimum wage, differentiated by regions to account for differing productivity levels, unemployment rates, and living costs. - Lower the uncertainty over and costs of dismissals, which remain high in international comparison. - On ALMPs, ensure effective coordination between the central and local administrations, with close attention to design and incentives. ### I. Structural Reforms — Product Markets - 2017 Article IV policy advice: - Strengthen the competition law in line with the recommendations of the Competition Authority and ensure an annual process of adopting pro-competition laws. - Enhance competition in areas such as local public service provision, transport, and closed professions. - Fully implement existing legislation (e.g., retail sector) and enhance the Authority to sanction anti-competitive practices. - Actions since 2017 Article IV: - Parliament approved the Annual Competition Law in August 2017. - The actual pro-competition measures included in the law were weakened significantly during the parliamentary debates, as well as subsequently. - Next steps recommended: - Tackle decisively barriers to competition that are high in sectors such as local services, professions, and retail, including through a new competition law if needed. Refrain from reversing or weakening past reforms. - Strengthen the enforcement powers of the Competition Authority. ### I. Structural Reforms — Public Administration - 2017 Article IV policy advice: - Implement fully the public administration reform and broaden public sector reform to include all local public services, reorganize careers and accountability of public sector managers, improve the skill mix in the public sector, enhance mobility, match positions with skills, and align wages with productivity. - Implement fully the new procurement reform, broaden its coverage, and remove remaining impediments to competition. Monitor reform outcomes. - Actions since 2017 Article IV: - Implementing decrees for the reform of public sector managers have expired. - The new government is introducing a bill to reform public administration by cutting red tape, simplifying procedures through digitization, and improving efficiency by reforming managerial roles and fighting absenteeism. - The implementation of the privatization or rationalization of public enterprises has been weakened and delayed to 2020. - Next steps recommended: - Given repeated shortfalls in reforming successfully, improve the managerial and administrative capacity to implement reforms and address weaknesses in coordination between the center and regions. - Enhance the effectiveness of procurement reform—by securing savings of the centralized purchasing units and tackling difficulties in public works. - Streamline, consolidate or privatize local state-owned enterprises. - Publish ambitious targets or key performance indicators to track and clearly communicate progress. ### I. Structural Reforms — Insolvency reforms - 2017 Article IV policy advice: - Adopt promptly the proposed insolvency overhaul, while maintaining ambitious goals for the rationalization of corporate debt restructuring and special procedures for large enterprises. - Implementation requires considerable efforts to improve court functioning, the qualification of insolvency administrators, and the development of registries and platforms for the sale of collateral. - Actions since 2017 Article IV: - A delegating law was approved in October 2017, establishing high-level principles to modernize the insolvency framework. - Registries and a platform for the sale of collateral were created and made operational. - Next steps recommended: - Adopt and implement the relevant legislative insolvency reform decrees. - Fold the special insolvency regime for large enterprises into the modernized insolvency framework. - Improve court functioning and ensure qualified insolvency administrators. - Reform civil procedures to simplify processes, facilitate collateral sales, and incentivize courts to reduce backlogs. - Consistent implementation across Italy would require development of uniform practices and attention to resource allocation. ### II. Fiscal Policy — Consolidation and Fiscal Quality - 2017 Article IV policy advice: - Adjust the structural primary balance by about 1½ percent of GDP, cumulatively, over 2018–20. - Improve the quality of fiscal policy: cut current primary spending (including pensions), while supporting the vulnerable and raising capital spending. - Lower tax rates on productive factors, shift taxation toward property and consumption, and broaden the tax base. - Actions since 2017 Article IV: - The 2018 budget postponed adjustment, repealing legislated VAT rate hikes and failing to specify high-quality offsetting measures. - The 2019 draft budget plan envisages a sizable expansion for 2019‒21 to increase spending on pensions, other social benefits and public investment and to lower income tax rates. - The 2019 draft budget plan allocates more resources for pensions