## 1. The Impact of Product Market Reforms on Firm Productivity in Italy ## Source details **Canonical URL:** [1. The Impact of Product Market Reforms on Firm Productivity in Italy](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16222.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16222.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16222.pdf.json) --- ### Context: long view — growth, productivity, and structural rigidities - Structural rigidities identified: - product and service market inefficiences, wage growth in excess of productivity, high taxation, an inefficient public sector, and lengthy judicial processes. - Historical performance and vulnerabilities: - one of the lowest productivity growth rates among advanced economies over the last three decades. - Public debt: around 100 percent of GDP at euro accession and eve of the global financial crisis; climbed to almost 133 percent of GDP (second highest in the euro zone). - Output contracted by 9 percent during 2007–14. - Manufacturing declined sharply in several subsectors; productivity in manufacturing has increased while services productivity has been declining. - Nonperforming loans rose to 18 percent of loans. - Medium-term outlook and risks: - Economy not expected to return to its pre-crisis (2007) real output peak until the mid-2020s under staff projections. - Italy likely to experience nearly two lost decades while euro zone partners grow cumulatively by 20–25 percent. - With slow growth, unemployment would remain high; absent productivity-enhancing measures, real wage growth in Italy would lag partners or competitiveness would lag. - Government reform agenda (initiatives underway or passed): - Jobs Act being implemented. - Legislation on reform of cooperative and mutual banks. - Insolvency system being revised. - Framework law on public administration approved; some implementing decrees issued. - Reform of the state budget underway. - Education system reform approved and being implemented. - Legislation passed and constitutional referendum planned for October on institutional reforms to facilitate decision making and transfer of competencies from regions to center. - Policy imperative: - Urgent need to accelerate and deepen reforms: ambitious product and service market reforms; a new wage bargaining framework; insolvency reforms; room for notable cuts in the labor tax wedge while achieving medium-term fiscal targets. ### Near-term developments (economic performance and labor market) - 2015 performance: - Economy expanded by 0.8 percent. - 2015–2016 quarterly dynamics: - 2015 year-end: seasonally-adjusted 0.2 percent q-o-q; 2016 Q1: 0.3 percent q-o-q. - Components and indicators: - Private consumption and inventory re-stocking key contributors to 2015 growth; external demand weighed on growth. - Investment recovery very slow; investment ratio remains far below key euro zone partners after sharp decline in 2010–14. - Real exports back to pre-crisis (2008 Q1) peak but lag partners 15–25 percent above pre-crisis peaks. - Current account and trade balances remain in surplus. - Inflation very low; headline back in negative territory since February; long-term inflation expectations significantly below the ECB’s objective. - Labor market: - Unemployment declined to 11.7 percent at end 2015 (from a peak of 13.1 percent in November 2014). - Long-term unemployment close to 60 percent of unemployed persons. - Youth unemployment above 35 percent. - Female labor force participation remains relatively low. - Job creation picked up among those aged 50–64; share of workers in new permanent contracts up notably. - Skilled young Italians increasingly emigrating abroad. - Poverty and inequality: - Incidence of absolute poverty increased to 5.7 percent (1.4 percentage point higher than 2011). - Income inequality has increased and is well above the OECD average. ### Banking sector: asset quality, profitability, and resolution - NPLs and provisioning: - NPLs stabilizing at about 18 percent of loans. - Provisions amount to 45 percent (excluding collateral and guarantees). - Profitability and lending: - High NPLs adversely affect profitability—profit margins among the lowest in Europe—and weigh on banks’ ability to extend credit. - Credit to corporate sector about 11 percent lower than five years ago; credit to households growing modestly. - Bank surveys suggest incipient improvement concentrated among larger and healthier firms. - Capital and market performance: - Banks raised about €4 billion in capital in H1 2015 after 2014 AQR and stress tests. - Common equity tier 1 ratios improved to 11.5 percent on average for significant banks at end 2015 (about 2 percentage points below average in EBA sample). - Italian banks lost over 40 percent of their market value in 2015. - Bank resolutions and bail-in: - Four small troubled banks (about 1 percent of system-wide deposits) resolved late November 2015 before stricter BRRD bail-in requirement effective 2016. - Resolution cost €3.6 billion borne by national resolution fund, which drew liquidity from three major banks. - Limited bail-in of equity and subordinated debt; senior bondholders spared. - Nearly half of €0.8 billion of subordinated debt bailed in was held by retail investors; a fund set up to compensate many retail investors. ### Banking sector: detailed vulnerabilities, NPL initiatives, and market measures - Profitability & funding under ECB easing: - ECB easing lowers NIMs of Italian banks by 11 basis points on average (staff estimate). - To offset lower NIMs, lending growth in Italy would need to increase to at least 3.6 percent annually (about 3 percentage points above current credit growth). - One-third of banks in sample could still face profitability challenges even under favorable funding. - NPL initiatives: - GACS: government guarantees for securitization senior tranches rated investment grade; fees paid by banks should cover expected costs; staff view: at best a marginal impact on the price gap between book and market values. - Atlante: private fund created April 2016; has raised €4.25 billion; invested €1.5 billion in Banco Popolare di Vicenza in May 2016 (about 99 percent stake); staff view: helped preserve financial stability but not a game changer given limited resources. - Bank of Italy creating NPL information center to encourage private non-bank participation. - Bail-in rules and retail exposure: - BRRD bail-in operational since January 1, 2016; requires bail-in of at least 8 percent of total liabilities pre-condition for resolution funds. - Deposits can be bailed in only for part exceeding €100,000. - Italian law establishes full depositor preference over unsecured senior debt from January 1, 2019. - Italian households hold about one-third of senior bank debt and almost half of total subordinated bank debt. - For majority of the 15 largest banks, the 8 percent minimum requirement would currently imply bail-in of retail investors of subordinated debt; for about two-thirds, losses would be imposed on some senior debt holders. - Supervisory and structural recommendations (selected): - Advance insolvency reforms; adopt debt restructuring principles for multilateral workouts and triage approach. - Accelerate NPL resolution: new NPL reporting by end 2016; require comprehensive NPL strategies with ambitious targets; consider time-bound tax incentives to accelerate workouts. - Encourage private asset managers and pooling for smaller banks. - Supervise and encourage consolidation with ex ante assessments for emerging banking groups. - Ensure Atlante governance: investments based on commercial considerations, timely disposal of assets if scaled up, encourage foreign investor participation. - Prompt resolution of unviable banks, address mis-selling to retail investors via penalties/remediation, strengthen safeguards, and safeguard poor households via means-tested social safety net. ### Fiscal developments and composition - Fiscal stance and targets: - Government tightened fiscal stance during crisis to peak structural primary surplus of 4.1 percent of GDP in 2013. - Fiscal policy eased since then; structural primary surplus projected to decline to 2.6 percent of GDP in 2016. - Overall deficit projected to decline to 2.4 percent of GDP in 2016 (from 2.9 percent of