## Financial Indicators (IMF staff report — content unit _cr0945)

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### Financial system resilience and recent performance
- No institution failed or fell short of regulatory requirements as the crisis intensified.
- Equity prices plunged; interbank market froze; corporate issuance dried up; some large Italian banks came under pressure; system remained solid.
- Italian banks’ recourse to ECB lending increased but "remained commensurate with their asset share in the euro area."
- Banks funded themselves through bond issuance to domestic retail investors, supporting loan growth up to mid-2008.
- Third-quarter profits for major banks remained positive but "much lower than last year" and were helped by IAS39.
- Bank CDS spreads rose but "remained below those of other European peers."
- Surveys indicate significant tightening ahead (mostly pricing and lending standards); household lending "already sharply declined, chiefly for demand reasons."
- Latest observation for financial indicators charted: "as of December 1, 2008."

### Explanatory factors for relative banking resilience (Box 1)
- Relationship-based intermediation and extensive bank-branch network, plus sound deposit-insurance, support solid deposit base and retail market for bank liabilities.
- Low contestability, high net interest margins and retail banking fees insulated banks from competition and reduced risk appetite.
- Rapid expansion into new EU member states and Russia generated double-digit profit growth until recently; exposures are now vulnerabilities.
- Regulatory provisions (e.g., on derivatives, covered bonds finalized in May 2007) were more stringent and may have inhibited riskier strategies.
- Past corporate fraud scandals (Parmalt and Cirio) and heavy sanctions may have reduced appetite for high-risk strategies.

### Authorities’ policy response and regulatory measures
- From 2007 BoI intensified monitoring, weekly liquidity reporting for large banks, prudential oversight, targeted inspections, more frequent stress testing, and counterparty risk reporting.
- Consob banned short sales in September 2008.
- Government enabling decrees (summary of powers):
  - allow capital injections via non-voting preference shares with conditionality;
  - guarantee new bank liabilities;
  - permit BoI to swap government debt for low-quality bank collateral (for up to €40 bn; operations started)—Treasury will guarantee BoI loans if needed;
  - boost BoI powers for prompt/early bank resolution;
  - fully underwrite the deposit guarantee fund.
- Details (pricing of state capital injections and bank obligations) await implementing legislation.
- Staff recommend full and prompt implementation and consideration of additional measures, including a voluntary government recapitalization scheme, emphasizing:
  - ensuring transparency;
  - minimizing market distortions;
  - limiting government involvement in banks’ decision-making, including via a clear exit strategy;
  - avoiding spillovers to other countries, especially CEE;
  - enhancing international regulatory and supervisory coordination.

### Longer-term financial sector goals
- Consider additional measures to strengthen financial stability and the growth-enhancing role of finance:
  - improving consumer protection;
  - further strengthening supervisory and regulatory frameworks;
  - enhancing coordination, efficiency and information sharing among regulators;
  - spurring competition and improving corporate governance.

---

### Macroeconomic impact, outlook, and near-term fiscal stance

### Near-term macroeconomic impact and projections
- Global financial crisis precipitated a recession: "Output is projected to contract by about ½ percent in 2008 and 1 percent in 2009, with risks tilted to the downside."
- Output contracted by "½ percent in each of the middle two quarters of 2008."
- Confidence "at its lowest level in over a decade"; consumption continued to decline despite still-positive employment gains and easing inflation.
- Gross fixed investment slowed sharply in first half of 2008; net exports turned firmly negative.
- Housing market cooling less than many European countries due to house prices having not risen as sharply.
- Staff near-term projections (December 3, 2008): 2008 GDP growth -0.4; 2009 GDP growth -1.0; 2008 inflation 3.5; 2009 inflation 1.6.
- Alternative forecasts (selected):
  - Ministry of Finance (Sept 23, 2008): 2008 GDP growth 0.1; 2009 GDP growth 0.5.
  - Bank of Italy (July 2008): 2008 GDP growth 0.4; 2009 GDP growth 0.4.
  - Confindustria (Dec 16, 2008): 2008 GDP growth -0.5; 2009 GDP growth -1.3.
  - European Commission (Nov 3, 2008): 2008 GDP growth 0.0; 2009 GDP growth 0.0.
  - OECD (Nov, 2008): 2008 GDP growth -0.4; 2009 GDP growth -1.0.

### Downside risks and sensitivity
- Negative risks dominate; uncertainty exceptionally large.
- External downside risks dominate given Italy’s high reliance on exports.
- Domestic risks: additional falls in consumer confidence and rising uncertainty.
- Staff estimate: prolonged credit crunch could cause investment to decline significantly, resulting in additional output loss of up to 1 percent a year for two years.
- Box 2 estimates:
  - Global downturn subtracted more than 1 percentage point from fixed investment growth to date; contribution of tighter credit conditions is about ½ ppt.
  - Increase in credit costs to date: over 70 bps; corporate credit growth pace not yet materially affected though bond placements dried up since Q2.
  - Household debt (2007): Italy 34 percent of GDP / 49 percent of DI; Spain 80 / 140; USA 98 / 134.

### Revised staff projections (January 2009)
- Staff project GDP decline by 2.1 percent in 2009 and by 0.1 percent in 2010 (IMF Jan 26, 2009: 2008 -0.6; 2009 -2.1; 2010 -0.1).
- Staff project inflation to fall to 1.2 percent in 2009 and remain under 2 percent in 2010.
- Recent indicators: exports slumped; business confidence at historical lows; industrial production and orders falling in November; consumer confidence weakened despite lower inflation (2.2 percent y/y in December).

---

### Fiscal developments, anti-crisis package, and fiscal framework

### Recent fiscal performance (2005–08) and outlook
- Structural fiscal balance improved by 2¾ percent of GDP in 2006−07, mainly from strong revenues.
- Overall deficit narrowed to 1.6 percent of GDP in 2007.
- Deficit likely rebounded to 2¾ percent of GDP in 2008 due to expansionary budget, weaker revenues, and temporary factors.
- Sovereign 10-year spreads over bunds exceeded 140 bps in December (compared with <30 bps a year ago); overall sovereign yields have fallen.
- Staff project 2009 fiscal deficit above 3 percent of GDP (staff earlier noted target deficit of "2.1 percent of GDP for 2009 is no longer in line..." and project deficit to widen to "above 3 percent of GDP").

### Government three-year package and anti-crisis measures
- Government three-year fiscal package aims for a broadly-balanced budget by 2011 through spending-based measures.
- Staff view: budgeted cyclically-adjusted consolidation for 2009 (staff estimate "around 0.3 percent of GDP") should be postponed; recession warrants timely, temporary, targeted and coordinated counter-cyclical response while fully implementing reductions in current spending.
- Recent anti-crisis package (Nov 28; updated end-Jan 2009) gross cost around ½ percent of GDP; staff estimate total cost (gross) 2009 0.36 percent of GDP; 2010 0.20 percent of GDP.
- Staff estimate contractionary measures 2009 0.15; 2010 0.11; total cost (net, staff estimate) 2009 0.21; 2010 0.09 (percent of GDP).
- Composition of anti-crisis measures (estimates in percent of GDP):
  - Expenditure increases (o/w): 2009 0.24; 2010 0.12.
  - Infrastructure investment: 2009 0.04; 2010 0.07.
  - Safety nets: 2009 0.17; 2010 0.02.
  - Mortgages: 2009 0.02; 2010 0.00.
  - Revenue reductions (o/w): 2009 0.12; 2010 0.08.
    - PIT: 2009 0.03; 2010 0.01.
    - Indirect tax reductions: 2009 0.01; 2010 0.00.
    - CIT/depreciation: 2009 0.07; 2010 0.07.

### Fiscal guidance and constraints
- Staff recommend postponing structural consolidation in 2009 while preserving reductions in current spending and implementing timely, temporary, targeted measures (examples: one-off outlays for vulnerable groups; bringing forward planned maintenance spending; reductions in government payment delays).
- Public infrastructure spending could support demand and long-term growth if accelerated transparently and efficiently, mindful of fiscal risks.
- Italy is constrained for aggressive fiscal stimulus due to large debt, spiking spreads, and prospect of rising global debt issuance.
- Staff emphasize maintaining a credible path to the MTO and underpinning medium-term expenditure-based consolidation through budget process streamlining, public administration productivity, public asset management, and fiscal federalism.

### Fiscal indicators (selected, exact values preserved)
- Italy: Fiscal Developments 2005–2008 (percent of GDP)
  - 2005: Overall Balance -4.3; Structural Balance 1/ -4.5; Public debt 105.9
  - 2006: Overall Balance -3.4; Structural Balance 1/ -2.9; Public debt 106.9
  - 2007: Overall Balance -1.6; Structural Balance 1/ -1.8; Public debt 104.1
  - 2008 est.: Overall Balance -2.7; Structural Balance 1/ -2.3; Public debt 105.7
  - 1/ Assumes staff's output gap, and net of one-off measures.

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### Policy recommendations to boost medium-term growth potential

### Structural reform priorities
- Continue and intensify structural reforms targeted at increasing growth potential to address "relentless decline in productivity."
- Priority areas:
  - further liberalizing retail trade and services;
  - continuing deregulation in the energy market (particularly gas);
  - strengthening the role of competition bodies in formulating policy;
  - implementing a second generation of labor market reforms to:
    - strengthen link between wages and productivity;
    - allow wages to better respond to regional differences;
    - make permanent contracts more flexible.
- Leverage international initiatives (e.g., revised Lisbon Agenda) and resist protectionism.
- Reinforce fiscal framework improvements: streamline budget process, increase public administration productivity, improve public asset management, advance fiscal federalism.
- Use reform opportunity to tackle longer-term fiscal challenges, notably welfare and pension reform (including legislating additional future increases in the retirement age, especially for women).

### Financial sector and supervision recommendations
- Fully implement bank support packages and make the funding guarantee scheme operational.
- Consider a voluntary pre-emptive recapitalization scheme for sound banks; scheme design principles:
  - Minimize market distortions; limit government involvement; clear exit strategy.
  - Ensure full transparency.
  - Operate on commercial terms but not unduly expensive to increase take-up.
  - Dividend policy should help repay government holdings.
  - Foster full and quick loss recognition to limit credit tightening.
  - Limit conditionality (for example on lending).
- Strengthen cross-border supervisory coordination to limit spillovers, particularly to CEE.

---

### Financial soundness, bank vulnerabilities, and crisis-management framework

### Key banking vulnerabilities (summary)
- Liquidity and funding: rising maturity mismatch due to reliance on shorter-term ECB refinancing and retail bond issues; sizeable debt redemptions for some large institutions in next 24 months; 12-month ahead redemptions largely pre-funded but some gaps remain.
- Capital: system capitalization meets regulatory requirements, but core Tier I capital in a few large banks fell below 6 percent since late 2007. Market-perceived capital shortfalls noted.
- Profitability: inefficiencies lead to relatively low profitability; annualized return on equity fell to 10 percent as of June (from 13 percent a year ago).
- Regional exposures: two large banks major players in several CEE countries; consolidated exposures moderate (below 10 percent of consolidated equity) but funding needs of subsidiaries could increase.
- Credit quality: households and corporate debt burdens rising; impaired loans rising; banks building up reserves; small enterprises likely under pressure.
- Cross-border regulatory risk: substantial cross-border operations exist; Europe lacks well-defined binding cross-border supervision/crisis-resolution and effective information-sharing.

### Selected bank-related figures (data as of October 2008, relative to 8% Core Tier 1 threshold)
- Unicredit: Capital shortfall 8,138 (millions of euros); Core Tier 1 6.9%
- Intesa Sanpaolo: 4,728; 6.3%
- MB0: 10.7%
- MPS: 2,939; 5.4%
- BP: 1,293; 6.0%
- UBI: 596; 7.1%
- BPM: 947; 7.3%
- Total (Italy): 17,788 (millions of euros)
- Total (Germany): 16,000
- Total (France): 23,000

### Bank crisis-management framework (ANNEX III)
- Three pillars: crisis procedures framework, deposit insurance scheme, liquidity and LOLR facilities; all functions executed or controlled by BoI.
- Decree Law 155 (Oct 9, 2008) amended resolution framework to include "severe crisis" (including liquidity) as trigger for special administration; BoI decides; capital injections by state would apply in such cases.
- Resolution tools: Special administration (SA) and Compulsory administrative liquidation (CAL); BoI appoints special administrators and oversight committees.
- Deposit insurance:
  - FITD protects deposits in banks incorporated under Italian law (excluding mutual banks); MBDPF protects mutual banks.
  - FITD coverage: €103,291 per depositor per bank (irrespective of currency).
  - FITD funded by bank contributions, ex-post, risk-adjusted; interventions authorized by BoI; FITD activated six times since creation.
  - Decree Law of Oct 9, 2008 empowered Ministry of Economy and Finance to issue state guarantee to back DI schemes.
  - Historical scope (as of June 2007): FITD covering about euro 395 bn of deposits in 297 institutions; MBDPF protects about euro 35 bn in 460 mutual banks.
- Liquidity support:
  - Eurosystem provides system-wide liquidity; national LOLR responsibility rests with BoI.
  - Decree 155 provides government guarantee for BoI loans to Italian banks and branches of foreign banks in severe liquidity crises.
  - BoI facility: temporary swaps between government securities held by BoI and assets held by Italian banks; renewable one-month maturity, remunerated with 1 percent fee p.a.; operations started Oct 16; facility total amount can reach €40 bn.
  - ECB liquidity operations (from Oct 8, 2008): unlimited amounts at fixed rate of 3.75 percent.

---

### Fiscal framework, federalism, and public sector sustainability (Annex I and related)

### Fiscal framework assessment and recent steps
- Fiscal frameworks improved via SGP, EU surveillance, and actions on debt/deficit accounting, central government spending control, phasing out one-offs, and Domestic Stability Pact.
- Fiscal position remains short of MTO; deficits broadly 2–4 percent of GDP; adjustment historically revenue-based.
- Recent actions (2008–09 budgets):
  - Program classification: 34 missions and 168 programs; UPBs reduced from ~1,500 to ~700.
  - 2009–13 DPEF: binding three-year package passed into law with three-year cost estimates by mission/program.
  - Budget timing advanced; managerial flexibility enhanced within programs.
  - Spending review pilot completed (justice, infrastructure, transport, internal affairs, education).
  - SIOPE computerized cash system rollout capturing 98 percent of public expenditure.