and other social benefits, including for partially reversing the 2011 pension reform) and for a citizenship income program, as well as for public investment. It also offers incentives to boost investment. - The 2018 budget lowered the corporate income tax rate and reduced social security contributions for select groups of new employees. - The 2019 draft budget plan provides tax relief to the self-employed and small enterprises. Consideration is being given to a “fiscal peace” program. - Next steps recommended: - Undertake a credible and balanced consolidation that delivers a small overall surplus in 4–5 years to put debt on a firm downward trajectory. - Cut current primary spending. Avoid pension reform reversals; rationalize pockets of excesses and adjust pension parameters to secure pension sustainability. - Comprehensively review the social protection system, with a view to scaling up the current inclusion income program to a modern, guaranteed minimum income scheme. - Raise capital spending, ensure high quality projects are selected, and tackle implementation bottlenecks. - Undertake a comprehensive reform to broaden the tax base, promote efficiency, and ensure fairness. - Broaden the tax base by reducing VAT compliance and policy gaps, removing other inefficient tax expenditures, introducing a modern property tax on primary residences, and combating tax evasion through stricter enforcement. - Reduce the labor tax wedge further. Avoid tax amnesties and reduce tax uncertainties. ### III. Financial Stability — NPL resolution and balance sheet health - 2017 Article IV policy advice: - Require banks to present comprehensive strategies for reducing NPLs significantly over the medium term. - Provide guidance and assessment on banks’ approaches to provisioning and loan restructuring practices as well as capacity to resolve NPLs using internal tools. - Deploy intensive and assertive supervisory challenge to further promote more coherent and realistic business models. - Actions since 2017 Article IV: - Significant banks agreed with the SSM on ambitious NPL reduction targets that have supported notable reductions in NPLs. - The Bank of Italy issued streamlined guidance on NPL reduction strategies to less significant banks and approached them to present their NPL reduction plans. - The ECB/SSM’s thematic review identified considerable opportunities for individual banks to improve their business models and processes. - Introduction of IFRS9 has provided temporary relief for balance sheet strains. - Next steps recommended: - Continue intensive supervisory oversight to ensure NPL reduction strategies are ambitious and credible for significant banks and extend fully to smaller banks. - Deploy assertive supervisory oversight to ensure banks proactively identify and address capital-depleting business lines; benchmarking and guidance would promote more effective and consistent use of risk-based pricing, cost allocation, and scenario analysis frameworks. ### III. Financial Stability — Banking consolidation and supervision - 2017 Article IV policy advice: - Assess ex ante whether the newly emerging consolidated banking groups are sound from capital, asset, management and liquidity perspectives, and profitable over the long run. - Subject all emerging groups to asset quality reviews, ensure robust governance and risk management structures, and follow up on issues found in the remaining smaller banks. - Set for each bank ambitious and credible targets for risk management and rationalization, accompanied by a viability assessment. - Actions since 2017 Article IV: - The formation of the new banking groups has been delayed. The groups are expected to emerge from the consolidation of some 270 cooperative banks by 2019:Q1. - Two are expected to fall under direct ECB/SSM supervision and will be subject to an asset quality review. - Next steps recommended: - Ensure—through intensive and assertive supervisory challenges and by imposing ambitious and credible targets—that banks have sound risk management and realistic and coherent business model assumptions. - Undertake rigorous supervisory analysis to ensure the three emerging banking groups start with a clean bill of health and are profitable over the long term, including by undertaking an asset quality review of all emerging groups, ensuring robust governance and risk management structures, and following up on issues found in the remaining smaller banks. ### III. Financial Stability — Resolution framework and safeguards - 2017 Article IV policy advice: - Effective use of the framework for the timely and orderly resolution of failing banks would prevent the costs of the weaker banks from being borne by the rest of the system and eventually raising stability concerns. - To address concerns about bailing in retail investors, consider identifying and dealing firmly with cases of mis-selling to retail investors and safeguarding poor households through a means-tested social safety net. - Actions since 