GDP in 2012–13). - Interest savings of more than 1 percent of GDP largely offset by fiscal relaxation. - Debt increased to 132.7 percent of GDP at end-2015. - Composition of spending and revenue measures: - Real primary spending contained mainly via cuts in capital spending and wage bill (attrition and wage freeze). - Social benefits including pensions rose and remain an outlier in euro area. - Tax easings: monthly bonus of €80 for workers with incomes below €24,000 (phased out up to €26,000); cuts in social contributions for new hires; elimination of effective real estate tax on primary residences. - Additional revenues via voluntary disclosure scheme and gaming revenues. ### Competitiveness and external position - External position and current account: - Average deficit of 1¼ percent of GDP in 2000s; moved into balance in 2013. - 2015 current account surplus: 2.2 percent of GDP, driven by growing trade surplus and lower commodity prices. - Staff assesses 2015 cyclically-adjusted current account surplus about 0–2 percent of GDP weaker than fundamentals and appropriate policies. - REER and competitiveness drivers: - Stagnant productivity and rising labor costs led to gradual REER appreciation since euro adoption. - 2015 fall in euro contributed to sizable REER depreciation close to 1999 levels. - Staff considers a real effective depreciation of 0–10 percent—supported by structural reforms—appropriate to restore competitiveness. ### Growth outlook and risks (2016–21 and longer term) - Growth projections: - Real GDP growth projected at 1.1 percent in 2016 and about 1¼ percent in 2017–18. - Measures in 2016 budget estimated to boost growth by about 0.3 percent in 2016 and 2017. - Investment expected to pick up gradually, financed largely by firms’ retained earnings and modest credit; bank financing could become a binding constraint unless balance sheets restored. - Backloaded fiscal consolidation per authorities’ plans would result in decline in real GDP growth in 2019–21 to around 0.8 percent. - Steady state growth around 0.8 percent, including a dividend on structural reforms of about 0.3 percent per year over medium to long term. - Absent reforms, staff estimates potential growth around ½ percent. - Risks: - Upside: strong implementation of structural reforms, larger-than-expected euro depreciation impact, sustained low energy prices. - Downside: delays in addressing bank asset quality, global financial market volatility (including Brexit), global trade slowdown, refugee influx and security threats, setbacks in reform process. - Downside risks could produce significant regional and global spillovers given Italy’s systemic weight. ### Structural reforms — priorities and product and service market reforms - Priority reform areas: - Product and service markets. - Public administration quality and efficiency. - Wage bargaining system to align wages with productivity and complement the Jobs Act. - Product and service market issues concentrated in: - Network industries (energy, transport). - Professional services (legal, notaries, pharmaceutical). - Provision of local public services. - Economic weight of affected services: - account for about one-third of total value added and about 30 percent of household final consumption; contribute about 40 percent of input to other sectors’ output. - Potential reforms and focus areas: - Strengthen Annual Competition Law per competition authority recommendations and ensure annual adoption of pro-competition laws. - Enhance competition in local public service provision (local transport, waste collection); rationalize local public companies. - Liberalize retail, electricity generation (hydroelectric plants), radio spectrum, local public transport and taxis, ports and airports; reform permit schemes and right-to-use public infrastructure procedures. - Authorities’ stance: - Agreed on critical importance of enhancing competition. - Expected draft Annual Competition Law to be adopted by mid-2016; National Plan for Professional Reform submitted February 2016. - Other areas (communications, healthcare, transport, other public services) to be tackled in future annual competition laws linked to public administration reform. ### Box 1 — Empirical findings on product market reforms and firm productivity (key quantitative associations) - Data and method: - IMF Working Paper WP/16/119 using Orbis firm-level data 2003–13, PMR, and Italy’s input-output matrix. - Quantitative associations: - A one-standard deviation improvement in the PMR is associated with: - 3 percent relatively higher growth in sales in previously regulated sectors. - 10 percent relatively larger firms (in terms of output). - 4.7 percent relatively higher value added per worker in previously regulated sectors. - Firms that use regulated inputs more intensely increase size and productivity relatively more upon deregulation of network sectors. - Complementarity with public service quality: - In provinces with more efficient public services, the positive association between deregulation and firm performance is significantly stronger. - Example: a one-standard-deviation improvement in the PMR associated with a 0.3 percent increase in output for a firm in the upper quartile of government efficiency, but only 0.1 percent for a firm in the lower quartile. ### Public sector inefficiencies — findings, reforms, and priorities - Key public sector performance indicators: - 1,120 days to enforce a contract (World Bank Doing Business 2016). - 227 days to obtain a construction permit. - 124 days to get an electricity connection. - Average tendering procedure: 210 days (EU average 77.4 days). - Number of single-bid contracts awarded: close to one third. - Number of local public enterprises: more than 8,000. - Skills mismatches found in one-third of positions studied by agency for collective bargaining for public administration. - Public sector weaknesses: - Excessively long and burdensome bureaucratic procedures; overlapping competences; lack of administrative capacity; aging workforce; perception of corruption; dominance of local monopolies; notable regional differences. - Reforms enacted and proposed: - Enabling law approved August 2015 to simplify procedures, streamline decision making, rationalize local public enterprises, improve recruitment and management of staff. - Legislative decrees proposed January 2016 and in process of implementation; others planned for later in 2016. - Procurement reform: centralizing purchasing to about 35 bodies. - New framework to regulate state-owned enterprises; enhanced oversight by Court of Auditors. - State-owned enterprises left outside rationalization perimeter include Eni, Enel, Finmeccanica, Poste Italiane, Cassa Depositi e Prestiti, Ferrovie, and Rai. - Stricter rules planned for disciplinary firing of public sector workers. - Implementation challenges and priorities: - Improve skill-mix; match positions with skills; align wages with productivity; accelerate court processes; tackle privileges and employment in public enterprises, including privatization; ensure procurement coverage; strengthen anti-corruption and AML/CFT on domestic politically exposed persons. - Authorities intend to complete legislative process by end-2016. ### Civil justice reforms (Box 2) — findings and recommendations - Court performance: - Italy among slowest in EU for civil/commercial dispute adjudication; civil/commercial cases resolved in first instance on average in more than 500 days. - Appeals can extend to around six years. - Government actions: - Promote alternative dispute resolution; reinforce auxiliary court staff; introduce better information technology. - Project Strasbourg 2.0: court performance indicators and best practices. - Reform priorities: - Reform appeal system; strengthen enterprise courts for commercial justice and insolvency; introduce enforcement and new forms of security interests over movable assets; effective electronic civil procedure (processo civile telematico) to reduce enforcement time. - Technical implementation details remain, including efficient notice-based registry and legal transposition of May measures. ### Debt sustainability and risks (Annex II key points) - Summary judgment: - Public debt about 133 percent of GDP and yet to peak. - Debt should decline