### Policy priorities to reduce rigidities
- Deepen budget system reform:
  - For next DPEF, enhance realism of baseline projections and align fiscal targets with sub-national agreements.
  - Overhaul 1978 budget law; streamline legislation related to spending programs; increase civil service management flexibility.
- Pursue cost-conscious fiscal federalism:
  - Implement transparent formula-based equalization; robust independent monitoring; harmonize accounting; increase civil service mobility.
  - Review property taxation given abolition of tax on primary residences; consider offsetting measures or streamlining sub-national governments.
- Better manage public assets: ensure proceeds from sales do not delay consolidation; speed progress on divestment; ensure transparency of bank-support operations and consolidated accounts.

### Transfers to enterprises (percent of GDP)
- All budget transfers to enterprises: 2005 2.5; 2006 1.4; 2007 7.1; 2008 1.9.
- Selected public enterprises (percent of GDP):
  - Railroad company (FS): 2005 0.44; 2006 0.46; 2007 0.53; 2008 0.32.
  - Highway company (ANAS): 2005 0.17; 2006 0.20; 2007 0.17; 2008 0.22.
  - Post office: 2005 0.05; 2006 0.05; 2007 0.04; 2008 0.07.

### Public debt dynamics and sustainability (selected projections and exact values)
- Baseline public sector debt (percent of GDP): 2005 105.9; 2006 106.9; 2007 104.1; 2008 105.7; 2009 108.2; 2010 109.7; 2011 110.7; 2012 111.0; 2013 111.1.
- Change in public sector debt: 2005 2.1; 2006 1.0; 2007 -2.8; 2008 1.6; 2009 2.5; 2010 1.5; 2011 1.0; 2012 0.4; 2013 0.0.
- Identified debt-creating flows (3): 2005 1.5; 2006 -0.3; 2007 -2.4; 2008 0.8; 2009 2.4; 2010 1.3; 2011 0.8; 2012 0.2; 2013 -0.2.
- Primary deficit: 2007 -3.4; 2008 -2.4; 2009 -1.8; 2010 -1.6; 2011 -1.6; 2012 -1.7; 2013 -1.9.
- Average nominal interest rate on public debt (percent): 2007 4.8; 2008 5.0; 2009 5.0; 2010 4.9; 2011 4.9; 2012 4.9; 2013 5.0.
- Automatic debt dynamics (2): 2007 1.1; 2008 3.1; 2009 4.2; 2010 3.0; 2011 2.4; 2012 2.0; 2013 1.8.

### Scenario tests and shocks (summary)
- Public debt sustainability tests include growth shock, primary balance shock, interest rate shock, combined shock (permanent one-half standard deviation shocks), and real depreciation and contingent liabilities shocks (one-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities in 2007).
- Combined shock and other scenarios produce higher public debt paths relative to baseline.

---

### Labor market diagnosis, reforms, and policy sequencing

### Key stylized facts and problems
- Employment gains since mid-1990s; unemployment declined to 6.1 in 2007.
- Temporary employment share rose from 7.2 percent (1995) to 12.4 percent (2007); part-time share rose from 10.5 percent to over 15 percent.
- Temporary employment drove employment growth; permanent employment rose only 7 percent over same period.
- Nearly 50 percent of unemployed have been out of work for more than one year.
- Stagnant labor productivity and earnings growth increased unit labor costs.

### Institutional weaknesses
- Collective bargaining: two-tier system with national sectoral bargains and limited firm-level bargaining; "minimi tabellari" create de facto wage floor.
- Unemployment insurance (UI): ordinary UI net replacement rate 60 percent initially but drops to zero after 8 months (12 months for workers aged over 50); in 2005, 2.3 percent of labor force received UI benefits.
- Employment protection: reforms eased fixed-term and part-time rules but protections for regular employment remain largely unchanged (e.g., Art. 18); asymmetric deregulation increased atypical contracts and employment risk.

### Reform directions and sequencing (Box 1)
- Product market deregulation should be prioritized to yield employment gains and facilitate labor market reform.
- Second-generation labor market reforms recommended:
  - Address wage determination to link wages more closely to productivity and allow regional differentiation.
  - Broaden and streamline social safety net (e.g., UI coverage and duration) to support worker reallocation and permit more flexible dismissal rules for permanent contracts.
  - Finance safety net reform partly by reducing replacement rates and spending on active labor market policies; eliminate piecemeal measures (e.g., tax reductions on overtime/bonus pay).
  - Labor tax reductions should be broad-based and combined with modifications to wage bargaining to increase firm-level bargaining scope.
  - Combine further EPL reduction with UI reform to ensure increased employment risk is buffered.

### Fiscal and sequencing considerations
- Model-based simulations indicate cuts in labor taxation raise employment but are generally not self-financing; costly unless combined with more flexible wage bargaining and other measures.
- Sequencing: product market reforms first can provide substantial employment gains at little to no cost and facilitate subsequent labor market reform.

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*Source: IMF staff report excerpts (content unit _cr0945).*

### 1. Financial Indicators.................................................................................................

### 1. Financial Indicators

### Financial system resilience and recent performance
- The financial system "has so far withstood the turbulence": no institution failed or fell short of regulatory requirements as the crisis intensified.
- Equity prices plunged, the interbank market froze, corporate issuance dried up, and some large Italian banks came under pressure; nonetheless the system remained solid.
- Italian banks’ recourse to ECB lending increased but "remained commensurate with their asset share in the euro area."
- Banks continued to fund themselves through bond issuance to domestic retail investors, supporting loan growth up to mid-2008.
- Third-quarter profits for the major banks remained positive but "much lower than last year" and were helped by the application of the new international accounting rules (IAS39).
- Bank CDS spreads rose but "remained below those of other European peers," reflecting a relatively safer risk profile.
- Surveys indicate significant tightening ahead (mostly in terms of pricing and lending standards); household lending has "already sharply declined, chiefly for demand reasons."
- The latest observation for financial indicators charted is "as of December 1, 2008."

### Explanatory factors for relative banking resilience (Box 1)
- Relationship-based intermediation and an extensive bank-branch network, combined with a sound deposit-insurance system, support a solid deposit base and retail market for bank liabilities; most other financial services are channeled via banks’ networks.
- Low (until recently) contestability, high net interest margins and retail banking fees insulated banks from competition and reduced appetite for risk.
- Growth opportunities abroad (new EU member states and Russia) led to rapid expansion into emerging markets, generating double-digit profit growth until recently; these exposures are turning into vulnerabilities as the crisis affects the region.
- Regulatory provisions (e.g., on derivatives, covered bonds finalized in May 2007) have been more stringent than in some other countries and may have inhibited riskier strategies.
- Past corporate fraud scandals (Parmalt and Cirio) and heavy sanctions may have reduced banks’ appetite for high-risk strategies.

### Authorities’ policy response and regulatory measures
- From 2007 the Bank of Italy (BoI) intensified monitoring and disclosure of banks’ risky exposures, liquidity monitoring (weekly reporting for large banks), prudential oversight of risk management and contingency plans, targeted inspections, and more frequent stress testing and counterparty risk reporting.
- The high-level interministerial committee on financial stability held frequent ad-hoc meetings; Consob banned short sales as the crisis intensified in September 2008.
- The government passed two enabling decrees that:
  - allow the government to inject capital into troubled banks on a case-by-case basis through non-voting preference shares, with conditionality attached;
  - guarantee new bank liabilities;
  - permit the BoI to swap government debt for low-quality bank collateral (for up to €40 bn; operations have already started)—if needed, the Treasury will guarantee the BoI loans;
  - boost the BoI’s powers to initiate prompt and early bank resolution to avoid losses;
  - fully underwrite the deposit guarantee fund.
- Details of the scheme—especially pricing of state capital injections and bank obligations—are awaiting implementing legislation.
- Staff recommend full and prompt implementation of recent financial sector support measures and consideration of additional measures, including a voluntary government recapitalization scheme, with emphasis on:
  - ensuring transparency;
  - minimizing market distortions;
  - limiting government involvement in banks’ decision-making, including via a clear exit strategy;
  - avoiding spillovers to other countries, especially Central and Eastern Europe (CEE);
  - enhancing international regulatory and supervisory coordination.

### Longer-term financial sector goals
- Consider additional measures to strengthen financial stability and support the growth-enhancing role of the financial sector:
  - improving consumer protection;
  - further strengthening supervisory and regulatory frameworks;
  - enhancing coordination, efficiency and information sharing among regulators;
  - spurring competition and improving corporate governance in the financial sector.

### Macroeconomic impact and near-term fiscal stance
- The global financial crisis precipitated a recession: "Output is projected to contract by about ½ percent in 2008 and 1 percent in 2009, with risks tilted to the downside."
- Output contracted by "½ percent in each of the middle two quarters of 2008."
- Confidence is "at its lowest level in over a decade"; consumption continued to decline despite still-positive employment gains and substantial easing of inflationary pressures.
- Gross fixed investment slowed sharply in the first half of 2008; net exports turned firmly negative.
- The housing market is cooling less than in many European countries due to house prices having not risen as sharply.

### Fiscal policy guidance amid the crisis
- The government's three-year fiscal package aims for a broadly-balanced budget by 2011 through spending-based measures.
- The target deficit of "2.1 percent of GDP for 2009 is no longer in line with the deteriorating macroeconomic environment": staff project the deficit to widen to "above 3 percent of GDP."
- The budgeted cyclically-adjusted consolidation for 2009 (estimated by staff at "around 0.3 percent of GDP") should be postponed; the recession warrants a counter-cyclical fiscal response that is timely, temporary, targeted and coordinated, while fully implementing the budget’s envisaged reductions in current spending.
- The fiscal package recently submitted to Parliament is "likely to imply a broadly neutral fiscal stance for 2009" and is generally in line with staff considerations.
- "If the growth outlook deteriorates significantly, a somewhat larger stimulus could be considered."

### Policy recommendations to boost medium-term growth potential
- Continue and intensify structural reforms targeted at increasing growth potential, aligned with the need to address the "relentless decline in productivity."
- Priority reform areas:
  - further liberalizing retail trade and services;
  - continuing deregulation in the energy market;
  - strengthening the role of competition bodies in formulating policy;
  - implementing a second generation of labor market reforms to strengthen the link between wages and productivity, allow wages to better respond to regional differences, and make permanent contracts more flexible.
- Leverage international initiatives to spur reform while resisting tendencies toward protectionism.
- Reinforce fiscal framework improvements to underpin medium-term expenditure-based consolidation, including streamlining the budget process, increasing public administration productivity, improving public asset management, and advancing fiscal federalism.
- Use the reform opportunity to advance longer-term fiscal challenges, notably reforming the welfare system.

*IMF Staff Report — Chapter: Financial Indicators*

### 12.      The revenue-based fiscal consolidation has come to an end. The structural fiscal

### 12.      The revenue-based fiscal consolidation has come to an end.

### Fiscal developments (2005–08)
- The structural fiscal balance improved by 2¾ percent of GDP in 2006−07, mainly due to exceptionally strong revenues.
- The overall deficit narrowed to 1.6 percent of GDP in 2007.
- The deficit likely rebounded to 2¾ percent of GDP in 2008, reflecting the expansionary budget, weaker revenues, and some temporary factors, entailing a loosening in structural terms and a higher expenditure ratio, with the primary current spending ratio reaching a record high.
- Sovereign 10-year spreads over bunds exceeded 140 bps in December (compared to less than 30 bps a year ago), reflecting greater risk aversion and lower bund yields—overall sovereign yields have, however, fallen (which the authorities have moved quickly to lock in).

- Italy: Fiscal Developments: 2005-08 (percent of GDP)
  - 2005: Overall Balance -4.3; Structural Balance 1/ -4.5; Public debt 105.9
  - 2006: Overall Balance -3.4; Structural Balance 1/ -2.9; Public debt 106.9
  - 2007: Overall Balance -1.6; Structural Balance 1/ -1.8; Public debt 104.1
  - 2008 est.: Overall Balance -2.7; Structural Balance 1/ -2.3; Public debt 105.7
  - 1/ Assumes staff's output gap, and net of one-off measures.

### III. Outlook and risks: continued weakness
- Near-term outlook
  - Output is projected to fall by about ½ percent in 2008 and 1 percent in 2009, given negative carry-over from worse-than-expected output declines in Q2 and Q3 2008, weak recent indicators, and expected weaker partner country demand.
  - The projected deterioration in Italy’s growth rate between 2008 and 2009 reflects Italy’s relatively low level and variance of potential growth, tempered by insulating factors: resilient banking system, low private sector leverage ratios, a less inflated housing market, and recent industrial restructuring.

- Downside risks and sensitivity
  - Negative risks dominate; uncertainty is exceptionally large.
  - Downside external risks dominate due to Italy’s high reliance on exports.
  - Domestic risks include additional falls in consumer confidence linked to the deteriorating macroeconomic context and rising uncertainty.
  - Staff estimate that in the event of a prolonged credit crunch (i.e., decline in loan volumes accompanied by further widening of spreads), investment could decline significantly, resulting in an additional output loss of up to 1 percent a year for two years.

### Box 2 — Channeling the financial turmoil to the real economy
- Overall effect so far
  - The Italian economy has mostly been affected through partner country demand; Italy’s growth plunged in sync with other industrial countries.
- Investment
  - Bleak demand prospects domestically and abroad weighed heavily on business confidence and hence investment.
  - Italian firms, on average, rely less on external funding for investment and growth.
  - Staff estimates: the global downturn subtracted more than 1 percentage point from fixed investment growth to date; the contribution of tighter credit conditions is about ½ ppt.
  - Increase in credit costs to date: over 70 bps; corporate credit growth pace not yet materially affected, though bond placements have dried up since Q2.
- Consumption
  - Consumption dampened by weak confidence and, until recently, eroding disposable incomes due to rising inflation.
  - Direct effect of financial turbulence on consumption moderate due to negligible housing wealth effect and low recourse to borrowing for consumption.
  - Household debt burdens are rising (from low levels); household surveys indicate growing concerns about meeting mortgage payments, though delinquency rates are still low.