2017 Article IV: - A medium-sized bank that has undergone repeated recapitalizations in recent years and is supervised directly by the SSM was in effect bailed out by a group of Italian banks that purchased the bank’s subordinated debt while committing to underwrite a share capital increase. - Next steps recommended: - For problem banks, swift recapitalization or timely and effective use of the resolution framework is essential to avoid weaknesses from lingering too long, excessively burdening taxpayers and the rest of the system, and threatening stability. - Safeguards should be introduced to ensure expected new MREL is effective, including by limiting the proportions of MREL held by retail investors and rigorous enforcement of MiFID rules. *Annex IV. Progress Against IMF Recommendations — cr1940* ### Annex V. Recently Published IMF Working Papers on Italy ### Annex V. Recently Published IMF Working Papers on Italy ### Structural reforms: Competitiveness, productivity, and insolvency (Papers A–C) - A. Competitiveness and Wage Bargaining Reform in Italy - Prepared by Alvar Kangur; Published on March 2018; Internet Link: WP/18/61 - Key findings: - Growth of Italian exports has lagged that of euro area peers. - Unit labor costs have risen faster than those in euro area peers. - Wages are set at the sectoral level and extended nationally and do not respond well to firm-specific productivity, regional disparities, or skill mismatches. - Nominally rigid wages have implied adjustment through lower profits and employment. - Wage developments explain about 45 percent of the manufacturing unit labor cost gap with Germany. - A search-and-match DSGE model finds substantial gains from moving from sectoral- to firm-level wage setting: at least 3.5 percentage points lower unemployment (or higher employment) rate and a notable improvement in Italy’s competitiveness over the medium term. - B. Corporate Indebtedness and Low Productivity Growth of Italian Firms - Prepared by Gareth Anderson and Mehdi Raissi; Published on February 2018; Internet Link: WP/18/33 - Key findings and methods: - Productivity growth in Italy was persistently anemic and lagged the euro area over 1999–2015 while corporate sector indebtedness increased. - Uses the ORBIS firm-level database and a novel estimation technique proposed by Chudik and others (2017) to account for dynamics, bi-directional feedback, cross-firm heterogeneity, and cross-sectional dependence from unobserved common factors. - After filtering unobserved common factors and controlling for firm-specific characteristics, finds significant negative effects of persistent corporate debt build-up on total factor productivity growth. - Finds weak evidence of a threshold level of corporate debt beyond which productivity growth drops off significantly. - Policy implications: tax design should discourage persistent corporate debt accumulation; effective and timely frameworks to reduce corporate debt overhangs are essential. - C. The Insolvency Regime for Large Enterprises in Italy: An Economic and Legal Assessment - Prepared by Nazim Belhocine, Daniel Garcia-Macia, and José Garrido; Published on September 2018; Internet Link: WP/18/218 - Key findings: - Italy’s special regime for large enterprises (“extraordinary administration”) is rarely successful in restructuring companies and instead typically leads to sale of the business after 2–3 years of administration. - Viable parts of groups are sold; remaining assets are disposed during a liquidation phase which is lengthier than under the general regime. - Creditors’ rights are sidelined and their investment is eroded, hindering legal certainty, economic efficiency, investment, and job creation. - The paper estimates the combined loss to creditors and the state could translate to a cost per transferred employee of about 14 times GDP per capita. - Recommendation: consider repealing the special regime and folding it into the general insolvency regime with added provisions for state intervention in specific well-defined circumstances. ### Fiscal policy (Paper D) - D. Italy: Toward a Growth-Friendly Fiscal Reform - Prepared by Michal Andrle, Shafik Hebous, Alvar Kangur and Mehdi Raissi; Published on March 2018; Internet Link: WP/18/59 - Objectives and approach: - Assess spending patterns to identify areas for savings; evaluate the pension system; analyze scope for revenue rebalancing; propose a package of spending cuts and tax rebalancing that is growth friendly and inclusive. - Key conclusions: - The Italian medium-term fiscal plan (published late 2017) aims to achieve structural balance by 2020, although concrete, high-quality measures to meet the target are yet to be specified. - A carefully designed package could have limited near-term output costs, achieve a notable reduction in public debt over the medium term, and help balance the need to bring down public debt while supporting the economic recovery. ### Financial sector and firm-level credit (Papers