gradually if government delivers necessary adjustment to achieve structural balance; if growth/inflation materialize and accommodative monetary policy keeps interest rates low. - If growth disappoints or contingent liabilities materialize, "debt will keep rising." - Achieving and maintaining for several years a structural surplus of about ½ percent of GDP should ensure that debt declines steadily. - Public debt facts and vulnerabilities: - Debt increased from about 100 percent of GDP in 2007 to 132.7 percent of GDP in 2015. - Gross financing needs: "14–17 percent of GDP." - Average maturity around 6½ years; about 70 percent of debt at fixed interest rates; two-thirds held by domestic investors. - Interest rate pass-through: a 100 basis point increase raises interest bill by 0.13 percent of GDP in year 1, about 0.3 percent in year 2, 0.4 percent in year 3, and 0.5 percent in year 4. - ECB net purchases of Italian public debt in 2015: about €80 billion vs. gross financing needs of €450 billion. - Baseline projections and assumptions: - Real GDP growth projected at 1.1 percent in 2016, 1¼ percent in 2017–18, declining to steady state 0.8 percent. - Long-run growth includes dividend of about 0.3 percent annually from reforms. - Spreads assumed around 150 bps; effective nominal interest rate around 3 percent through 2021, rising to around 5 percent beyond 2021. - Privatization proceeds: about 0.1 percent of GDP projected in 2016; no projection thereafter. - Debt path: peak at 133 percent of GDP in 2016, declining to 123 percent in 2021. - Key stress-test scenarios (selected outcomes): - Standard growth shock: average growth –1.1 percent in 2017–18; primary balance reaches only 1 percent of GDP by 2021; result: debt ≈ 144 percent of GDP and fails to come down. - Interest rate shock: spreads +200 bps; growth depressed by 0.4 p.p.; implicit average interest rate 3.6 percent by 2021; result: debt declines modestly to ≈ 128 percent by 2021. - Contingent liability shock: one-time increase in non-interest expenditure ≈ 10 percent of banking sector assets; primary balance worsens by 12 percent of GDP in 2017; result: debt rises to ≈ 149 percent of GDP. - Tolerance for risk and fan chart: - Probability of debt not declining below current level (≈ 133 percent of GDP) by 2021 about 13 percent if shocks symmetric; with modest asymmetric shocks to growth and primary balance probability rises to about 50 percent. - Debt-stabilizing primary balance table (excerpted values from figure): - Example rows/columns (values as in source figure): for nominal interest rate 0 and nominal growth rates 0 to 5: 0, 1.3, 2.6, 4.0, 5.3, 6.7; for nominal interest rate 1 and nominal growth 0 to 5: -1.3, 0.0, 1.3, 2.6, 4.0, 5.3; for nominal interest rate 2: -2.6, -1.3, 0.0, 1.3, 2.6, 3.9; for nominal interest rate 3: -3.9, -2.6, -1.3, 0.0, 1.3, 2.6. - DSA baseline key statistics (selected): - EMBIG (bp): 125 (as of June 01, 2016). - 5Y CDS (bp): 129. - Nominal gross public debt (% GDP): 2014 111.5; 2015 132.5; 2016 132.7; 2017 132.9; 2018 132.4; 2019 130.8; 2020 128.6; 2021 125.9 (alternate 2021: 123.0). - Public gross financing needs: 2014 22.9; 2015 32.2; 2016 26.5; 2017 20.4; 2018 16.9; 2019 16.4; 2020 16.1; 2021 14.0 (alternate 2021: 14.9). - Real GDP growth (percent): 2008 -1.1; 2009 -5.5; 2010 1.7; 2011 0.6; 2012 -2.8; 2013 -1.7; 2014 -0.3; 2015 0.8; 2016 (proj) 0.8; 2017 (proj) 1.1; 2018 1.3; 2019 1.2; 2020 0.8; 2021 0.8. - Unemployment rate (percent): 2008 6.7; 2009 7.7; 2010 8.3; 2011 8.4; 2012 10.7; 2013 12.1; 2014 12.6; 2015 11.9; 2016 (proj) 11.4; 2017 (proj) 10.9; 2018 (proj) 10.5; 2019 (proj) 10.1; 2020 (proj) 9.7; 2021 (proj) 9.3. ### Policy recommendations and staff appraisal (summary) - Fiscal policy: - Adopt an evenly-phased structural adjustment over 2017–19 of about ½ percent of GDP per year to achieve a small structural overall surplus of about ½ percent of GDP by about 2019, net of upfront reform costs. - Support adjustment with growth-friendly mix: reduce inefficient primary current spending where feasible; broaden the tax base (rationalize tax expenditures, reduce VAT gap); consider a modern real estate tax (recognizing political sensitivities); lower statutory tax rates on productive factors as fiscal space allows. - Structural reforms: - Front-load and fully implement structural reforms: product and service market liberalization, public administration modernization, wage-bargaining reform to align wages with productivity and broaden firm-level negotiation. - Strengthen competition in network industries, professional services, local public services, retail, transport, communications, healthcare, ports and airports. - Financial sector: - Advance bank balance sheet repair: accelerate NPL workouts, strengthen insolvency and out-of-court restructuring frameworks, require comprehensive NPL strategies with operational targets, consider tax incentives for accelerated workouts, encourage private asset management and consolidation. - Strengthen resolution frameworks and supervisory actions: systematic asset quality assessments for banks not under ECB comprehensive assessment; clearer expectations for consolidation; ensure adequate capital to support credit growth. - Address retail investor exposure to bank liabilities: remediate mis-selling, strengthen legal/regulatory safeguards, and consider means-tested social safety net for poor households. - Implementation emphasis: - Front-load financial, fiscal, and structural measures while favorable tailwinds exist (monetary easing, low commodity prices, fiscal support). - Ensure steadfast, full implementation to avoid past piecemeal reforms and implementation lags. ### Annex I: External sector assessment (selected) - FX and reserves: - "The euro has the status of a global reserve currency." - Reserves held by the euro area are typically low relative to standard metrics; the currency is free floating. - Depending on measure, Italy’s REER depreciated by 3-10 percent between 2014 and 2015 (year average on year average). - Staff assessment: - 2015 external position broadly consistent but likely still weaker than suggested by fundamentals and desirable policy settings. - Staff assesses CA gap for 2015 of -2 to 0 percent of GDP and recommends a modest REER depreciation of 0–10 percent to support adjustment. *Source: IMF staff report content unit _cr16222_ (selected excerpts).* ### 1. The Impact of Product Market Reforms on Firm Productivity in Italy _____________________________ 17 ### 1. The Impact of Product Market Reforms on Firm Productivity in Italy ### Context: The long view - Structural rigidities identified: - product and service market inefficiences, wage growth in excess of productivity, high taxation, an inefficient public sector, and lengthy judicial processes. - Historical performance and vulnerabilities: - Italy experienced one of the lowest productivity growth rates among advanced economies over the last three decades. - Public debt was around 100 percent of GDP both at the time of euro accession and at the eve of the global financial crisis, and has since climbed to almost 133 percent of GDP, the second highest in the euro zone. - Output contracted sharply by 9 percent during 2007–14, and the recession lasted longer than Italy’s European peers. - Decline was especially severe in manufacturing; several manufacturing subsectors, including high-tech, have been on a long-term decline. - Productivity in manufacturing has increased while that of services has been declining steadily for several years. - The decline in total output contributed to nonperforming loans rising to 18 percent of loans, an overhang weighing on recovery and potential growth. - Medium-term outlook and risks: - Under current staff projections, the economy is not expected to return to its pre-crisis (2007) real output peak until the mid-2020s. - Italy is likely to experience nearly two lost decades, while its euro zone partners are projected to grow cumulatively by 20–25 percent. - With slow growth, unemployment would remain high, well above pre-crisis levels; absent further productivity-enhancing measures, real wage growth in Italy would lag its partners or competitiveness would lag. - Government reform agenda (initiatives underway or passed): - Jobs Act (labor market legislation) being