- Household debt, selected countries, 2006 (% of GDP, % of DI)
  - Italy (2007): 34 / 49
  - Spain: 80 / 140
  - Euro area: 60 / ...
  - USA: 98 / 134

### Inflation, current account, and competitiveness
- Inflation
  - Inflation is expected to moderate in line with the slowdown in growth and global commodity prices.
  - Inflation moderated in November—coming down from a decade high peak—largely due to declining global prices for oil and food.
  - Core inflation remained elevated, widening the differential with the euro area; weak competition in the service sector (especially domestic trade) likely contributed.
  - As the output gap widens further, inflation is projected to slip well below 2 percent in 2009.

- Current account
  - The current account deficit is projected to widen to around 3 percent of GDP in 2008 and further in 2009 and decline only gradually over the medium term.
  - Nominal export strength roughly offset higher energy import bill so far in 2008; October/November data indicate accelerating contraction in both exports and (to a lesser extent) imports.
  - Trade account expected to deteriorate slightly in 2008−2010 due to weakened global demand weighing on exports, although imports also expected to suffer from lower domestic demand.
  - Over the medium term, export growth expected to gradually pick up as the global economy recovers; lower import prices would help reduce the trade deficit and gradually the current account deficit.
  - Main downside risks: slower partner country growth and a further deterioration of competitiveness.

- Competitiveness
  - Italy’s market share in world trade declined markedly since the mid 1990s, more than its peers.
  - CPI- and ULC-based real exchange rates point to continued appreciation that has dampened real exports.
  - Recent staff estimates using the CGER methodology indicate a competitiveness gap of some 8–9 percent.

- Estimates Applying the CGER Methodology to Italy (percent; percent of GDP)
  - France: MB 4.0; 2/ ERER 6.0; 3/ ES 19.0; 4/ 2008 -3.0; 2013 -2.9
  - Germany: MB -4.0; ERER 2.0; ES -15.0; 2008 7.3; 2013 6.5
  - Italy: MB 9.4; ERER 9.4; ES 8.1; 2008 -2.9; 2013 -2.8
  - 1/ Positive numbers indicate that REER is above equilibrium.
  - 2/ Macroeconomic balance.
  - 3/ Reduced-form equilibrium real exchange rate.
  - 4/ External stability.

### Views on the outlook (selected forecasts)
- IMF (December 3, 2008): 2008 GDP growth -0.4; 2009 GDP growth -1.0; 2008 inflation 3.5; 2009 inflation 1.6
- Ministry of Finance (Sept 23, 2008): 2008 GDP growth 0.1; 2009 GDP growth 0.5; 2008 inflation 3.8; 2009 inflation 2.8
- Bank of Italy (July 2008): 2008 GDP growth 0.4; 2009 GDP growth 0.4; 2008 inflation 3.8; 2009 inflation 2.8
- Confindustria (December 16, 2008): 2008 GDP growth -0.5; 2009 GDP growth -1.3
- European Commission (November 3, 2008): 2008 GDP growth 0.0; 2009 GDP growth 0.0
- OECD (November, 2008): 2008 GDP growth -0.4; 2009 GDP growth -1.0

### IV. The policy agenda: responding to the crisis and reinforcing long-term goals
- General guidance
  - Short-term actions are warranted to strengthen financial stability and provide a countercyclical fiscal response, tailored to Italy’s specific circumstances—especially high public debt and widening spreads—which constrain scope for an aggressive fiscal policy response.
  - Immediate actions should be aligned with longer-term reforms to address chronic lack of growth: decline in productivity over the last decade, stagnating incomes, rising unit labor costs, competitiveness gap, tepid growth, and a large unproductive public sector with poor quality spending, high effective tax burden, and persistent deficits.
  - Short-term measures should have longer-term goals: increase productivity and ensure fiscal sustainability.

A. Preserving financial soundness
- Key vulnerabilities (summary)
  - Liquidity and funding: rising funding maturity mismatch due to increased reliance on shorter-term ECB refinancing and retail bond issues; sizeable debt redemptions for some large institutions in the next 24 months; 12-month ahead redemptions largely pre-funded but some gaps remain; retail bond market recourse could be limited going forward.
  - Capital: while system capitalization meets regulatory requirements, core Tier I capital in a few large banks has fallen below 6 percent since late 2007. Market perceptions may view new ratios as weak relative to peers that received government-sponsored recapitalizations. Important shareholders (foundations) may have limited capacity to boost capitalization quickly.
  - Profitability: inefficiencies led to relatively low profitability even in good times; annualized return on equity fell to 10 percent as of June (from 13 percent a year ago); individual bank reports suggest some large banks would have registered losses in Q3 absent the boost from a new accounting rule.
  - Regional exposures: two large Italian banks are major players in several CEE countries; overall exposures seem moderate (below 10 percent of consolidated equity) but funding needs of subsidiaries could increase if host-country conditions deteriorate; exposures to Western Europe (Germany) already a negative factor.
  - Credit quality: households and corporate debt burdens, though low, are increasing; impaired loans are rising; banks building up reserves; small enterprises likely to come under particular pressure.
  - Cross-border regulatory risk: substantial cross-border operations exist, yet Europe still lacks a well-defined and binding mechanism of cross-border supervision and crisis-resolution and effective information-sharing.

- Selected bank-related figures and market perceptions
  - Large redemptions coming due in 2009-10 (Amortization, Euro Billions chart across 2008q4–2010q1 by bond type).
  - Market perception of capital shortfall and new Core Tier 1 (data as of October 2008, relative to the 8% threshold):
    - Unicredit: Capital shortfall 8,138 (millions of euros); Core Tier 1 6.9%
    - Intesa Sanpaolo: 4,728; 6.3%
    - MB0: 10.7%
    - MPS: 2,939; 5.4%
    - BP: 1,293; 6.0%
    - UBI: 596; 7.1%
    - BPM: 947; 7.3%
    - Total (Italy): 17,788
    - Total (Germany): 16,000
    - Total (France): 23,000
  - Large Banks: Return on Average Equity (ROAE), 2007: charted by country.

- Recommendations and recent measures
  - Fully implement recent bank support packages, especially by making fully operational the funding guarantee scheme.
  - Consider a voluntary pre-emptive recapitalization scheme available to sound banks to support investor confidence and foster credit growth.
    - Scheme design principles:
      - Minimize market distortions and limit government involvement in banks' decision-making, including via a clear exit strategy.
      - Ensure full transparency.
      - Operate on commercial terms but not unduly expensive to increase take-up, encourage private capital raising, and support credit growth.
      - Dividend policy should reflect the need to shore up confidence and repay government holdings.
      - Foster full and quick loss recognition to encourage re-capitalized banks to minimize credit tightening.
      - Limit conditionality (for example on lending).
  - These principles are reflected in the recent EU Communiqué (of December 5) on bank recapitalization schemes.

*Source: IMF staff report excerpt (paragraphs 12–22, Box 2, and related figures and tables).*

### 23.      Fostering international coordination is critical. Italy’s advocacy of a more

### _cr0945 - 23.      Fostering international coordination is critical. Italy’s advocacy of a more

### International coordination and cross-border banking spillovers
- Italy advocates a more coordinated international approach to crisis resolution and stronger cross-border supervision; this advocacy is described as welcome and should be continued alongside implementation of the international financial reform agenda, including the remaining FSF recommendations and finalizing implementation of EC Directives (in particular MIFID and the Takeover Directive).
- Italian banks’ regional footprint and exposures:
  - Italian banks account for about 44 percent of banking assets in Croatia, 25 percent in the Slovak Republic, 20 percent in Hungary, and 18 percent in Poland.
  - Italian banks have exposures in Russia, Ukraine and the Baltics.
- Policy guidance on cross-border bank support:
  - Authorities should be mindful of potential spillovers from Italian bank support actions for other countries, especially in CEE.
  - Government recapitalization funds should not be prevented from being used to recapitalize subsidiaries in other countries, if this were deemed an efficient way of supporting the domestic bank.
- European supervisory architecture:
  - The MEF pointed out that the financial turmoil has stressed the well-known drawbacks of the European supervisory architecture and has called for an urgent review aimed at introducing effective coordination instruments.

### Financial sector reforms and supervisory strengthening
- Immediate measures should support long-run growth-enhancing role of the financial sector.
- Key recommended supervisory and regulatory actions:
  - Establishing a personal bankruptcy law, noted as especially important given the weak growth outlook.
  - Intensifying efforts to ensure transparency and consumer protection as banks become increasingly reliant on bond issuance to retail investors.
  - Completing legislative efforts to reduce the number of regulators and improve coordination among them; the so-called “Authorities” law envisaged a “twin-peak” model reducing regulators from four to two (BoI and Consob).
  - Finalizing the removal of banks from the ownership of the BoI.
  - Enhancing the BoI’s stress testing to incorporate complex interlinkages across institutions and the macroeconomic environment.
  - Preserving and building upon strides made to spur competition and improve corporate governance.
  - Pursuing efficiency-enhancing measures such as reform of cooperative banks.
- Authorities’ stance:
  - Authorities broadly agreed with staff’s appraisal and main recommendations; they recognized growing vulnerabilities and the need to fully implement remaining measures, noting work was well under way and remaining legislation would be issued shortly.
  - Emergency recapitalization scheme operational but no recourse to it has been necessary.
  - On the voluntary bank recapitalization scheme, the BoI and Treasury emphasized continued financing of the economy as a main objective; the BoI favored relatively light conditionality.
  - Authorities stressed the need for close coordination among European countries in designing bank support packages.
- Research references cited in source (titles preserved as in text): “Corporate Governance Reforms in the EU: Do They Matter and How?” WP 08/91, and “Reform of Italy’s Cooperative Banks” WP 08/78.

### Providing short-run support while maintaining fiscal sustainability
- Government three-year fiscal package objectives:
  - Targets significant adjustment in 2009 and a broadly-balanced budget by 2011, in line with Italy’s undertakings under the SGP.
  - Adjustment plan described as appropriately expenditure-based, targeting an increase in the cyclically-adjusted balance of 0.6 percentage points in 2009, with a headline deficit of 2.1 percent of GDP.
  - Plan based on real growth rising from 0.5 percent in 2009 to 1.2 percent in 2011.
- Staff-adjusted near-term outlook and risks:
  - Staff projects the fiscal deficit in 2009 to be above 3 percent of GDP, mainly due to weaker growth, while the expenditure ratio would rise even if nominal spending plans are observed.
  - Adjusting for staff’s output gap and other minor factors, the cyclically-adjusted balance (excluding the impact of the package announced on November 28) would increase by 0.3 percent of GDP (and by 0.5 percent of GDP net of one-off measures).
  - Risks include adverse shifts in tax elasticities during the downturn, and expenditure savings not being fully realized.
  - Debt ratio will likely rise further due to the gap between still-high average interest rate on government debt and falling growth rates, a lower primary balance, and possible bank support operations.
- Policy recommendation on timing and composition of measures:
  - Macroeconomic considerations and need for coordinated international response argue for delaying planned structural consolidation in 2009.
  - While preserving and fully implementing reductions in current spending, timely, temporary, targeted and coordinated counter-cyclical measures could lessen output decline without significantly undermining fiscal sustainability.
  - Examples of suitable measures: one-off outlays for vulnerable groups; bringing forward planned maintenance spending; reductions in government payments delays.
  - Recent measure limiting interest deductibility for banks could be deferred and its modalities reconsidered.
  - Public infrastructure spending, especially accelerating existing projects, would support short-term demand and longer-term growth if implemented rapidly, transparently, and efficiently, with due regard to fiscal risks and using recommendations of the recent spending review.
  - Avoid piecemeal responses; maintain a credible path to the MTO.
  - The “anti-crisis” package submitted to Parliament is broadly in line with these considerations, implying a broadly neutral fiscal stance for 2009. If the growth outlook deteriorates significantly, a somewhat larger fiscal stimulus could be considered.
- Constraints on aggressive fiscal stimulus:
  - Italy is ill-placed to launch a more aggressive fiscal response due to: large debt, spiking spreads over Bunds, and prospect of debt issuance rising globally.
  - Delays in adjustment will likely raise interest costs and undermine confidence.
  - Italy’s growth problems stem from low potential, not cyclical, growth; past relaxations have not been effective.

### Italy’s recent fiscal measures to counter the crisis (Box 3)
- Overview:
  - On November 28, the government passed an “anti-crisis” decree aiming to support the flagging economy.
  - Package gross cost is around ½ percent of GDP but aims to be broadly neutral in net terms taking into account offsetting (mainly revenue-raising) measures.
  - Total economic impact could go beyond fiscal cost, especially if measures to accelerate investment projects prove effective.
- Main categories of countercyclical measures:
  - Support to families/individuals (bulk of fiscal cost):
    - Main measure is a one-off bonus to low-income households.
    - Provisions to cap interest rates on mortgages, make additional social payments, cut taxes on productivity bonuses, and limit road tolls and household utility payments.
  - Support to enterprises:
    - Mainly “cash-flow” support: postponing timing of certain tax payments and reducing government payment delays.
    - Measure on guaranteeing bank borrowing, with specific targets for financing small and medium-sized enterprises—modalities to be clarified in a separate decree.
  - Acceleration of investment:
    - Appointing special officials to take charge of key projects to accelerate implementation, more investment financing for railroads, and additional financing for the main national projects.
- Evaluation and fiscal cost:
  - Package likely ex-post fiscal cost — even assuming shortfall of offsetting revenue-raising measures in a weak economy — is likely to be 0.2-0.3 percent of GDP, within available scope for fiscal stimulus.
  - Key measure (bonus) characterized as timely, temporary, and targeted, though not all measures conform to these principles.
  - Omnibus “decree-law” structure offers immediate effect and policy diversification but may be perhaps too diversified.
  - Flexibility exists for future implementation via follow-up decrees on issues such as bank borrowing guarantees.
  - Appropriate implementation and controlling fiscal risks from bank guarantees and investment projects are important to maximize effect on confidence and contain costs.