E–F) - E. Credit-Supply Shocks and Firm Productivity in Italy - Prepared by Sebastian Doerr, Mehdi Raissi and Anke Weber; Published on October 2018; Internet Link: https://doi.org/10.1016/j.jimonfin.2018.06.004. - Key findings: - Examines implications for firm productivity of adverse shocks to bank lending using loan-level syndicated lending data and a novel identification scheme exploiting heterogeneous loan exposure of Italian banks to foreign borrowers in distress. - Finds that a negative shock to bank credit supply reduces firms’ loan growth, investment, capital-to-labor ratio, and productivity. - Transmission from credit supply to firm productivity is linked to labor market rigidities that delay or distort adjustment of firms’ desired labor and capital allocations. - Effects are stronger for firms with higher capital intensity and external financial dependence. - F. Household Wealth and Resilience to Financial Shocks in Italy - Prepared by Daniel Garcia-Macia; Published on August 2018; Internet Link: WP/18/196 - Key findings and methods: - Documents changes in Italian household financial wealth over two decades by constructing a matrix of bilateral financial sectoral exposures. - Italy’s household sector is wealthier than most euro area peers in absolute terms and relative to income, with a sizable fraction held by the rich and upper middle classes. - Households became increasingly exposed to the financial sector, which was in turn exposed to the highly indebted real and government sectors. - Simulates financial shocks to gauge household sector’s ability to absorb losses, including illustrative calculations for a fall in the value of government bonds and for bank bail-ins versus bailouts. ### Comprehensive reform strategy and quantified benefits (Paper G) - G. Italy: Quantifying the Benefits of a Comprehensive Reform Package - Prepared by Michal Andrle, Alvar Kangur and Mehdi Raissi; Published on March 2018; Internet Link: WP/18/60 - Key findings: - Simulates growth and competitiveness effects of a package of fiscal, financial, wage bargaining, and other structural reforms. - Credible implementation of such a comprehensive package yields substantial medium-term dividends at negligible near-term growth costs. - Real GDP growth is estimated to be substantially higher over the medium term, while the real effective exchange rate depreciates notably. *Annex V. Recently Published IMF Working Papers on Italy (extracted summaries).* ### 5. Italian yields moderated slightly following the EC’s announcement that ### 5. Italian yields moderated slightly following the EC’s announcement that ### Market reaction and sovereign spreads - 10-year sovereign yield fell about 25 basis points. - Yield remains high at about 2¾ percent. - Spreads vis-à-vis German bunds around 250 basis points. - Staff note: sustained high sovereign spreads risk passing through to borrowing costs of firms and households, weighing on credit provision and growth, and raising financial stability concerns. ### Updated macroeconomic projections - Real GDP growth projections updated to reflect revised fiscal plan: - 2019: lowered from 0.8 percent to 0.6 percent. - 2020: increased from 0.7 percent to 0.9 percent. - Over the medium term, negative effect of sustained high spreads dominates stimulus, leaving projections broadly unchanged. - Deficit and debt outlook: - Deficit projected to rise from about 2.1 percent of GDP in 2019 to 3 percent of GDP in 2020 and beyond unless broad political support activates the VAT safeguard clause or finds compensatory measures. - Public debt would remain very high at above 130 percent of GDP and vulnerable to adverse shocks. ### Government’s flagship measures — design and risks - Decree law approved January 17, 2019 specified design of pension reversal and citizenship income measures; staff concerns: drawbacks in design carry risks for potential growth and fiscal costs. - Reversal of past pension reforms: - Early retirement rules eased; increases number of pensioners, lowers labor force participation and potential growth, and adds to an already high pension bill. - Eligibility: workers at least 62 years of age with a minimum 38 years of contributions; women at least 59 years of age with a minimum 35 years of contributions. - These ages are well below statutory retirement age of 66 years 7 months and effective retirement age of 63½ years. - Potential pool of early retirees further expanded by allowing workers to fill gaps in contribution history at subsidized rates. - Automatic adjustments of statutory retirement age to life expectancy were canceled for 2019–20. - Measures to limit cost: delaying payouts; early pension benefits cannot be combined with labor income above a certain limit; scheme offered experimentally during 2019–21. - Citizenship income program: - Means-tested poverty relief program operational in April 2019, replacing the inclusion income program. - Beneficiaries must commit to participating in local public works and accept at