implemented. - Legislation on reform of cooperative and mutual banks. - Insolvency system being revised. - Framework law on public administration approved and some implementing decrees issued. - Reform of the state budget underway. - Reform of the education system approved and being implemented. - Legislation passed and a constitutional referendum planned for October on institutional reforms to facilitate decision making and the transfer of competencies from regions to the center. - Policy imperative: - Urgent need to accelerate and deepen reforms, including ambitious product and service market reforms to enhance competition and investment; a new wage bargaining framework to align wages with productivity; insolvency reforms to deal with current nonperforming loans; and making room for notable cuts in the labor tax wedge while achieving medium-term fiscal targets. ### Near-term developments (economic performance and labor market) - 2015 performance: - Economy expanded by 0.8 percent, buoyed by exceptionally accommodative monetary policy, declining commodity prices, and improved confidence. - 2015–2016 quarterly dynamics: - Quarterly growth slowed over the course of 2015 to end the year at a seasonally-adjusted 0.2 percent q-o-q and picked up slightly to 0.3 percent q-o-q in 2016 Q1. - Components and indicators: - Private consumption and inventory re-stocking were key contributors to 2015 growth; external demand weighed on growth. - Investment recovery is very slow; the investment ratio remains far below that of key euro zone partners after the sharp decline in 2010–14. - Net exports shifted from contributing positively to being a drag on growth; real exports are back to their pre-crisis (2008 Q1) peak but lag large euro area partners that are 15–25 percent above pre-crisis peaks. - Current account and trade balances remain in surplus. - Inflation is very low; headline is back in negative territory since February (owing in part to the decline in oil prices and subdued demand); long-term inflation expectations remain significantly below the ECB’s objective. - Labor market: - Unemployment declined to 11.7 percent at end 2015 (from a peak of 13.1 percent in November 2014). - Long-term unemployment remains high at close to 60 percent of unemployed persons. - Youth unemployment is above 35 percent. - Female labor force participation remains relatively low. - Regional differences are sizable. - Job creation picked up among those aged 50–64 and the share of workers in new permanent contracts is up notably. - Skilled young Italians are increasingly emigrating abroad, which weighs on potential growth. - Poverty and inequality: - Incidence of absolute poverty increased to 5.7 percent (1.4 percentage point higher than 2011) with significant regional differences. - Income inequality has increased and is well above the OECD average. ### Banking sector: asset quality, profitability, and resolution - Nonperforming loans and provisioning: - NPLs appear to be stabilizing at about 18 percent of loans, one of the highest in the euro zone. - Provisions amount to 45 percent (excluding collateral and guarantees). - Profitability and lending: - High NPLs are adversely affecting profitability—profit margins are among the lowest in Europe—and weighing on banks’ ability to extend credit. - Overall lending conditions are subdued: credit to households has been growing modestly, but credit to the corporate sector has continued to decline and is about 11 percent lower than five years ago. - Recent bank surveys suggest an incipient improvement in supply of and demand for credit, but improvements are concentrated among larger and healthier firms. - Capital and market performance: - Following the 2014 asset quality review and stress tests, banks raised about €4 billion in capital in the first half of 2015. - Common equity tier 1 ratios improved to 11.5 percent on average for the significant banks at end 2015, about 2 percentage points below the average and the lowest in a sample of large European banks compiled by the EBA Risk Dashboard. - Italian banks lost over 40 percent of their market value in 2015 amid concerns about the speed of dealing with the NPL overhang and weak profitability. - Bank resolutions and bail-in: - Four small troubled banks, accounting for about 1 percent of system-wide deposits, were resolved in late November 2015, before the stricter bail-in requirement under the Bank Recovery and Resolution Directive (BRRD) came into effect at the start of 2016. - The banks were split into four bridge banks and one bad bank, with the resolution cost of €3.6 billion borne by the national resolution fund, which in turn drew upon liquidity from three major banks. - A limited bail-in of equity and subordinated debt was implemented and senior bondholders were spared. Nearly half of the €0.8 billion of subordinated debt that was bailed in was held by retail investors; a fund has been set up by other banks to compensate a large number of retail investors. ### Fiscal developments and composition - Fiscal stance and targets: - The government tightened the fiscal stance considerably during the crisis to register a peak structural primary surplus of 4.1 percent of GDP in 2013. - Since then, fiscal policy has been eased and is set to ease further in 2016, with the structural primary surplus projected to decline to 2.6 percent of GDP. - The overall deficit is projected to decline to 2.4 percent of GDP in 2016 (from 2.9 percent of GDP in 2012–13). - Interest savings of more than 1 percent of GDP have largely been offset by the fiscal relaxation. - Debt continued to increase to 132.7 percent of GDP at end-2015. - Composition of spending and revenue measures: - Real primary spending has been contained mainly through cuts in capital spending and the wage bill (through attrition of the workforce and a wage freeze). - Social benefits including pensions continued to rise and remain an outlier in the euro area (although full implementation of past pension reforms would ensure its long-term sustainability). - The government has eased the tax burden through measures such as a monthly bonus of €80 for workers with incomes below €24,000 (phased out for incomes up to €26,000); cuts in social contributions for new hires; and the elimination of an effective real estate tax on primary residences. - Additional revenues were sought through a voluntary disclosure scheme and gaming revenues. *Source: IMF staff report chapter titled "1. The Impact of Product Market Reforms on Firm Productivity in Italy" (excerpts provided).* ### 10. Italy’s competitiveness has suffered from stagnant productivity and rising labor costs. ### 10. Italy’s competitiveness has suffered from stagnant productivity and rising labor costs. ### External position and competitiveness - As of 2015, Italy’s external position was broadly consistent but likely still weaker than suggested by medium-term fundamentals and desirable policy settings. - Current account developments: - Average deficit of 1¼ percent of GDP in the 2000s. - Current account moved into balance in 2013. - By 2015, current account registered a surplus of 2.2 percent of GDP, driven by a growing trade surplus and helped by lower commodity prices. - The 2015 cyclically-adjusted current account surplus was about 0–2 percent of GDP weaker than justified by fundamentals and appropriate policies. - Savings-investment perspective: - The steady rise of the current account since 2010 is mainly related to the decline in investment as both the corporate and the public sector deleveraged. - Competitiveness drivers: - Stagnant productivity and rising labor costs have led to a gradual appreciation of the real effective exchange rate (REER) since Italy’s joining the euro zone, both in absolute terms and relative to the euro zone average. - In 2015, the fall in the value of the euro contributed to a sizable depreciation of the REER, bringing its value close to 1999 levels. - Staff considers that a real effective depreciation of 0–10 percent—supported by structural reforms—would be appropriate to restore competitiveness (based on a broad range of indicators and model-based estimates of the REER gap for 2015). ### Fiscal expenditures and macro indicators (nominal and real levels) - Table excerpt (selected lines