### Fiscal dynamics, spending risks, and long-term sustainability
- Spending and revenue dynamics highlighted in source figures and discussion:
  - The adjustment is expenditure-based; spending needs to slow sharply in 2009-11.
  - Real primary current spending needs to be negative over the period to meet objectives.
  - The 3-year spending-curbing package is backloaded and ultimately relies on politically demanding budget reform and federalism.
  - Explicit expenditure risks may dent progress in deficit reduction.
- Historical and comparative debt dynamics:
  - Italy’s consolidation stopped short of budget balance in contrast to others.
  - Italy has been a nonvirtuous outlier in debt dynamics, reducing debt less than other high-debt countries, with reliance on privatization and other one-offs that may no longer be available.
  - Gross public debt would be at its 1994 level without temporary measures.
  - Italy’s comparative lack of debt reduction has been slowly reflected in market spreads.
- Long-term policy recommendations:
  - The current crisis should not eclipse need for bolder action on longer-term fiscal challenges.
  - Long-term debt sustainability hinges on reaching the MTO and achieving productivity growth well above that of recent years.
  - Further reforms to the welfare system are needed as outlined in the government’s recent green paper.
  - In particular, legislating additional future increases in the retirement age (especially for women) could tackle Italy’s still-comparatively-high pension spending.
  - Such reforms could allow for faster debt reduction and/or freeing resources to strengthen Italy’s weak social safety net.

*Source: IMF staff report excerpt provided in the content unit.*

### 31.      Italy’s fiscal framework has been improving steadily over time, but insufficiently

### _cr0945 - 31.      Italy’s fiscal framework has been improving steadily over time, but insufficiently

### Fiscal framework: assessment and recent steps
- Longstanding pattern: perennial need for consolidation addressed piecemeal, often by “emergency” annual packages that were only partially effective; efficiency-oriented reforms (managerial flexibility initiated in 1997; fiscal federalism 2001) repeatedly delayed or scaled back, reducing both the quantity and quality of fiscal adjustment. (Paragraph 31)
- Recent actions taken by the government (Paragraph 32):
  - streamlining the budget process and strengthening its medium-term orientation;
  - increasing the productivity of public administration by containing the cost of public employees and implementing a comprehensive plan to reduce the burden of administration;
  - advancing measures to improve cost effectiveness in the education sector, following the recent spending review;
  - finalizing the draft law on fiscal federalism (currently with Parliament) to increase fiscal autonomy and discipline of all levels of government.
- Policy priorities recommended to build on recent steps (Paragraph 32):
  - Deepen budget system reform:
    - For next year’s medium-term plan, enhance realism of baseline projections and have fiscal targets reflect agreements with sub-national governments.
    - Reduce rigidities by overhauling the budget law, streamlining legislation related to spending programs, and increasing flexibility in the management of civil servants. (Annex I referenced)
  - Pursue cost-conscious fiscal federalism:
    - Implement a transparent, formula-based, equalization scheme.
    - Establish a robust and independent regime for monitoring fiscal targets.
    - Harmonize accounting and increase civil service mobility.
    - Conduct a comprehensive review of property taxation, especially since the tax on primary residences has recently been eliminated; if reform risks higher costs, consider bolder offsetting measures including streamlining the structure of sub-national governments.
  - Better manage public sector assets:
    - Ensure potential proceeds from sales of public assets do not delay consolidation.
    - Faster progress on divestment and minimizing the drain on the public purse, with a focus on enhancing competition.
    - Ensure full transparency of any bank-support operations and government guarantees, and produce timely consolidated accounts for the non-financial public sector.
- Authorities’ stance during the crisis (Paragraph 33):
  - Agreed to some limited temporary measures to address the crisis while remaining committed to the adjustment plan.
  - MEF noted limited room for maneuver given high debt burden and rising spreads; believed the deficit could still be below the 3 percent limit in 2009.
  - Prioritized accelerating investment spending and supporting credit extension to stimulate growth.
- Views on longer-term reforms (Paragraph 34):
  - Pension reform seen as politically sensitive with potential negative impact on confidence; MEF’s long-term age-related spending projections do not indicate urgency.
  - Budget process and fiscal federalism reforms expected to proceed slowly; MEF aims to build on pilot spending review and reduce rigidities.
  - Fiscal federalism reforms dependent on follow-up legislation over the next couple of years.
  - Forthcoming retirement of many public employees and potential revision of the accounting law seen as opportunities to generate cost savings.

### Transfers to key enterprises (explicit figures from Combined report on the economy)
- All budget transfers to all enterprises (Percent of GDP): 2005 2.5; 2006 1.4; 2007 7.1; 2008 1.9
- Selected public enterprises (Percent of GDP):
  - Railroad company (FS): 2005 0.44; 2006 0.46; 2007 0.53; 2008 0.32
  - Highway company (ANAS): 2005 0.17; 2006 0.20; 2007 0.17; 2008 0.22
  - Post office: 2005 0.05; 2006 0.05; 2007 0.04; 2008 0.07
- Note: Transfers by the central government. (Source: Combined report on the economy)

### Competitiveness and productivity: diagnosis
- Core problem: chronic lack of growth due to declining productivity (Paragraph 35).
- Recent decade: unprecedented fall in factor productivity in both manufacturing (from a high level) and services (from a low level), underpinning rising unit labor costs and falling behind peers in GDP per-capita terms.
- Structural factors identified (Paragraph 35):
  - policy and regulatory rigidities limiting competition and hindering the business environment;
  - low efficiency related to prevalence of small and medium-sized enterprises unable to exploit economies of scale;
  - limited process and product innovation, hindered by labor market rigidities;
  - outdated specialization patterns, especially in manufacturing based on traditional low-skill products.

### Competitiveness: recent progress and shortcomings
- Modest micro-based competitiveness improvements reflect private-sector driven restructuring in sectors already exposed to competition; reallocation toward higher-tech sectors occurred but slower than EU peers, missing opportunities in service exports, especially tourism (Paragraph 36).
- Government actions to date (Paragraph 36):
  - Passed the local public services bill (albeit falling short of requirements).
  - Simplified legislation.
  - Implemented a law instituting competition assessments and regulatory impact analysis.
  - Incorporated the Antitrust Authority’s recommendations in a competition bill to be discussed by Parliament annually.
- Caveat: reform momentum appears to have slowed.
- Product and professional services regulation indicators: Italy appears more regulated relative to peers (OECD-based indices referenced in the text and figures).

### Labor market: reforms, effects, and further needs
- Past reforms improved employment, labor force participation, and unemployment rates, but employment-to-population ratio remains among the lowest in the euro area (Paragraph 36).
- Deregulation of fixed- and part-time contracts increased labor market flexibility but:
  - resulted in more “atypical” employment;
  - contributed to stagnant labor productivity;
  - exposed workers to increased employment risk without commensurate improvements in the social safety net;
  - implies recent employment gains can be easily reversed.
- Empirical point: Temporary employment has been the key driver of employment growth (OECD, Labor Force Statistics, 2007). (Figure referenced)
- Recommended “second generation” labor market reforms (Paragraph 38):
  - Address wage determination that prevents wages from being more closely linked to productivity.
  - Broaden and streamline the social safety net, particularly unemployment benefits, to support redundancies and widen scope for reducing dismissal restrictions of permanent contracts.
  - Finance social safety net reform in part by reducing replacement rates and spending on active labor market policies, and by eliminating piecemeal measures such as tax reductions on overtime/bonus pay.
  - Any reductions in labor taxation should be broad-based and combined with modifications of the wage bargaining framework to increase scope for firm-level bargaining.
  - Labor market reform should be complemented by early product market reforms (Annex II).

### Structural reform strategy and international initiatives
- Need for a comprehensive structural reform strategy to revive growth potential; piecemeal reforms risk paralysis and reversals, while broad-ranging reforms produce synergies (Paragraph 37).
- Priority reform areas (Paragraph 37):
  - further liberalize retail trade and professional services;
  - continue deregulation in the energy market, particularly gas;
  - strengthen the role of competition bodies in policy formation at an early stage;
  - eliminate cross-vetoes for infrastructure projects of national interest;
  - increase public discussion documents and expert committees to strengthen public acceptance (example: Australia’s Productivity Commission).
- International initiatives as an opportunity (Paragraph 39):
  - Government’s new national reform program aligns priorities for the next three years with the revised Lisbon Agenda objectives.
  - All levels of government should follow through and reduce the large transposition deficit, including ambitious transposition of the EU Services Directive by the end-2009 deadline.
  - Resist tendencies toward protectionism (e.g., barriers to foreign ownership) that would undermine economic prospects.

### Box 4 summary: restructuring and competitiveness
- Standard measures show a modest competitiveness gap, but exports remained robust in nominal terms and there is anecdotal evidence of firm restructuring (Box 4).
- Positive signs:
  - Moderate export quality upgrading proxied by unit value growth (also imperfect indicator of cost pressures).
  - Some redirection toward dynamic markets and increased outsourcing.
- Ambiguous or negative signs:
  - Competitive pressure on Italy’s exports consistently higher than key EU comparators, reflecting unfavorable specialization.
  - No major positive trends from sluggish services sectors, FDI flows, and technological content of exports.
  - Intersectoral reallocation away from traditional activities limited; restructuring may have further to go.
- Conclusion: Export quality improvements likely alleviated some competitiveness gap but not enough to offset broader structural shortcomings weighing on external performance.

### Authorities’ view (Paragraph 40)
- Authorities broadly agreed with staff’s assessment of competitiveness and labor market shortcomings but argued aggregate indicators may not fully capture ongoing industrial restructuring.
- BoI pointed to micro data evidence of rising variability in profitability, strong nominal export growth, rising export unit values, firm turnover, and an increase in average firm size as signs of higher competition.
- Authorities expected unemployment to rise further with slowing or possibly negative employment growth and agreed on key institutional shortcomings: wage bargaining limiting firm-level negotiation scope and an insufficient, uneven social safety net.

*IMF staff report content unit: _cr0945 - 31. Italy’s fiscal framework has been improving steadily over time, but insufficiently*

### 41.      The government considered their structural reform plans adequate and did not

### _cr0945 - 41.      The government considered their structural reform plans adequate and did not

### Structural reform stance and policy choices
- The government considered their structural reform plans adequate and did not see scaling up efforts as a top priority at this time.
- The Bank of Italy (BoI) agreed that the structural reform momentum had slowed and that it needs to be revived.
- The Ministry of Economy and Finance (MEF) and other interlocutors pointed to the government’s commitment to policy continuity and the progress achieved to date.
- The government expressed doubt that reforming the unemployment system could form part of an immediate crisis response, given the implementation lags and permanent expenditure involved.
- In line with this view, the government has recently opted for supplementing existing instruments, such as the industry-specific unemployment support schemes (“cassa integrazione”), rather than overhauling the welfare system.

### Wage determination and labor-market measures
- The government pointed to ongoing tripartite negotiations aimed at:
  - increasing the use of firm-level bargaining by linking nationally bargained wages to projected inflation (excluding imported inputs), and
  - reducing taxation on supplemental wages negotiated at the firm level.

### Macroeconomic performance (selected indicators, annual percentage change or percent of GDP as noted)
- Real GDP: 0.6 (2005), 1.8 (2006), 1.5 (2007), -0.4 (2008), -1.0 (1/2009 staff estimate), -0.5 (1/2009 projection) — latest reading 2008Q3.
- Public consumption: 1.9 (2005), 0.8 (2006), 1.2 (2007), 0.7 (2008), 0.4 (1/2009), 0.0 (1/2009) — latest reading 2008Q3.
- Private consumption: 0.9 (2005), 1.1 (2006), 1.4 (2007), -0.3 (2008), -0.3 (1/2009), 0.1 (1/2009) — latest reading 2008Q3.
- Gross fixed capital formation: 0.7 (2005), 2.5 (2006), 1.2 (2007), 0.1 (2008), 0.0 (1/2009), -1.9 (1/2009) — latest reading 2008Q3.
- Exports of G&S: 1.0 (2005), 6.2 (2006), 5.0 (2007), 0.5 (2008), 0.3 (1/2009), -1.6 (1/2009) — latest reading 2008Q3.
- Imports of G&S: 2.2 (2005), 5.9 (2006), 4.4 (2007), 0.1 (2008), 0.2 (1/2009), -0.5 (1/2009) — latest reading 2008Q3.
- Private sector credit (end of period, twelve-month, adjusted for securitizations): 7.7 (2005), 11.0 (2006), 9.8 (2007), 7.3 (2008), ... (Oct-08), 5.9 (Oct-08).
- 6-month interbank rate (end of period): 2.6 (2005), 3.8 (2006), 4.9 (2007), 4.3 (2008), ... (Nov-08), 5.2 (Nov-08).
- Government bond rate, 10-year (end of period): 3.5 (2005), 4.2 (2006), 4.7 (2007), 4.8 (2008), ... (Nov-08), 4.5 (Nov-08).

### Resource utilization and labor market
- Potential GDP growth: 1.2 (2005), 1.3 (2006), 1.1 (2007), 0.8 (2008), 0.7 (2009).
- Output Gap (% of potential): -0.8 (2005), -0.2 (2006), 0.2 (2007), -0.4 (2008), -2.7 (2009).
- Natural rate of unemployment: 7.6 (2005), 6.8 (2006), 6.2 (2007), 6.6 (2008), 6.7 (2009).
- Employment growth: 0.7 (2005), 1.8 (2006), 1.0 (2007), 1.3 (2008), 0.5 (2009).
- Unemployment rate (%): 7.7 (2005), 6.8 (2006), 6.2 (2007), 6.7 (2008), 6.9 (2009).