least one of three job offers from employment centers. - Benefits are set at 100 percent of the relative poverty line for tenants without income, compared to international good practice of 40–70 percent. - Benefits relatively more generous in the South, implying larger disincentives to work and risks of welfare dependency. - Added benefits decline too quickly with family size (penalizing poor larger families) while pensioners are treated preferentially. - Adequate controls will be essential for effective targeting. ### Financial sector developments and stability actions - ECB/SSM appointed temporary administrators to Banca Carige (Italy’s tenth largest bank) after failure to raise equity to meet regulatory capital requirements. - Banca Carige accounts for less than 1 percent of system assets. - Nonperforming exposures above 25 percent of total loans at mid-2018. - Share price fell over 80 percent in 2018. - Entire issuance of subordinated debt (€320 million) purchased at a coupon of 13 percent by other Italian banks via voluntary arm of deposit insurance scheme. - Rejection by shareholders of capital increase led to resignation of most management and Board. - Government emergency law: - Allows precautionary recapitalization of up to €1 billion. - Extended guarantees for new bond issuances of up to €3 billion until June 2019. - Temporary administrators appointed until early April; SSM gave the bank until end-2019 to meet capital requirements sustainably. ### Banking sector resilience and priorities (authorities’ perspective) - Strengthening since the Great Financial Crisis: - Common Equity Tier 1 ratio average reached 13.1 percent in September 2018, up from 7.0 percent at end-2008. - Credit quality improvements: - Ratio of new NPLs to total performing loans: 1.7 percent in Q3 2018, down from 6.1 percent at end-2009. - Burden of outstanding net NPLs on banks shrunk to less than 5 percent of banks’ total loans. - Gross NPLs: 216 billion euro at end-September 2018, down from 360 billion euro at end-2015. - Net NPLs: 99 billion euro at end-September 2018, down from 197 billion euro at end-2015. - Coverage ratio increased by 9 percentage points to 54 percent. - Secondary market for NPLs enabled disposal of gross bad loans for 80 billion euro over the period. - Policy and supervisory measures: - Bank of Italy guidelines on NPL reduction strategies for Less Significant Institutions issued January 2018; plans under evaluation. - Need to further enhance capitalization, efficiency, and profitability; diversify revenue and reduce operating costs. - Importance of pursuing strategies to tackle technological development and competitive pressures. ### Key statistics and projections (select figures from Table 1 and text) - Market and fiscal: - 10-year sovereign yield fell about 25 basis points. - Yield about 2¾ percent. - Spread around 250 basis points. - General government net lending/borrowing: -2.1 percent in 2019; -2.9 percent in 2020; -3.0 percent in 2021–23 (Table 1 shows series: -2.4, -1.9, -2.1, -2.9, -3.0, -3.0, -3.0 for 2017–23). - General government gross debt: 131.2, 131.4, 130.9, 130.7, 130.9, 131.0, 131.1 (2017–23, Table 1). - Growth and demand (Table 1 projections): - Real GDP: 1.6 (2017), 1.0 (2018), 0.6 (2019), 0.9 (2020), 0.7 (2021), 0.6 (2022), 0.6 (2023). - Real domestic demand: 1.3, 1.1, 0.6, 1.1, 0.8, 0.6, 0.6. - Private consumption: 1.5, 0.6, 0.7, 1.1, 0.8, 0.7, 0.6. - Gross fixed capital formation: 4.3, 3.2, 1.4, 1.0, 0.6, 0.6, 0.7. - Prices and labor (Table 1): - Consumer prices: 1.3, 1.2, 1.3, 1.5, 1.6, 1.7, 1.7. - Unemployment rate (percent): 11.3, 10.7, 10.5, 10.3, 10.1, 10.0, 9.9. - External sector (Table 1): - Current account balance (% of GDP): 2.8, 2.4, 2.5, 2.2, 1.9, 1.7, 1.4. ### Policy implications and recommendations (implied in staff and authorities’ text) - Address risks from high sovereign spreads to prevent pass-through to lending rates and protect growth and financial stability. - Ensure fiscal credibility to avoid sustained rise in deficit and debt: - Activate VAT safeguard clause or find compensatory measures if needed. - Reform design caution: - Pension reversals and citizenship income should be calibrated to avoid large negative effects on labor force participation, potential growth, and fiscal costs. - Implement adequate controls to ensure effective targeting of citizenship income. - Strengthen banking sector measures: - Continue NPL reduction, bolster capitalization and profitability, and adapt to technological and regulatory changes. - Advance structural reforms to lift potential growth: - Reinvigorate public investment and improve project planning and procurement. - Improve business climate via public administration efficiency, insolvency reform, civil justice improvements, and tax reform dialogue. *January 17, 2019 — Content unit: cr1940 - 5. Italian yields moderated slightly following the EC’s announcement that* --- _Source: https://www.imf.org/-/media/files/publications/cr/2019/cr1940.pdf_