shown in source; nominal levels (€ billions) and real levels (2010 € billions)): - Total spending: 2008 780.7; 2012 819.2; 2015 826.4; Real: 2008 798.5; 2012 796.4; 2015 781.4. - Primary spending: 2008 700.2; 2012 735.7; 2015 758.0; Real: 2008 716.2; 2012 715.1; 2015 716.7. - Social benefits: 2008 320.6; 2012 354.8; 2015 377.6; Real: 2008 328.0; 2012 344.9; 2015 357.0. - Wage bill: 2008 170.3; 2012 166.1; 2015 161.7; Real: 2008 174.2; 2012 161.5; 2015 152.9. - Gross capital formation: 2008 48.5; 2012 41.4; 2015 37.4; Real: 2008 49.6; 2012 40.2; 2015 35.4. - Other primary spending: 2008 160.8; 2012 173.4; 2015 181.2; Real: 2008 164.5; 2012 168.5; 2015 171.4. - Interest bill: 2008 80.5; 2012 83.6; 2015 68.4; Real: 2008 82.3; 2012 81.2; 2015 64.7. - Sources: Eurostat, Istat. (Nominal and real levels reproduced exactly as in source.) ### Growth outlook and risks (2016–21 and longer term) - Growth projections: - Real GDP growth is projected at 1.1 percent in 2016 and about 1¼ percent in 2017–18, supported by expansionary monetary and fiscal policies and continued low oil prices. - Measures contained in the 2016 budget are estimated to boost growth by about 0.3 percent in 2016 and 2017. - Investment is expected to pick up gradually, financed largely by firms’ retained earnings and modest credit provision by the banking sector; bank financing could become a binding constraint unless strong progress is made in restoring corporate and bank balance sheet health. - Weak external demand is expected to weigh on net exports. - Backloaded fiscal consolidation according to the authorities’ plans would result in a decline in real GDP growth in 2019–21 to around 0.8 percent. - Beyond that, growth of around 0.8 percent is projected in the steady state, including a dividend on structural reforms of about 0.3 percent per year over the medium to long term, in line with the authorities’ estimate. - Absent reforms, staff estimates potential growth of around ½ percent, reflecting crisis legacies, unfavorable demographics, and slow productivity growth predating the crisis. - As the output gap closes, inflation will rise gradually, yet slower than that of Italy’s euro zone partners owing to a projected productivity differential. - Relatively low nominal growth is expected to slow the pace at which Italy can grow out of crisis legacies and structural vulnerabilities. - Risk assessment: - Risks are tilted to the downside; risks are manifold and interconnected. - Upside risks: better-than-anticipated effects of monetary and fiscal easing; strong implementation of structural reforms; larger-than-expected lagged impact of euro depreciation; sustained period of low global energy prices. - Downside risks: delays in addressing bank asset quality; intensified global financial market volatility, including from Brexit; global trade slowdown weighing on exports; refugee influx and security threats complicating policy making; setbacks in the reform process leading to stagnation. - If downside risks materialize, regional and global spillovers could be significant given Italy’s systemic weight. - Authorities’ efforts to address low productivity, high public debt, and bank balance sheet vulnerabilities are of paramount importance; efforts at the European level should continue to strengthen the euro zone’s architecture. ### Policy discussions and consensus with authorities - Broad agreement with authorities on near-term outlook and long-term challenges. - Real growth projections in 2016–17 are largely aligned across IMF, MEF, and BoI: - IMF: 2016 1.1; 2017 1.3. - MEF (2016 Stability Program, Apr 2016): 2016 1.2; 2017 1.4. - BoI (Macro Projections, June 2016): 2016 1.1; 2017 1.2. - Authorities expect the GDP deflator and thus nominal growth to be somewhat higher and consider the economy’s resilience improved due to ongoing reforms. - Authorities view a further pickup in investment as critical to sustained recovery and see slowdown in external demand as a key downside risk. - Policy tension: - Authorities prioritize growth, including through fiscal accommodation, and avoiding exacerbating financial deleveraging, as a step up in growth could facilitate bank balance sheet cleanup and lower the debt burden. - Staff suggested deeper structural reforms and a pro-growth fiscal policy mix to create space for earlier fiscal adjustment and stronger financial sector policies, thereby building buffers faster and improving medium-term resilience. ### Structural reforms — priorities and reforms to raise growth - Sustained implementation of reforms and broadening the effort in three priority areas are key: - Product and service markets. - Public administration to improve quality of services, enhance efficiency, and lower costs to business and investment. - A wage bargaining system to align wages with productivity, improve competitiveness, and complement the Jobs Act. - Historical context: - In the last two decades there have been: about five important labor market reforms, three public administration reforms, three education system reforms, and numerous justice reforms. - Reforms were generally piecemeal and implementation lagged; overall economic results were less than desired. ### Product and service market reforms — issues and recommended areas - Key problems concentrated in: - Network industries (e.g., energy and transport). - Professional services (e.g., legal, notaries, and pharmaceutical). - Provision of local public services. - Economic weight: - These services account for about one-third of total value added in the economy and about 30 percent of household’s final consumption, and contribute about 40 percent of input to other sectors’ output. - Monti government reforms (2011–12) aimed at reducing entry barriers, removing unnecessary regulation, and administrative simplification; de jure measures improved but business perceptions of de facto barriers remain considerable. - Potential reforms and focus areas: - Strengthen the Annual Competition Law in line with the competition authority’s recommendations and ensure an annual process of adopting pro-competition laws. - Provision of local public services: - Enhance competition in local public service provision to tackle rent seeking and yield sizable economic benefits. - Competition authority proposals include liberalizing local transport and waste collection. - Past spending reviews proposed rationalizing local public companies over three years to improve efficiency and service quality. - Retail, transport, and permits: - Italy’s retail sector is one of the most regulated in Europe per OECD product market regulation indicators. - Large-surface retail outlets remain subject to special rules; incumbents are excessively protected; restrictions on promotions, discounts, and below-cost sales are very severe. - Scope for further liberalization in electricity generation (hydroelectric power plants), radio spectrum frequencies, local public transport and taxis, ports and airports. - Permit schemes and long periods of right-to-use public infrastructure without competitive procedures hinder competition. - Enhancing competition in these inputs should raise growth. - Authorities’ stance: - Agreed on the critical importance of enhancing competition in product and service markets. - Expect the current draft Annual Competition Law to be adopted by mid-2016 and concurred there is scope to strengthen it in areas including legal and professional services. - Government submitted the National Plan for Professional Reform in February 2016 to implement the European Directive on recognition of professional qualifications. - Other areas such as communications, healthcare, transport and other public services are expected to be tackled in future annual competition laws and linked to public administration reform. ### Box 1 — The Impact of Product Market Reforms on Firm Productivity in Italy (key findings) - Italy’s standing on de jure and de facto measures: - According to OECD PMR, Italy was the sixth least regulated economy as of 2013 among 31 OECD economies. - World Bank Doing Business indicator paints a different picture; Italy moved from thirtieth place out of 31 OECD economies in 2012 to twenty-ninth place in 2015. - Empirical evidence (IMF Working Paper WP/16/119 using Orbis firm-level data 2003–13, PMR, and