### Prices and labor cost indicators
- GDP deflator: 2.1 (2005), 1.7 (2006), 2.3 (2007), 2.4 (2008), 2.0 (2009), 2.9 (2008Q3).
- Consumer prices: 2.2 (2005), 2.2 (2006), 2.0 (2007), 3.5 (2008), 1.6 (2009), 4.1 (2008Q3).
- Hourly compensation: 4.6 (2005), 2.9 (2006), 2.5 (2007), 5.5 (2008), 2.2 (2009), 3.7 (2008Q3).
- Productivity: 0.5 (2005), 0.2 (2006), 0.4 (2007), 0.1 (2008), 0.4 (2009), -0.8 (2008Q3).
- Unit labor costs: 4.1 (2005), 2.7 (2006), 2.1 (2007), 5.4 (2008), 1.8 (2009), 7.5 (2008Q3).

### Fiscal indicators (percent of GDP, selected)
- Central government balance: -3.8 (2005), -2.7 (2006), -2.2 (2007), -2.7 (2008), -3.5 (2009).
- General government balance: -4.3 (2005), -3.4 (2006), -1.6 (2007), -2.7 (2008), -3.4 (2009).
- Structural balance (in % of potential GDP): -4.0 (2005), -3.3 (2006), -1.8 (2007), -2.1 (2008), -2.0 (2009).
- Structural balance net of one-offs (in % of potential GDP): -4.5 (2005), -2.9 (2006), -1.8 (2007), -2.1 (2008), -1.6 (2009).
- Public debt ratio: 105.9 (2005), 106.9 (2006), 104.1 (2007), 105.7 (2008), 108.2 (2009).

### Exchange rate and external sector (selected)
- Exchange rate (NC/US$): 1.2 (2005), 1.3 (2006), 1.4 (2007), 1.5 (2008), 1.5 (2009), 1.3 (Oct-08).
- Nominal effective rate: CPI based (2000=100): 107.3 (2005), 107.8 (2006), 109.9 (2007), ...... (latest).
- Real effective exchange rate based on CPI (2000=100): 112.1 (2005), 111.8 (2006), 113.2 (2007), ...... (latest).
- Current account balance: -1.6 (2005), -2.6 (2006), -2.5 (2007), -2.9 (2008), -3.2 (2009).
- Trade balance: 0.0 (2005), -0.6 (2006), 0.1 (2007), -0.3 (2008), -0.6 (2009).
- Gross national saving: 19.1 (2005), 19.0 (2006), 19.0 (2007), 18.6 (2008), 19.0 (2009).
- Gross domestic investment: 20.8 (2005), 21.5 (2006), 21.5 (2007), 21.5 (2008), 22.3 (2009).

### General government accounts (percent of GDP, selected rows)
- Total revenues: 44.5 (2002), 45.1 (2003), 44.5 (2004), 44.2 (2005), 45.9 (2006), 47.2 (2007), 47.3 (2008), 47.6 (2009 Staff), 47.5 (2009 Budget), 48.6 (2010 Budget).
- Total expenditures: 47.4 (2002), 48.6 (2003), 48.0 (2004), 48.5 (2005), 49.3 (2006), 48.7 (2007), 49.9 (2008), 50.1 (2009 Staff), 50.9 (2009 Budget), 50.7 (2010 Budget).
- Social transfers: 16.5 (2002), 16.8 (2003), 16.9 (2004), 17.0 (2005), 17.0 (2006), 17.3 (2007), 17.8 (2008), 17.8 (2009 Staff), 18.3 (2009 Budget), 18.2 (2010 Budget).
- Interest payments: 5.5 (2002), 5.1 (2003), 4.7 (2004), 4.6 (2005), 4.6 (2006), 5.0 (2007), 5.1 (2008), 5.2 (2009 Staff), 5.2 (2009 Budget), 5.3 (2010 Budget).
- Overall balance: -2.9 (2002), -3.5 (2003), -3.5 (2004), -4.3 (2005), -3.4 (2006), -1.6 (2007), -2.7 (2008), -2.5 (2009 Staff), -3.4 (2009 Budget), -2.2 (2010 Budget).
- Public debt (Maastricht definition / public debt row): 105.7 (2002), 104.4 (2003), 103.8 (2004), 105.9 (2005), 106.9 (2006), 104.1 (2007), 105.7 (2008), 103.7 (2009 Staff), 108.2 (2009 Budget), 102.9 (2010 Budget).

### Financial soundness and vulnerabilities (selected)
- Regulatory capital to risk-weighted assets: 11.2 (2002), 11.4 (2003), 11.6 (2004), 10.6 (2005), 10.7 (2006), 10.4 (2007), 10.4 (2008).
- Regulatory tier I capital to risk-weighted assets: 8.2 (2002), 8.5 (2003), 8.8 (2004), 8.1 (2005), 7.8 (2006), 7.6 (2007), 7.4 (2008).
- Nonperforming loans, share of total gross loans: 6.5 (2002), 6.7 (2003), 6.6 (2004), 5.3 (2005), 5.1 (2006), 4.6 (2007), 4.8 (2008, June).
- Return on assets: 0.5 (2002), 0.5 (2003), 0.6 (2004), 0.7 (2005), 0.8 (2006), 0.8 (2007), ... (2008).
- Liquid assets to total assets (liquid asset ratio): 7.8 (2002), 8.6 (2003), 8.3 (2004), 7.5 (2005), 6.5 (2006), 5.7 (2007), 5.3 (2008).

### Balance of payments and external indicators (selected)
- Current account balance (percent of GDP): -1.7 (2005), -2.6 (2006), -2.5 (2007), -2.9 (2008), -3.2 (2009), -3.3 (2010), -3.2 (2011), -3.0 (2012), -2.8 (2013).
- Exports of goods f.o.b. (percent of GDP): 21.0 (2005), 22.4 (2006), 23.9 (2007), 25.4 (2008), 24.2 (2009), 24.5 (2010), 24.7 (2011), 25.2 (2012), 25.7 (2013).
- Imports of goods f.o.b. (percent of GDP): 20.9 (2005), 23.1 (2006), 23.8 (2007), 25.8 (2008), 24.8 (2009), 25.1 (2010), 25.2 (2011), 25.5 (2012), 25.9 (2013).
- Balance on goods and services: 0.0 (2005), -0.7 (2006), -0.3 (2007), -0.9 (2008), -1.2 (2009).

### Public sector debt sustainability (selected projections and assumptions)
- Baseline public sector debt (percent of GDP): 104.4 (2003), 103.8 (2004), 105.9 (2005), 106.9 (2006), 104.1 (2007), 105.7 (2008), 108.2 (2009), 109.7 (2010), 110.7 (2011), 111.0 (2012), 111.1 (2013).
- Change in public sector debt: -1.3 (2003), -0.5 (2004), 2.1 (2005), 1.0 (2006), -2.8 (2007), 1.6 (2008), 2.5 (2009), 1.5 (2010), 1.0 (2011), 0.4 (2012), 0.0 (2013).
- Identified debt-creating flows (3): 0.1 (2003), -1.4 (2004), 1.5 (2005), -0.3 (2006), -2.4 (2007), 0.8 (2008), 2.4 (2009), 1.3 (2010), 0.8 (2011), 0.2 (2012), -0.2 (2013).
- Primary deficit: -1.6 (2003), -1.2 (2004), -0.3 (2005), -1.3 (2006), -3.4 (2007), -2.4 (2008), -1.8 (2009), -1.6 (2010), -1.6 (2011), -1.7 (2012), -1.9 (2013).
- Automatic debt dynamics (2): 1.5 (2003), 0.3 (2004), 1.9 (2005), 0.9 (2006), 1.1 (2007), 3.1 (2008), 4.2 (2009), 3.0 (2010), 2.4 (2011), 2.0 (2012), 1.8 (2013).
- Average nominal interest rate on public debt (percent): 5.0 (2003), 4.7 (2004), 4.6 (2005), 4.5 (2006), 4.8 (2007), 5.0 (2008), 5.0 (2009), 4.9 (2010), 4.9 (2011), 4.9 (2012), 5.0 (2013).
- Average real interest rate (percent): 1.9 (2003), 2.1 (2004), 2.5 (2005), 2.8 (2006), 2.6 (2007), 2.6 (2008), 2.9 (2009), 3.0 (2010), 2.9 (2011), 2.9 (2012), 3.0 (2013).
- Inflation rate (GDP deflator, percent): 3.1 (2003), 2.6 (2004), 2.1 (2005), 1.7 (2006), 2.3 (2007), 2.4 (2008), 2.0 (2009), 1.9 (2010), 2.0 (2011), 2.0 (2012), 2.0 (2013).
- Growth of real primary spending (deflated by GDP deflator, percent): 3.7 (2003), 1.1 (2004), 2.1 (2005), 3.6 (2006), -0.7 (2007), 2.1 (2008), 0.8 (2009), 0.8 (2010), 0.7 (2011), 0.5 (2012), 0.8 (2013).
- Public sector debt-to-revenue ratio: 231.5 (2003), 233.3 (2004), 239.5 (2005), 232.7 (2006), 220.8 (2007), 223.5 (2008), 228.0 (2009), 230.5 (2010), 232.5 (2011), 233.7 (2012), 234.2 (2013).
- Gross financing need 6/: 29.7 (2003), 25.6 (2004), 25.0 (2005), 23.3 (2006), 21.1 (2007), 23.0 (2008), 24.8 (2009), 23.4 (2010), 23.6 (2011), 23.5 (2012), 23.5 (2013).

### Scenario tests and shocks (summary from Figure 9)
- Public debt sustainability bound tests include growth shock, primary balance shock, interest rate shock, combined shock (permanent one-half standard deviation shocks), and real depreciation and contingent liabilities shocks (one-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities in 2007).
- Baseline and historical comparisons show baseline public debt around 111 (historical/baseline references in figure boxes).
- Combined shock and other scenarios produce higher public debt paths compared with the baseline in the projection horizon.

*Source: IMF staff calculations and national authorities as presented in the provided content.*

### ANNEX I— THE CHALLENGE OF FIXING FISCAL FRAMEWORKS

### ANNEX I— THE CHALLENGE OF FIXING FISCAL FRAMEWORKS

### I. Introduction — Key findings
- Italy’s fiscal frameworks have improved in recent years through the SGP’s excessive deficit procedure, EU-led surveillance, and authorities’ actions on debt and deficit accounting, central government spending control, phasing out of one-off measures, and deficit containment under the domestic stability pact.
- The fiscal position falls well short of the MTO (structural balance).
- Deficits have been broadly in the 2–4 percent of GDP range.
- Adjustment has been largely revenue-based rather than spending-based; tax hikes delivered quicker annual adjustment than spending cuts.
- Italy’s record of meeting nominal spending plans is weak compared to other large EU countries (notably Germany); despite periodic expenditure cuts, the spending ratio has risen steadily.
- Budget institutions are fragmented, time-consuming, legalistic, lack transparency and result-orientation; the bulk of budget spending is mandatory/incremental and governed by many rigid laws.
- Unsettled intergovernmental rules and data weaknesses support incremental bargaining for central transfers, recurring subnational debts and deficit surprises (notably in health care), and dependence of many public enterprises on sizable transfers.
- Lack of uniform data on local government finances and consolidated public enterprise sector complicates fiscal policy responses.

### II. Improving budget institutions — Background
- Identified institutional weaknesses (IMF 2007):
  - An “incrementalist” approach to budget formulation.
  - Excessively fragmented voted budget: some 1,500 line items in 2007.
  - Lack of meaningful medium-term orientation; forward projections not true baseline costs.
  - Parliamentary approval allows proliferation of micro-amendments (about 12,000 presented during the 2007 budget discussion).
  - Many ex-ante controls on execution constrain managers’ flexibility and focus on legal compliance rather than efficiency.
  - Weak information base on costs and effectiveness of spending programs.
  - Little focus on budget outturns, weak accountability for performance.

### III. Recent reforms — measures introduced in 2008–2009 budgets
- Rationalizing budget structure and aligning with government objectives:
  - A program classification introduced in the 2008 budget and refined for the 2009 budget: 34 high level missions and 168 programs.
  - UPBs (Unita Previsionale di Base) reduced from 1,500 to around 700; UPBs remain the basic control unit for budget execution as required by the 1978 accounting law.
- Strengthening medium-term orientation:
  - 2009–13 medium-term plan (Documento di Programmazione Economico-Finanziaria, DPEF) and subsequent legislation established a binding three-year package of measures passed into law.
  - Documents include three-year estimates of costs of existing policy, broken down by missions and programs.
- Streamlining annual budget timing and transparency:
  - Key budget decisions advanced to June/July (anticipated in the DPEF) rather than December.
  - “Maneuvers” passed via a confidence vote in summer shortened legislative debate; DPEF more detailed and explicitly indicates aggregate revenue and expenditure plans.
- Enhancing managerial flexibility within programs:
  - Budget documentation sets spending caps for missions and programs; some flexibility to transfer resources within programs but confined to a small percentage of expenditure once exogenously driven expenditure is excluded.
  - For the first time line ministries can propose transfers from UPBs in policy areas already defined by legislation to other priorities to meet aggregate constraints.
- Spending review exercises:
  - Technical committee (2007) reviewed cost-effectiveness in five areas: justice, infrastructure, transport, internal affairs, education.
  - Final results reported mid-2008; technical committee dissolved at pilot end; General Accounting Department intends to continue and mainstream the exercise.
- Improving budget execution information:
  - Computerized cash transactions system (SIOPE) rollout: in 2008 to health and public welfare entities; now captures 98 percent of public expenditure.
  - SIOPE provides standardized codification of cash operations and real-time monitoring of cash flows.

### IV. Going forward — Policy recommendations to reduce structural rigidities
- Rigidities categorized:
  - (i) Mandatory charges (oneri inderogabili): pre-existing obligations where exact amounts are not predetermined (pensions, public sector payroll, interest payments).
  - (ii) Legislated expenditure (fattori legislativi): activities encumbered by legislative prescriptions specifying exact spending requirements.
- Example (Ministry of Communication, 2008 Draft):
  - UPB 1.1.1 Operations: 3,026,787
    - Of which: Personnel 2,756,971 — 1.4 percent of total — Mandatory
    - Goods and services 269,186 — 0.14 percent of total — Discretionary
  - UPB 1.1.2 Interventions: 154,034,252
    - Of which: 105,648 — 0.05 percent — Discretionary
    - 250,000 — 0.13 percent — Mandatory
    - Existing legislation encumbered: 153,678,604 — 77.84 percent — Encumbered
    - Examples of legislative encumbrances: Law 488/1999 20,658,276; Law 28/2000 3,329,138; Law388/2000 21,691,190; Law 448/2001 20,000,000; Law 289/2002 5,000,000; Law 350/2003 27,000,000; Law 311/2004 1,000,000; Law 296/2006 10,000,000; Law 296/2006 45,000,000.
  - UPB 1.1.6 Investments: 40,356,797
    - 356,797 — 0.18 percent — Discretionary
    - Existing legislation encumbered: 40,000,000 — 20.26 percent — Encumbered
- Recommended reforms:
  - Overhaul the 1978 budget law (law 468/1978) to amend accounting basis and introduce greater control flexibility; redefine UPBs and align with new program structure to facilitate control and appropriation by programs while retaining options to control other categories if needed.
  - Rationalize legislation encumbering spending programs by selecting priority programs and revising underlying legislation; continue spending review exercise.
  - Increase flexibility in civil servant management to facilitate geographic and functional mobility; make line ministries responsible for delivering policy objectives within a hard budget constraint that includes personnel costs.
  - Enhance medium-term orientation of the budget:
    - For the next DPEF, fiscal targets should reflect agreements with subnational governments to bring forward Domestic Stability Pact negotiations and increase credibility.
    - Consider setting quantified targets for major areas of spending in the DPEF or making binding the total level of primary spending for the year ahead.
    - Strengthen realism of cost estimates for maintaining existing policy by using clearly specified objectively determined cost drivers (e.g., rate of inflation) agreed during initial policy discussions; updates should be purely technical.
  - Systematically review expenditure programs for efficiency and effectiveness as part of the budget process; improve spending review process to identify programs to be eliminated, expanded, initiated, or redesigned.
  - Improve information base before moving to full program budgeting and performance targets:
    - Improve mapping of cost objects to programs continuously, potentially via enhancement of accounting systems before appropriation by program.
    - Develop performance measurement and indicators collaboratively with line ministries before moving to a performance targeting regime.
    - Establish a comprehensive database covering financial, output and outcome information.

### V. Inter-governmental fiscal relationships — Background
- Italian fiscal federalism characterized by significant reliance on transfers; vertical gaps narrowed over time but remain large.
- In late 1990s regions assigned taxes replacing some state transfers (IRAP, surcharge on IRPEF); horizontal inequities significant (South more dependent than North).
- Draft law approved October 3, 2008: gradually replace sub-national dependence on central transfers with own source revenues or greater share in national taxes.

### VI. Determining expenditure needs — Current situation and reform proposals
- Current situation:
  - Many spending assignments devolved to lower governments; center retains foreign policy, national security, macroeconomic policy, income redistribution, tax collection, constitutional matters, setting public service standards.
  - Health is bulk of regional spending; lower levels responsible for road maintenance, school construction, environment, waste and sewage, some health services, employment services, subsidies; costs determined based on historical spending.
  - Constitutional Court: center legislates fundamental principles in overlapping competencies; regions undertake financing and administrative functions; anomalies remain (e.g., education financed and provided by center).
- Reform proposals:
  - Move from historical-cost based costing to benchmark/standard costs for sub-national public services where center sets national service standards (LEA) — health, education, social assistance; also develop standard costs for local transport services.
  - For municipalities and provinces, spending on “fundamental functions” to be determined on a per capita basis estimated using historical trends and adjusted for demographic, geographic, social and economic features; transition time up to five years.
- International experience and trade-offs:
  - Benchmarking/formula funding systems can be expenditure-, service- or outcome-defined; DRGs in health cited as an example.
  - Trade-off between simple approaches (risk of being unrepresentative) and complex, data-intensive approaches (continuous redefinition).
  - Two broad formula mechanisms:
    - Case payments based on actual output: incentivize increased output and efficiency; align with performance budgeting.
    - Capitation methods based on estimates of output: emphasize fair funding to deliver a standard of service; fewer incentives for results but less demanding of administrative data and audit.
  - Some combination of mechanisms may be appropriate; system must define funding implications if state redefines or updates LEA.
- Additional measures if high costs materialize:
  - Consider streamlining subnational government structure.
  - Review public service “delivery chains” and rationalize duplication of spending competencies and civil service posts; enhance coordination and information sharing.

### VII. Revenue assignments — Current situation, proposals and international context
- Current situation:
  - Sub-national revenue assignments cover roughly half of current expenses.
  - Few genuinely autonomous sub-national taxes; most are shared taxes, surcharges, or have base controlled by center.
  - IRAP is main locally based tax for regions.
  - Local property tax (ICI) was main municipal own revenue but abolished in May 2008 for primary residences.
- Reform proposals:
  - Decentralized entities to have three main revenue sources: (i) own taxes (local legislation), (ii) derived taxes (national legislation with some local discretion on rates/relief), (iii) national tax sharing arrangements for IRPEF and national VAT (IVA).
  - For regions, these taxes will gradually replace IRAP (which covers most health expenditure).
  - Tax sharing based on principle of “territoriality”; main base intended for sharing is national VAT; VAT’s even distribution reduces equalization transfers but gives low ownership due to center’s control of base and rate.
  - Ability to institute new own taxes constrained by provision forbidding taxation of the same base by different government levels; flexibility to vary rates (e.g., IRAP) has not been utilized except as centrally imposed sanction or for industrial policy.
  - Tax assignments calculated according to nature of expenditure financed but will not be earmarked; equalization fund to ensure regions can finance services at required standard.
- International considerations:
  - Tax autonomy provides advantages: cater to local preferences, foster yardstick competition, harden budget constraints.
  - Italy slightly below average internationally in percent of taxes allocated to lower levels and discretion to set rates and relief.
  - Properties of tax bases: central governments often retain personal and corporate income taxes; VAT often retained centrally to avoid complexities; consumption taxes allocated via sharing can be evenly distributed.
  - Sub-national tax assignments should: (i) link taxpayers to service provision; (ii) not distort resource allocation; (iii) not exacerbate vertical/horizontal imbalances; (iv) be easily administered/enforced.
  - Property taxes are among the best local revenue sources; surcharges on personal income tax are simple but can create horizontal inequity; tax sharing gives no marginal autonomy; excise taxes suited if applied by destination principle.
- Moving forward:
  - Sub-national entities need revenue flexibility at the margin to increase service level/quality and to be responsible for cost overruns.
  - With gradual elimination of IRAP (over 50 percent of regional tax revenue), an alternative region-controlled tax needs identification.
  - Increase flexibility for sub-national governments to vary IRPEF surcharge rates accompanied by a reduction in the central rate.
  - Reconsider abolition of ICI on primary residences or accompany it with alternative property taxation sources.

### VIII. Tax autonomy and sub-national tax profile (selected figures)
- Table 2: Tax autonomy of sub-national governments, 2006 (percent of tax revenue; margin of autonomy)
  - Region:
    - IRAP: 52.2 — Tax rate can vary between 3.25 and 5.25 percent
    - Surcharge on IRPEF: 8.3 — Rate can vary between 0.9 and 1.4 percent
    - Automobile taxes: 6.9 — Variable by 10 percent relative to previous year
    - Tax share special regions: 30.7 — None: Fixed rates
  - Province:
    - Tax on auto insurance: 46.7 — None: Fixed tax
    - Transcription tax: 28.3 — Freely set up to 20 percent
    - Surcharge on electricity: 16.7 — Variable within given range
  - Municipality:
    - Local property tax: 58.9 — Tax rate variable between 4 and 7 per thousand
    - Tax on solid waste disposal: 20.2
    - Surcharge on IRPEF: 7.7 — Freely set up to 0.5 percent
  - Source: Banca d’Italia with Istat data.
  - Note: 1/ Percent of tax revenue; weights for each level do not add up to 100 because of omitted minor taxes.

### IX. Equalization scheme — Current situation and reform proposals
- Current situation:
  - Most grants are untied and considered mandatory from central budgeting perspective.
  - Equalization grants to cover vertical imbalances go from center to regions and local governments; additional grants from regions to local authorities.
  - Expenditure for special programs financed by EU grants and national cofinancing.
  - Equalization system creates a soft budget constraint for sub-national governments:
    - Transfers fixed ex-ante when budgets determined, largely based on previous year’s spending.
    - Equalization calculated largely in terms of spending levels; own revenue deducted from permissible spending to determine transfer level, disincentivizing local tax effort.
    - At end of year grants can be “topped up” to cover unforeseen deficits (especially in health and transport); rules for late adjustments unclear and appear influenced by bargaining power.
- Reform proposals:
  - Move from equalization based on spending to equalization based on revenue capacities and expenditure needs.
  - Phase out expenditure estimates based on historical spending in favor of standard costs for certain mandated functions.
  - Replace ordinary grants by tax revenues, leaving only equalization grants and special purpose grants for central (and EU) policy objectives.
  - Regional equalization transfers to be calibrated according to category of devolved expenditure.

*Prepared by Bogdan Lissovolik and Justin Tyson. Source: _cr0945 - ANNEX I— THE CHALLENGE OF FIXING FISCAL FRAMEWORKS.*

### 1. For LEA mandated expenditure, a vertical equalization fund will financed by

### _cr0945 - 1. For LEA mandated expenditure, a vertical equalization fund will financed by

### Vertical and horizontal equalization: design and mechanics
- Vertical equalization fund (for LEA mandated expenditure)
  - Financed by sharing the VAT base.
  - First round: a share of VAT collected in each region is calculated at a rate sufficient to fully cover LEA functions (estimated according standard costs) in at least one region, after subtracting the region’s share in IRPEF and own revenues.
  - Second round: an additional share of VAT is calculated at a rate sufficient to fully cover LEA expenditure in all other regions, after subtracting their share in the IRPEF, own revenues, and VAT shares based on the first round calculations.
  - Note: “There are clearly different solutions to this based on the share of IRPEF that is decided.” (footnote 6)
- Horizontal equalization fund (for non-LEA expenditure)
  - Financed by surcharges on the IRPEF.
  - Transfers determined by equalizing only revenue capacity against a standard calculated using an average IRPEF surcharge rate.
  - Regions with above (below) average IRPEF per capita contribute (draw from) the fund.
- Responsibilities and calculation
  - Regions will have greater responsibility for managing equalization funds for provinces and municipalities under their jurisdiction.
  - Equalization needs calculated as the difference between a standard cost per capita for recurrent expenses and a standard value for own revenue sources and national tax shares.

### International experience and empirical lessons
- Italy’s overall dependence on transfers is not unusual in OECD context (Figure 4).
- Grants objectives include: reducing vertical and horizontal fiscal imbalances; implementing national standards in public services; fostering national priorities; enhancing local expenditure efficiency.
- Academic findings cited:
  - Excessive grant dependence associated with weaker budget discipline at sub-national level (example: Germany, Rodden, 2006).
  - Excessive grant dependence associated with weaker economic performance (example: Austria, Blochlieger, 2007).
  - Equalization schemes must avoid disincentives to develop local revenues and incentives to inflate expenditure needs.
  - Equalization based on both revenue capacities and expenditure needs addresses limitations of revenue-only or expenditure-only approaches (Ahmad and Searle, 2006).

### Moving forward: principles and recommended features
- Transparency and formulae
  - Equalization fund for national standards should be based on transparent formulae and rules that can be easily monitored.
  - Discretionary choices by recipient levels to increase service levels should be financed by own resources.
  - Eliminate current system of ex-post bargaining and impose hard budget constraints.
- Incentives
  - Consider setting equalization at below 100 percent for non-LEA functions to incentivize own revenue effort.
- Closed-loop financing and multi-year predictability
  - Treat equalization scheme as a “closed loop”: inflows to the equalization fund (e.g., VAT share) should be fixed ex-ante in the budget cycle, preferably for three years in the DPEF, to reduce discretionary influence of the center and harden the budget constraint.
  - The share could be reviewed every three years or so and would be less prone to expenditure drift. (footnote 7: “Or the share for the outer year in the medium-term projection could be revised annually.”)
  - Arrangement equivalent to imposing a balanced operating budget requirement, after equalization grants, on all sub-nationals in the DSP.
- Institutional implementation
  - Equalization scheme should be implemented and enforced by an autonomous agency free from bargaining.
  - Transparent formulae and independent monitoring will increase transparency and reduce discretionality.
  - Permanent Conference on Public Finance (composed of representatives from all levels of government) to determine mechanics and monitor operation is positive if allowed to operate based on pre-established rules and not political bargaining; the agency should meet at the start of the budget cycle. (footnote 8)

### Fiscal discipline and stability: current situation and reforms
- Current vehicle: Domestic Stability Pact (DSP)
  - Aim: set a fiscal path for all levels consistent with Stability and Growth Pact (SGP).
  - Contains fiscal targets, monitoring mechanism, and sanctions; set within annual budget law after consultation with lower levels; a separate pact for health spending.
- Weaknesses of DSP
  - Lack of consistency with SGP targets, periodic amendments to rules and targets, varying coverage, sensitivity to cyclical conditions (Fedelino, 2005).
  - Health sector problematic: outside DSP coverage and subject to significant cost overruns.
- Reform proposals and enforcement
  - Fiscal federalism proposals aim to increase sub-national responsibility for fiscal outcomes; enforcement mechanism within new federal framework not yet defined.
  - Binding three-year adjustment packages consistent with longer-term fiscal objectives were anticipated as part of the 2009−13 DPEF.
  - Sharing deficit targets across levels is easier if accounting practices are harmonized.
- International evidence on fiscal federalism
  - Mixed findings: some studies link federal arrangements to macroeconomic fragility (Wibbels, 2000); others find dangers exaggerated for OECD countries (Thornton and Mati, 2007) or sub-national tiers can aid fiscal consolidation (Darby, Muscatelli and Roy, 2005).
  - Instruments to limit risks fall into four categories: administrative controls; centrally-imposed rules; formalized cooperation; market discipline.
  - Pure market approaches effective only if central government can credibly commit not to bail out sub-nationals (historical US and Canada examples cited).
- Moving forward recommendations for fiscal stability
  - Ensure federalism reforms are budget neutral at general government level.
  - Changes to rates/shares that regions can command from VAT and income tax need offset at central level to avoid raising tax burden and to signal center’s commitment to fiscal stability.
  - Revise DSP to have comprehensive coverage and provide stable, credible fiscal objectives for all levels.
  - Ideally target a zero operating budget balance after equalization grants, according to a harmonized definition, consistent with multi-year adjustments in the DPEF.
  - For next year’s DPEF, fiscal targets should reflect agreements with subnational governments, effectively bringing forward some DSP negotiations.
  - Establish a credible system of sanctions for budget indiscipline, perhaps combined with a no-bailout clause for local government (center must earn credibility).
  - Enforcement mechanisms should be transparent and non-discretionary, with responsibilities delegated where possible to autonomous agencies and courts.