Italy’s input-output matrix): - Reforms that raise competition affect the economy via: - Direct effects on regulated sectors: reallocation across firms, exit of inefficient firms, innovation and technology adoption, raising sectoral productivity. - Downstream effects: lower mark-ups, greater availability and quality of services, benefiting firms that use outputs of regulated industries as inputs. - Quantitative associations: - A one-standard deviation improvement in the PMR is associated with 3 percent relatively higher growth in sales, 10 percent relatively larger firms (in terms of output), and 4.7 percent relatively higher value added per worker in previously regulated sectors. - Firms that use regulated inputs more intensely increase their size and productivity relatively more upon deregulation of network sectors. - Complementarity with public service quality: - In provinces with more efficiently provided public services, the positive association between deregulation and firm performance in previously regulated sectors is significantly stronger. - Example: a one-standard-deviation improvement in the PMR is associated with a 0.3 percent increase in output for a firm in a province in the upper quartile of government efficiency, but only 0.1 percent for a firm in the lower quartile. *Source: IMF staff report text provided in the content unit.* ### 22. Public sector inefficiencies weigh on investment and productivity. According to the ### 22. Public sector inefficiencies weigh on investment and productivity ### Public sector performance: findings and key statistics - It takes 1,120 days to enforce a contract (World Bank’s Doing Business indicators for 2016). - It takes 227 days to obtain a construction permit. - It takes 124 days to get an electricity connection. - Average length of a tendering procedure is 210 days, compared to an EU average of 77.4 days. - The number of single-bid contracts that are awarded is close to one third. - The number of local public enterprises has proliferated to more than 8,000. - Skills mismatches were found in one-third of positions studied by the agency for collective bargaining for the public administration. - Public sector weaknesses identified: excessively long and burdensome bureaucratic procedures; overlapping competences and intra-institutional conflicts; lack of administrative capacity, including an aging workforce and skill-job mismatches; perception of corruption; dominance of local monopolies in service provision; notable regional differences. ### Reforms enacted and proposed - An enabling law was approved in August 2015 to: - simplify procedures; - streamline and accelerate decision making; - rationalize local public enterprises; - improve recruitment and management of staff. - A set of legislative decrees was proposed for discussion by the government in January 2016 and is in the process of being implemented; others are planned for later in 2016. - Procurement reform underway, including centralizing purchasing power to about 35 bodies, down from tens of thousands. - New framework to systematically regulate state-owned enterprises in line with principles of efficient management, protection of competition, and reduced public expenditure; enhanced oversight role for the Court of Auditors. - New provisions clarify that state-owned enterprises are subject to the bankruptcy legislation. - Major state-owned enterprises left outside the perimeter of rationalization include Eni, Enel, Finmeccanica, Poste Italiane, Cassa Depositi e Prestiti, Ferrovie, and Rai. - The government plans to implement stricter rules for disciplinary firing of public sector workers. ### Implementation challenges and policy priorities - Timely implementation and follow-up are key; challenges that need to be tackled include: - improving the skill-mix in the public sector; - matching positions with skills; - aligning wages with productivity; - accelerating court processes to ensure timely enforcement, including by the public administration of laws; - tackling privileges and employment in public enterprises, including through privatization; - ensuring most products at all levels of government are covered under rationalized procurement procedures; - further strengthening anti-corruption efforts, particularly by implementing AML/CFT measures on domestic politically exposed persons. - Authorities intend to complete the legislative process by end-2016. - In the context of the 2016 stability law, a broader range of public administrations and local governments is required to purchase through centralized procurement bodies and use benchmark pricing. ### Civil Justice Reforms (Box 2): findings and recommendations - Italy has one of the slowest court systems in the adjudication of civil and commercial disputes in the EU. - According to the European Justice Scoreboard 2016, only Malta, Portugal and Cyprus have less efficient systems for the resolution of civil and commercial cases. - Civil or commercial cases are resolved in first instance on average in more than 500 days from the start of the process. - Appeals can multiply that by more than three times to around six years. - Government actions to improve the judicial system and reduce backlog: - promoting alternative dispute resolution techniques; - reinforcing auxiliary staff of the courts with personnel from other parts of the public sector; - introducing better information technology. - Project Strasbourg 2.0: development of court performance indicators and best practices to reduce the gap between best managed courts and underperforming courts. - Reform priorities and technical recommendations: - reform of the appeal system, including rationalizing the type of cases that reach the Supreme Court (Corte di Cassazione); - further strengthen enterprise courts to improve commercial justice in corporate litigation and insolvency cases; - recent reforms to reduce the time for enforcement of secured claims are important steps, including enforcement of commercial secured credit and introduction of new forms of security interests over movable assets; - effective introduction of the electronic civil procedure (processo civile telematico) should reduce the time for enforcement of unsecured credit; - many technical details remain to be solved, including creation of an efficient, notice-based registry and transposition into law of measures announced in early May that require attention to technical implementation of new contracts and security interests. *Italic: Source — _cr16222 - 22. Public sector inefficiencies weigh on investment and productivity.* ### 1.5 percent to the ECB’s marginal refinancing rate of zero. At the ### _cr16222 - 1.5 percent to the ECB’s marginal refinancing rate of zero. At the ### Bank profitability, funding conditions, and loan growth - Under very favorable funding terms (including the ECB’s deposit rate decline and historical pass-through of term premia to NIMs), overall system profitability would improve, assuming sufficient loan demand. - Even so, one-third of banks in the sample could still face profitability challenges, which may not be solved through higher loan growth. - Staff estimates that the current easing measures by the ECB lower the NIMs of Italian banks by 11 basis points on average. - To maintain current profitability over the amortization period of their loan book and offset the negative impact of lower NIMs, lending growth in Italy would need to increase to at least 3.6 percent annually (or about 3 percentage points above current credit growth). - For the larger banks, robust credit growth could improve bank profitability. - It would be important to ensure that banks have adequate capital to support strong credit growth. ### Empirical basis and notes - Calculations and charts are based on Bloomberg L.P., EBA Transparency Exercise (2015), ECB, SNL, and IMF staff calculations. - Note: 1/ based on the historical pass-through of policy rates and the elasticity of net interest margins to changes in term premia between Jan. 2010 and Feb. 2016; total mortgage and corporate loans at end-2015 to EA residents.; scenario is based on the estimated impact of the increase of monthly asset purchases (until Sept. 2017) by the ECB and a reduction of the deposit rate by 10 bps (as per ECB decision on March 10). ### NPL initiatives, securitization, and backstops - Authorities set aside previous plans for a system-wide bad bank and instead launched or supported initiatives to backstop capital issuances of banks and facilitate NPL securitization. - Bank of Italy is helping create an NPL information center to encourage private non-bank participation in the market for NPLs. - GACS: - Mechanism to provide government guarantees for the securitization of NPLs. - Banks can move their bad loans at market values into special purpose vehicles for eventual sale to markets. - Banks can buy public guarantees for the senior tranches of securities issued against these bad loans, as long as these tranches are rated as investment grade. - No state aid is expected, since the fees paid by the banks for the public guarantees should cover expected costs. - Staff view: at best a marginal impact on the large gap between price of NPLs on banks’ books and their market price. - Banks expressed cautious optimism; some indicated intent to create vehicles involving GACS, although none has yet been finalized. - Atlante: - Created in April 2016 by Italy’s largest banks together with nonbank financial institutions and banking foundations to prevent failure of capital increases by smaller banks. - Has raised €4.25 billion so far. - Aim: backstop capital increases of banks and possibly purchase non-investment grade tranches of NPL securitizations to reduce pricing gaps. - In May 2016, capital raising by Banco Popolare di Vicenza failed to attract private investors; Atlante invested €1.5 billion, taking over 99 percent stake in the bank. - The announced capital increase by Banca Veneto is an important test of attracting sufficient private sector support to avoid Atlante investment. - Staff view: Atlante helped preserve financial stability but is not a game changer given limited resources. ### Resolution framework, bail-in rules, and retail investor exposure - Bail-in provisions of the BRRD have been operational in Italy since January 1, 2016. - Bail-in requires bail-in of at least 8 percent of total liabilities as a pre-condition for availing resolution funds. - Liabilities subject to bail-in: capital instruments, then subordinated debt, and subsequently uncovered bank bonds and other senior liabilities. - Deposits can be bailed in only for the part exceeding €100,000. - Italian law extends BRRD by establishing full depositor preference over unsecured senior debt from January 1, 2019. - Between January 1, 2016 and December 31, 2018, uninsured deposits rank pari-passu with senior debt, unless the resolution authorities decide otherwise. - Italian households hold about one-third of senior bank debt and almost half of total subordinated bank debt. - Bank of Italy: about 50 percent of senior retail bonds will mature in 2017 and only a small amount will be left by 2020, assuming banks find alternative sources of financing. - Staff calculations (based on publicly available data from SnL) indicate that, for the majority of the 15 largest Italian banks, the 8 percent minimum requirement would currently imply bail-in of retail investors of subordinated debt; for about two-thirds of the banks in the sample, losses would also be imposed on some senior debt holders. - The example highlights the importance of proactive measures to ensure banks’ viability. ### Structural vulnerabilities and need for a more proactive strategy - The financial sector remains subject to risks: a number of banks may continue to find it difficult to generate sufficient profits to bolster capital, write-off bad debts, and finance new credit. - Buffers to cope with shocks are very limited; not evident that the banking system is durably ahead of its problems. - Emphasis needed on a comprehensive framework facilitating and supporting: - NPL workouts, - Procedures for timely bank restructuring and insolvency, - Coordinated approach to banking system consolidation. ### Policy recommendations and supervisory actions - Advancing insolvency reforms: - Recent reforms to accelerate debt enforcement are welcome; impact will be realized over time. - Distressed enterprises need a streamlined and flexible system of out-of-court and in-court restructuring options, with fast-track solutions for existing stock of NPLs. - Adoption of debt restructuring principles for multilateral workouts and a triage approach for indebted firms recommended. - Establish enterprise courts with insolvency competences, qualified insolvency administrators, and adoption of best practices by courts across Italy. - Rordorf Commission systematization offers opportunity to integrate reforms, incorporate special procedures for large companies, introduce incentives for early treatment, and rationalize creditor priorities. - Accelerating NPL resolution: - Bank of Italy implementing a new NPL reporting framework by end 2016. - Banks should be required to present comprehensive NPL strategies with ambitious targets to significantly reduce NPLs over the medium term (including internal workout procedures, outsourcing to external servicers, joint ventures, and sales). - Best practice elements: separate NPLs from usual credit management, develop comprehensive loan restructuring tools, require enhanced management and board focus on NPL strategy. - A dedicated expert team in the Bank of Italy could critically review banks’ NPL strategies, provide feedback, and require urgent mitigation where shortfalls are identified. - Consider time-bound tax incentives to encourage accelerated workouts and removal of bad debt and real estate assets from balance sheets. - Encourage private asset management companies to pool NPLs from smaller banks lacking resources or capacity. - Supervisory encouragement and oversight of consolidation: - Consolidation can improve efficiency, particularly for weaker banks. - Emerging banking groups need ex ante assessment for capital, assets, management, earnings and liquidity. - Subject banks not under SSM supervision to capital assessment following an asset quality review, with follow-up actions aligned with regulatory requirements. - Supervisor should set clearer expectations for consolidation including viability and time-bound operational cost reductions. - Banks’ business models need greater efficiency via streamlining branch networks and exploiting synergies. - Atlante governance and limits: - Although privately run, supervisors should ensure future investments are based solely on commercial considerations and tied to strict governance improvements in investee banks. - If Atlante is scaled up or similar initiatives launched, require timely disposal of assets (bank equity or junior tranches of NPL securities). - Encourage foreign investor participation. - Resources currently available are unlikely to notably impact NPL pricing. - Prompt resolution of unviable banks: - Political concern over bailing in retail investors is a barrier to applying the resolution framework. - To address concerns, consider: - (i) identifying and dealing firmly with cases of mis-selling to retail investors through penalties on sellers and remediation for buyers (e.g., structured buy-back or debt exchange programs); - (ii) preventing irregular selling practices to retail customers by strengthening legal and regulatory safeguards, increasing quality of information, and improving controls; - (iii) safeguarding poor households through a means-tested social safety net that is a more efficient and better targeted instrument. - Central bank liquidity backstops for viable banks remain the quintessential stabilizer and backstop against contagion. ### Authorities’ stances and trade-offs - Authorities view NPLs as at a turning point with the flow of new bad debts projected to decline as the economy recovers. - Authorities stress that recent insolvency reforms, Atlante, and GACS would reduce the high stock of NPLs over time and caution against aggressive NPL reduction that would be procyclical and undercut growth. - Authorities favor swift market-driven bank consolidation but are cautious about forcing consolidation given fragile confidence. - Authorities argue that BRRD bail-in rules exacerbate systemic risk and that a longer transition would have been preferable; they contend European state-aid rules are being applied too