### Complementary reforms required for fiscal federal arrangements
- Harmonize budget processes and systems across levels of government.
  - Integrate review of “delivery chains” with spending review exercise in budget system reform.
  - Examine shared or overlapping services to reduce duplication of spending competencies and civil service posts.
  - Cascade central-level budget policies and spending reforms to local levels for effective spending improvements.
- Reduce overlaps in expenditure competencies through increased labor market flexibility where needed.
- High-quality data and accounting
  - Establish sound benchmark costs and related equalization scheme requires high-quality, frequently updated, comparable data across regions and government units.
  - Some data could be sourced to an independent authority; much depends on a modern and consistent accounting system across levels.
  - Refinement of program classification at the center must be coordinated with other levels.
  - Ensuring high-quality data should precede reforms that establish expenditure and revenue quantities.

---

### Annex II — Labor market: introduction, background, and regulatory framework (selected findings)
- Labor market overview
  - Employment-to-population gains since mid-1990s; unemployment rate declined to 6.1 in 2007, just over half the rate in 1995.
  - Reforms (1997 Treu measures, 2003 Biagi reforms) increased aggregate employment but increased labor market dualism.
- Trends in contract types (1995–2007)
  - Temporary employment share increased from 7.2 percent to 12.4 percent.
  - Part-time employment share increased from 10.5 percent to over 15 percent.
  - Number of workers in temporary arrangements more than doubled; permanent employment increased by only 7 percent.
  - Part-time employment increased by 65 percent; full-time employment grew 9 percent cumulatively over same period.
- Remaining weaknesses
  - Employment growth slowing; employment share of working-age population substantially smaller than most European countries.
  - Hours worked about EU average; do not compensate for low employment share.
  - Nearly 50 percent of unemployed have been out of work for more than one year.
  - Stagnant labor productivity and continued earnings growth increased unit labor costs.
- Productivity and competitiveness
  - Manufacturing earnings growth over past decade averaged 2.6 percent annually in Italy, below average rate of over 3.2 percent in other EU15 countries.
  - Tax wedge for married individual with two children and average income is 33.7 percent in Italy, below EU average of 34.2 percent.
  - High labor costs largely due to low productivity.
- Key institutional hindrances
  - Collective wage bargaining
    - About 60 percent of workers covered by collective bargaining agreements; effective coverage even higher.
    - Two-tier system limits firm-level bargaining, especially for small enterprises and many in the South; nationally negotiated wages dominate and exacerbate regional differences.
  - Unemployment insurance (UI)
    - Ordinary UI net replacement rate is 60 percent initially but drops to zero after 8 months (12 months for workers aged over 50).
    - Complex eligibility rules mean few unemployed receive UI benefits (in 2005, 2.3 percent of labor force received UI benefits, about a third the rate in other EU countries).
    - Wage supplementation funds (CIG) can be substantially more generous but limited to certain contracts and participating firms (mostly large firms in the North).
    - Lack of sufficient social safety net inhibits efficient worker reallocation regionally and by skill.
  - Employment protection
    - Reforms reduced restrictions on fixed-term and part-time arrangements to about the EU15 average by 2003, but restrictions on regular employment remain largely unchanged.
    - Permanent employment protections (e.g., Art. 18 in Law 300/1970) make layoffs difficult and costly; perceived rigidity remains high.
    - Asymmetric deregulation favored atypical contracts, increasing employment risk for many and contributing to worsening productivity trends.
- Implication: Asymmetric labor market institutions (rigid wage bargaining, uneven UI, asymmetric EPL) and lack of regional differentiation in institutions contribute to low productivity and high unit labor costs.

*Source: IMF staff content from _cr0945 - 1. For LEA mandated expenditure, a vertical equalization fund will financed by (PDF).*

### Box 1. Key Reforms of the Italian Labor Market

### Box 1. Key Reforms of the Italian Labor Market

### Historical reform trajectory and legislative milestones
- Over the past two decades, Italy’s labor market has undergone substantial reform.
- Adverse macroeconomic conditions, including an unemployment rate that exceeded 12 percent during the late 1980s, and Italy’s envisaged entry into the EMU in 1999, resulted in several reform measures (patti sociali) starting in the early 1990s.
- Key reform measures and laws:
  - The social pact of 1993, which included the incomes policy arrangement and laid down the foundations of the industrial relations and collective bargaining framework currently still in practice.
  - The Treu measures in 1997 (Law 197/1997), aimed at increasing employment and overall labor market flexibility.
  - Law 469/1993 on the privatization and decentralization of job centers, abolishing the principle of a public monopoly on employment services.
  - The Biagi reform in 2003 (Law 30/2003), which further deregulated atypical work arrangements and introduced new forms of atypical work.

### Collective bargaining structure and implications
- The 1993 social pact established a two-tier bargaining structure:
  - National (sectoral) level: determines terms and conditions of employment (renegotiated every four years) and basic wage guarantees (minimi tabellari, renegotiated every two years).
  - Second (regional or firm) level: optional, allows bargaining partners to supplement national contracts (valid for four years).
- Constraint: wages cannot be reduced below those negotiated in the minimi tabellari; as a result, second-level bargaining’s potential to improve wage–productivity links is limited by the de facto wage floor.
- Footnote: Although Italy does not have a statutory minimum wage, collectively agreed wages impose a de facto wage floor—even for workers not covered by collective bargaining—because Italian labor courts use the minimi tabellari as guiding parameters (see sec. 36 of the constitution on the right to fair wages).

### Treu (1997) and Biagi (2003) reforms — objectives and instruments
- Treu measures (Law 197/1997):
  - First legislative measures aimed specifically at increasing the employment rate, particularly in the South, and overall labor market flexibility.
  - Focused on reform “at the margin” by introducing temporary contracts and providing incentives for part-time work.
- Biagi reform (Law 30/2003):
  - Further deregulated atypical work arrangements such as temporary agency work (staff-leasing) and part-time work.
  - Introduced new forms of atypical work: on-call jobs (lavoro intermittente), job sharing, and occasional work (lavoro a progetto).

### Product market regulation and labor market outcomes
- In 2003, Italy ranked among the countries in the EU with the most regulated product markets; Italy’s high score is driven mostly by regulations of the economic structure and competition.
- Empirical relationship: simple correlations between employment and product market regulation show a strong, negative relationship, with Italy at the extreme end of this relationship.
- Box 2 summary (theory and evidence):
  - Product market regulations have been found to be negatively correlated with employment.
  - Mechanism: monopolistic market structures lead firms to set prices with markups, reducing output and employment; increased competition lowers prices, raises output, and can raise employment.
  - Interaction with labor market distortions: where unions are strong and extract rents, product market deregulation reduces firms’ rents and therefore workers’ wage premium—so the scope for employment gains is larger when unions are strong.
  - Policy implication: in the presence of rigid product and labor markets, reforming the product market first may have large payoffs and facilitate labor market reform.

### Lessons and directions for reform
- Diagnosis of institutional problems:
  - Problems are not excessive average wage growth, but a bargaining system that provides insufficient differentiation, leading to wage outcomes that are too restrictive for some subsets of the economy.
  - The UI system is not excessively generous but is too low on average and too uneven, missing those worker groups that most need it.
  - Employment protection is too high overall, and its asymmetry causes additional distortions.
- General lessons from successful reformers:
  - A labor market reform agenda should address inefficiencies in product markets. Given Italy’s product market is among the most regulated in Europe, product market deregulation should be a top priority.
  - Reforms should not be piecemeal; labor market reforms should be implemented in packages to avoid unintended consequences. Italy’s history shows piecemeal examples such as asymmetric liberalization of temporary employment, partial tax reductions, and expansion of the CIG scheme.
- More specific directions:
  - Extended use of second-level bargaining is crucial to obtain a more flexible and differentiated wage structure.
  - Reductions in labor taxes may be necessary to provide additional flexibility, but these should be broad-based, rather than partial, and should be implemented only with commitments of unions to moderate wage demands at the national level so as to broaden the scope for wage supplements at the firm-level, while ensuring that tax cuts benefit both workers and firms.
  - A further EPL reduction, and equalization across employment types, should be combined with a reform of the UI system, including a broadening of coverage and lengthening of duration—i.e., increased employment risk should be buffered by improved income insurance.

### Fiscal and sequencing considerations; model-based simulations
- Sequencing: product market reforms first can provide substantial employment gains at little to no cost and can facilitate subsequent labor market reform.
- Model-based simulations (labor market matching model akin to Mortensen and Pissarides, 1994):
  - Cuts in labor taxation unambiguously raise employment.
  - Cuts in labor taxation are generally not self-financing and can result in substantial medium-term fiscal costs unless combined with other measures, such as reduced wage demands.
  - For Italy, where fiscal constraints are especially relevant, broad-based reductions in labor costs are important but likely costly from a fiscal perspective unless combined with a more flexible wage bargaining structure.

*Source: _cr0945 - Box 1. Key Reforms of the Italian Labor Market*

### ANNEX III— ITALY’S BANK CRISIS-MANAGEMENT FRAMEWORK

### ANNEX III— ITALY’S BANK CRISIS-MANAGEMENT FRAMEWORK

### Overview: three pillars and institutional roles
- The system of crisis management and prevention rests on three pillars: the crisis procedures framework, the deposit insurance scheme, and the liquidity and lender of last resort facilities.
- All three functions are either executed or controlled by the Bank of Italy (BoI), removing coordination and information-sharing inefficiencies.
- The BoI’s track record: efficiency and speed of reaction to individual bank failures is described as good, with no loss of deposits and bank runs recorded at least since the inception of the deposit insurance scheme in 1987.

### Bank resolution procedures — legal framework and instruments
- Legal basis: The Banking Law of 1993 defines liquidation or restructuring of single credit institutions; the BoI plays a key role.
- Decree Law 155 of October 9, 2008:
  - Amends the bank resolution framework to include "severe crisis" with potential systemic effects (including liquidity) as a trigger for special administration, even when serious losses or violations are not ascertained.
  - Capital injections by the state would apply in such cases, with the BoI deciding.
- Classification of measures:
  - Two broad groups: crisis-prevention and crisis-resolution.
  - Preventive measures are not formally included in a prompt corrective-action framework; choice of action is at the sole discretion of the BoI.
- Preventive measures (examples listed in source):
  - Letters to banks (leaving it to the bank to develop measures).
  - Circulars.
  - Regulatory actions (measures imposed by the BoI).
  - Administrative sanctions for non-compliance.
- Resolution measures:
  - Special administration (SA) — BoI-led rehabilitation; BoI can submit proposal to the Ministry of Economy to place a bank under SA.
  - Compulsory administrative liquidation (CAL) — BoI-led procedure equivalent to bankruptcy for exceptionally serious capital losses or irreversible crisis.
  - Both SA and CAL apply to banking groups, with umbrella principle: parent in trouble → parent may be placed under SA and distressed member companies may be placed under same special regime.
- Powers and implementation:
  - BoI appoints special administrators and an oversight committee who replace management and auditors and exercise administration and control.
  - In emergencies, BoI can arrange provisional management by special administrators for up to two months.
  - If CAL is proposed, BoI (Supervision Department) prepares measures to liquidate, including procedures to take the bank out of payment systems and coordinate deposit insurance payout; after Minister approval, BoI appoints a special body to liquidate.
  - Payout of deposit insurance has almost never occurred; usual outcome is transfer of assets and liabilities to another bank preserving continuity and creditor protection.
  - Neither SA nor CAL prevents BoI from imposing penalties on a bank’s governing bodies.
- Grounds and enforcement:
  - BoI has extensive grounds for intervention and powers to fine bank managers.
  - Preventive supervisory tools include convening governing bodies, mandating action programs with timetables, imposing more stringent regulatory requirements (capital adequacy, risk limits, internal organization, etc.), prohibiting new activities or branch closures, and pecuniary administrative sanctions.

### Deposit Insurance Scheme (FITD and MBDPF)
- Coverage and structure:
  - Depositors in all banks incorporated under Italian law, except mutual banks, are protected by the Interbank Deposit Protection Fund (Fondo Interbancario di Tutela dei Depositi, FITD).
  - Mutual banks are protected under a separate scheme, the Mutual Banks Depositor Protection Fund (MBDPF).
  - There is no private co-insurance scheme.
- Coverage levels:
  - EU-required minimum recently raised to €50,000.
  - FITD provides €103,291 per depositor per bank, and deposits are protected irrespective of currency.
- Funding and intervention rules:
  - FITD is funded by bank contributions, ex-post, and risk-adjusted according to size of deposit base covered and risk profile.
  - All interventions of the FITD must be authorized by the BoI; choice of intervention determined by the “least-cost” principle.
  - FITD can: pay off depositors; cover shortfalls between assets and liabilities in case of transfer to a third party; provide support interventions (e.g., guarantees) which can be initiated only if bank is placed under SA.
- Supervisory role and sanctions:
  - FITD does not have supervisory powers but monitors financial ratios of members.
  - In case of non-compliance with FITD guidelines or unpaid contributions, FITD can: suspend voting rights; remove a bank’s representative; impose pecuniary sanctions; exclude the member from FITD.
- Usage history and state backing:
  - Since creation, FITD was activated only six times.
  - The Decree Law of October 9, 2008, empowered the Ministry of Economy and Finance to issue a state guarantee to back up the DI schemes.
- Historical scope (as of June 2007, per source footnote):
  - FITD was covering about euro 395 bn of deposits in 297 institutions.
  - MBDPF protects depositors of about 460 mutual banks and covers euro 35 bn.

### Liquidity support and lender-of-last-resort (LOLR) arrangements
- Eurosystem/system-wide liquidity:
  - System-wide liquidity is provided by the ECB via open market operations and standing facilities.
  - Standing facilities allow a broad range of institutions discreet access against a broad range of collateral.
- National responsibility for LOLR:
  - LOLR facilities and decisions in the EU rest with national authorities; hence responsibility rests with the BoI.
  - In case of insolvency, the government guarantees the BoI’s liquidity support.
  - Decree 155 (October 9, 2008) provides that in severe liquidity crises, the government guarantees loans granted by the BoI to Italian banks and branches of foreign banks.
  - The BoI had no specific LOLR line open as of November 2008.
- Measures adopted under Decree Law 157 (13 October, 2008) and related BoI actions:
  - The Eurosystem’s credit operations, following ECB changes on 8 October 2008, allow demand for liquidity to be met for unlimited amounts at the fixed rate of 3.75 per cent.
  - The BoI decisions (as listed in source):
    1. Reduce from €1,000,000 to €500,000, with immediate effect, the minimum threshold for loans to be eligible for refinancing operations, without prejudice to the right to make further adjustments in accordance with ECB guidelines.
    2. Activate a new facility for temporary swaps between government securities held by the BoI and assets held by Italian banks:
       - Transactions renewable, maturity of one month.
       - Remunerated with a fee of 1 per cent on an annual basis.
       - Banks may swap debt instruments in various currencies and with a rating lower than that of eligible ECB collateral.
       - Operations started on October 16, will be carried out twice a week.
       - Facility’s total amount can reach €40 bn.
- Additional operational detail:
  - The BoI contributes to implementation of Eurosystem credit operations for matters within its competence.

*Source: ANNEX III— ITALY’S BANK CRISIS-MANAGEMENT FRAMEWORK (Staff Report for the 2008 Article IV Consultation—Informational Annex).*

### 1.      Recent global and domestic indicators have deteriorated, prompting a significant

### Recent global and domestic indicators have deteriorated, prompting a significant downward revision to staff projections

### Growth outlook and recent macro indicators
- Recent developments:
  - Exports slumped; business confidence fell to historical lows; industrial production and orders continued falling in November; consumer confidence weakened further despite lower inflation (2.2 percent year-on-year in December).
  - Coupled with downward revisions to partner country growth and world trade, staff now project GDP to decline by 2.1 percent in 2009 and by 0.1 percent in 2010.
  - The risks to this projection, mainly relating to the global outlook, remain tilted to the downside.
  - The forecast for 2009 is similar to that made by the Bank of Italy and the European Commission in mid-January (-2 percent), but staff envisage a more gradual recovery thereafter.
  - Staff project inflation to fall to 1.2 percent in 2009, and remain under 2 percent in 2010, reflecting weaker international commodity prices and the significant output gap.

- GDP growth projections (in percent):
  - 2008 2009 2010
  - IMF (January 26, 2009) -0.6 -2.1 -0.1
  - Revisions from staff report -0.2 -1.1 -0.3
  - Bank of Italy (January 14, 2009) -0.6 -2.0 0.5
  - European Commission (January 19, 2009) -0.6 -2.0 0.3

- Other indicators and narrative from charts and sources:
  - Advanced country growth and world trade projections have been revised downward (difference relative to the Nov. 2008 WEO, annual percentage change).
  - World trade (volume) and country growth differences are shown relative to the staff report; specific chart values are reported in source figures.
  - Sources: Haver, and IMF January 2009 WEO.

### Fiscal position and anti-crisis package
- Overall fiscal outlook:
  - Revenues continued to flag in December as cyclical conditions deteriorated.
  - Staff project the 2009 fiscal deficit to widen to 3.9 percent of GDP—including the effects of the recent anti-crisis package approved by Parliament at end-January, 2009—as automatic stabilizers operate.
  - The public debt ratio is forecast to rise to 109.4 percent of GDP.
  - Risks to the fiscal balance remain to the downside, reflecting risks to growth and potential adverse shifts in revenue elasticities.
  - In line with other high-debt Euro area sovereigns, 10-year spreads over German bunds remained elevated (around 140 basis points at end-January).

- Estimates of Italy's anti-crisis package costs (in percent of GDP):
  - Expenditure increases (o/w) 2009 2010
    - 0.24 0.12
  - Infrastructure investment 2009 2010
    - 0.04 0.07
  - Safety nets 2009 2010
    - 0.17 0.02
  - Mortgages 2009 2010
    - 0.02 0.00
  - Revenue reductions (o/w) 2009 2010
    - 0.12 0.08
  - PIT 2009 2010
    - 0.03 0.01
  - Indirect tax reductions 2009 2010
    - 0.01 0.00
  - CIT/depreciation 2009 2010
    - 0.07 0.07
  - Total cost (gross) 2009 2010
    - 0.36 0.20
  - Contractionary measures 1/ 2009 2010
    - 0.15 0.11
  - Total cost (net) 1/ 2009 2010
    - 0.21 0.09
  - 1/ Staff estimate.

### Key projections and risks (summary bullets)
- GDP: decline by 2.1 percent in 2009; decline by 0.1 percent in 2010.
- Inflation: 1.2 percent in 2009; remain under 2 percent in 2010.
- Fiscal deficit: 3.9 percent of GDP in 2009 (including anti-crisis package).
- Public debt ratio: 109.4 percent of GDP (forecast).
- 10-year spreads over German bunds: around 140 basis points at end-January.
- Anti-crisis package total cost (gross): 0.36 percent of GDP in 2009; 0.20 percent of GDP in 2010.
- Anti-crisis package total cost (net, staff estimate): 0.21 percent of GDP in 2009; 0.09 percent of GDP in 2010.

*Source: IMF staff estimates and related figures as presented in the document.*

### 3.      Financial market strains have persisted, and sovereign risk indicators remain

### 3.      Financial market strains have persisted, and sovereign risk indicators remain elevated.

### Financial market conditions and banking-sector developments
- CDS spreads for the largest banks edged down by some 20 to 40 basis points during the past month, while equity valuations remained at historical lows.
- Italy’s voluntary bank recapitalization scheme for sound banks has been approved by the European Commission but has not yet been promulgated.
- Authorities adopted measures in October 2008 to preserve financial stability, protect savers, and maintain bank liquidity and capitalization; additional measures were introduced to strengthen banks’ ability to finance economic activity.
- The Ministry of Economy and Finance is authorized to:
  - participate in the recapitalization of banks whose capital levels are deemed insufficient by the Bank of Italy;
  - subscribe financial instruments issued by sound listed Italian banks that qualify as regulatory capital support;
  - guarantee emergency loans granted by the Bank of Italy to Italian banks and branches of foreign banks operating in Italy (in the event of a severe liquidity crisis).
- Coordinated euro-area measures: the Ministry can issue state guarantees for Italian banks’ new liabilities with maturity between three months and five years.
- Bank of Italy measures: activation of a facility allowing banks to temporarily exchange assets for government securities held by the Bank of Italy.
- Crisis-resolution framework: procedures for special administration and provisional management of banks extended to cases of “severe crises”, including liquidity crises.

### Macroeconomic outlook and recent performance
- Output:
  - Real GDP: 2008: -0.6 percent; 2009 (projected): -2.1 percent; latest reading: -0.5 (2008Q3) as reported in table.
  - Staff projects a small negative growth in 2010; risk of prolonged downturn cannot be ruled out.
- Demand components (latest readings, 2008Q3 unless noted):
  - Public consumption: 1.0 (2008), 0.9 (2009), latest reading 0.0.
  - Private consumption: -0.4 (2008), -0.4 (2009), latest reading 0.1.
  - Gross fixed capital formation: -1.9 (2008), -7.8 (2009), latest reading -1.9.
  - Final domestic demand: -0.4 (2008), -1.7 (2009), latest reading -0.5.
  - Stock building contribution: -0.1 (2008), 0.3 (2009), latest reading -0.1.
  - Net exports contribution: 0.3 (2008), -0.3 (2009), latest reading -0.3.
  - Exports of G&S: -1.3 (2008), -3.2 (2009), latest reading -1.6.
  - Imports of G&S: -2.4 (2008), -2.3 (2009), latest reading -0.5.
- Prices and labor:
  - GDP deflator: 3.1 (2008), 2.3 (2009), latest reading 2.9 (2008Q3).
  - Consumer prices: 3.5 (2008), 1.2 (2009), latest reading 4.1 (2008Q3).
  - Unemployment rate: 6.8 (2008), 7.3 (2009).
  - Employment growth: 0.3 (2008), 0.1 (2009).
- Money and credit (end of period, percent change):
  - Private sector credit: 7.3 (2008), ... (2009), latest reading 5.9 (Oct-08).
  - National contribution to euro area M3: 10.8 (2008), ... (2009), latest reading 7.8 (Oct-08).
- Interest rates (end of period):
  - 6-month interbank rate: 4.3 (2008), ... (2009), latest reading 4.3 (Nov-08).
  - Government bond rate, 10-year: 4.7 (2008), ... (2009), latest reading 4.7 (Dec-08).
- External sector:
  - Current account balance: -2.4 (2008), -2.0 (2009); projected to narrow gradually over the medium term as external demand and exports pick up.
  - Trade balance: 0.1 (2008), 0.4 (2009).

### Fiscal developments, projections, and policy stance
- Recent trajectory:
  - Structural fiscal balance improved by 2¾ percent of GDP in 2006-07, mainly due to exceptionally strong revenues; overall deficit narrowed to 1.6 percent of GDP in 2007.
  - Deficit likely rebounded to 2¾ percent of GDP in 2008, reflecting an expansionary budget, weaker revenues, and temporary factors.
  - Fiscal deficit likely to widen to around 3.9 percent of GDP in 2009.
  - Public debt projected to reach 109.4 percent of GDP in 2009.
- Table highlights (percent of GDP, selected rows):
  - Total revenues: 2008 Staff 47.2; 2009 Staff 47.3; 2009 Budget 47.2; 2010 Budget 48.7.
  - Total expenditures: 2008 Staff 49.7; 2009 Staff 49.7; 2009 Budget 51.1; 2010 Budget 50.8.
  - Overall balance: 2007 Staff -1.6; 2008 Staff -2.7; 2009 Staff -3.9; 2010 Budget -2.2.
  - Primary balance: 2007 Staff 2.4; 2008 Staff 2.4; 2009 Staff 1.3; 2010 Budget 3.1.
  - Structural overall balance (percent of potential GDP): 2007 Staff -1.7; 2008 Staff -2.2; 2009 Staff -2.0; 2010 Budget -0.3.
  - Public debt: 2007 104.1; 2008 105.6; 2009 109.4; 2010 102.9.
- Policy orientation:
  - Authorities anchored a three-year fiscal framework (2009-2011) aimed at reaching a balanced budget by 2011.
  - The revenue-based fiscal consolidation has come to an end; current anti-crisis fiscal package focuses on temporary, targeted, and timely measures and acceleration of public investment projects.
  - Measures are designed to have limited budgetary impact, high multiplicator effects, and to be temporary; authorities expect overall 2009 deterioration largely cyclical.
  - Ongoing fiscal framework reforms: streamlined 2009 budget process, spending review pilot project completed, efforts to increase productivity of public administration, and fiscal federalism reform to increase fiscal autonomy and discipline.

### Executive Board and policy recommendations
- Executive Directors:
  - Welcomed authorities’ measures to strengthen financial stability and temporary, targeted fiscal measures while remaining committed to fiscal sustainability.
  - Urged prompt implementation of measures and stepping up long-run structural reform agenda to enhance growth potential.
  - Supported intensified monitoring and prudential oversight of the financial sector and looked forward to implementation of the voluntary government recapitalization scheme while minimizing spillovers.
  - Supported the government’s anti-crisis fiscal package but saw little scope for further stimulus; some Directors noted a somewhat larger stimulus could be considered if the growth outlook deteriorates further.
  - Emphasized the importance of reductions in current spending to underpin fiscal sustainability and welcomed commitments to attain fiscal balance in the medium term.
- Structural policy calls:
  - Reduce regulation, increase competition, and improve the business environment to raise productivity and growth potential.
  - Further liberalize retail trade and services, continue deregulation in the energy market, and strengthen the role of competition bodies.
  - Implement a second generation of labor market reforms to strengthen the link between wages and productivity, allow wages to better respond to regional differences, and make permanent contracts more flexible, in tandem with an enhanced social safety net.
  - Follow through on plans to tackle longer-term fiscal challenges, in particular reforming the welfare system.

### Structural features and reform priorities
- Competitiveness and productivity:
  - Low productivity growth combined with steady increases in unit labor costs underlie Italy’s competitive gap and slow growth potential.
  - Signs of industry restructuring: movement toward higher value-added goods and improved export quality; world market shares declined at constant prices but remained relatively stable at current prices.
  - National Reform Programme (submitted to the EU Commission) envisages measures before 2010 to liberalize products and services markets; measures recently approved for the electricity sector and local public services.
- Public administration and public spending:
  - Comprehensive reform of the public administration programmed as part of the 2009 budget, including linking wage increases to productivity.
  - Spending review pilot project completed covering justice, infrastructure, transports, internal affairs, and education.
  - Budget office now responsible for selecting priority programs, reviewing legislation, and identifying opportunities for reducing spending and improving efficiency.
- Labor market and safety nets:
  - Reforms in past years increased labor market mobility and job creation; recession is increasing stress on the labor market.
  - Social safety net strengthened with additional funding for the unemployment protection scheme (“cassa integrazione”).
  - Changes in collective bargaining to increase wage flexibility and strengthen linkage to productivity: basic wage rates negotiated at national level considering expected inflation (excluding energy prices); wages tied to productivity via decentralized negotiations.

*Source: IMF Public Information Notice (PIN) No. 09/16, February 6, 2009 — IMF Executive Board Concludes 2008 Article IV Consultation with Italy.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr0945.pdf_