restrictively and inhibit less costly restoration of banking sector health financed by private resources. ### Fiscal policy (summary of related section) - For 2016, authorities are pursuing a very small deficit reduction, implying a sizable relaxation of about 0.7 percent of GDP in structural terms. - No adjustment is planned in the structural primary balance for 2017; a 0.2 percent adjustment is proposed for 2018; a backloaded adjustment of ½ percent for 2019. - This path postpones achievement of structural balance to 2019–20 (against previously agreed target of 2018). - Debt will remain high but on a downward trend, relying on achievement of ambitious privatization proceeds projected at ½ percent of GDP per year over the next three years. - Authorities plan to continue lowering taxes, including on corporate income in 2017 and on personal income in 2018, and cancel planned hikes in VAT and excise rates (the safeguard clause). - Canceled safeguard measures to be replaced in part by spending review measures, including review of tax expenditures and measures to improve tax compliance. - Authorities estimate cumulative savings in recent years around €25 billion; spending reviews to seek qualitative improvements through more efficient budget processes and procurement reform. - Plans include a small increase in capital spending and proposals under consideration to ease path to early retirement through actuarially fair cuts in pension benefits or bank loans to retirees that capitalize part of their future benefit stream. *Italic — Source: IMF staff report content (selected excerpts) contained in the provided PDF content unit.* ### 36. To strengthen the credibility of the adjustment and bring debt down more decisively ### To strengthen the credibility of the adjustment and bring debt down more decisively ### Adjustment and debt dynamics - Italy’s high debt level leaves very little space to adjust to adverse shocks and makes it vulnerable to shifts in market sentiment and changes in interest rates. - Under the baseline, debt is expected to decline very gradually, but debt dynamics are fragile and debt could get back on a rising path under moderate scenarios (Annex II). - With growth stabilizing at around 1–1½ percent in the coming years, and declining thereafter, greater priority should be given to building buffers by reducing the debt burden to strengthen confidence and growth. - In the event of adverse shocks, automatic stabilizers should be allowed to operate. ### Structural surplus and phasing - Recommended phasing: - For 2017–19, an adjustment of about ½ percent of GDP per year (in the structural primary balance) would allow rebuilding buffers while not overly taxing growth. - In case of clearly defined and bolder reforms, the path could be adjusted to accommodate their temporary upfront costs; however, not all structural reforms entail direct and measurable budgetary costs, so general reforms should not be used to postpone needed adjustment. - Outcome of the path: - This path would result in a small structural overall surplus of about ½ percent of GDP by about 2019. - Multipliers (as reported in the source): - According to the 2016 DEF: revenue multipliers are 0.2 in the first year, 0.6 in the second year and 0.8 beyond; spending multipliers are 1 in the first two years, before declining to 0.3 in year 5. - Bank of Italy estimate: fiscal multipliers are 0.3 in the first year and 0.5 in the second year. - Note on cumulative multipliers in simulations: Maximum is 0.8 in the first year, 1 in the second year. Average is 0.6 in the first year, 0.8 in the second year. Minimum is 0.3 in the first year, 0.5 in the second year. ### Pro-growth fiscal mix and tax/spending priorities - Fiscal path should be supported by a growth-friendly policy mix emphasizing: - More efficient and reduced levels of spending. - Broadening the tax base. - Lowering statutory tax rates on labor and capital. - Spending constraints and choices: - Primary spending has been contained in real terms recently largely through wage restraint and cuts in capital spending, so the “low hanging fruit” have been exhausted. - Achieving fiscal targets and creating space to lower the labor tax wedge requires further reduction in primary current spending, potentially including politically difficult choices on high levels of social spending. - Any discussion of early retirement options should not reverse gains from the 2012 pension reforms or undercut pension sustainability. - Tax base and revenue measures: - Broadening the tax base—by rationalizing relatively large tax expenditures and reducing the VAT gap (which is among the highest in the euro zone)—is recommended. - Introducing a modern real estate tax is advised as a relatively efficient tax instrument (noting the authorities’ stated unpopularity of a real estate tax on primary residences). ### Authorities’ position - Authorities view fiscal policy as balancing support for growth and bringing debt down; given weak environment and risks, they consider more restrictive fiscal policy potentially counterproductive and favor postponing consolidation until a stronger cyclical position. - They expected ambitious privatization proceeds to result in a small decline in the debt ratio in 2016 and a balanced budget over the medium term adequate to bring debt down. - They plan to continue reducing the tax burden on households and firms, keep spending under control, increase spending efficiency and quality of public services (procurement, public administration, state budget reforms), and broaden the tax base through voluntary compliance and review of tax expenditures. - They do not intend to introduce a real estate tax on primary residences. ### Staff appraisal: growth, vulnerabilities, and reform priorities - Recent macro outcomes and projections: - Projected growth this year: 1.1 percent. - Growth projected to rise to 1¼ percent in 2017–18. - Growth projected at about 0.8 percent per year over the medium term. - Unemployment has started to come down but remains very high. - Nonperforming loans (NPLs) are around 18 percent of loans. - Public debt has edged up marginally to close to 133 percent of GDP. - Recovery assessment: - The recovery is likely to be fragile and prolonged with downside risks; limited financial sector and fiscal buffers make Italy vulnerable to shocks. - Even with timely implementation of reforms, Italy is expected to return to its pre-crisis output peak only in about a decade; over the same period, Italy’s euro zone partners are expected to rise by 20–25 percent above their pre-crisis peaks. - Reform and policy imperatives: - Strengthen and deepen reforms (institutional, public administration, fiscal, labor market, banking sector) and ensure steadfast full implementation to break from past implementation lags. - Front-load financial, fiscal, and structural measures while current favorable tailwinds exist (monetary easing, low commodity prices, fiscal support). - Deeper structural reforms that enhance competition in product and services markets and modernize the wage bargaining system (to broaden firm-level negotiation, align wages with productivity, aid smaller firms and the South) could boost growth and investment in the near and medium term. - Bold implementation of public administration reform to lower the cost of doing business, improve investment climate, improve skill-mix in public sector, simplify functions and procedures, tackle privileges and employment in public enterprises, including through privatization. - Financial sector repair: - Further steps to materially reduce NPLs over the medium term, lower cost of risk, and improve operating efficiency are recommended, including: - More intensive use of out-of-court debt restructuring mechanisms. - Strengthened supervision to facilitate decisive progress in reducing NPLs. - Systematic assessment of asset quality for banks not subject to the ECB comprehensive assessment, with follow-up actions in line with regulatory requirements. - An effective framework for timely and orderly resolution of failing banks to avoid system-wide costs. - Mechanisms such as Atlante can buy time but reforms should be implemented speedily to contain costs. - Concerns related to bail-in of retail investors should be dealt with expeditiously. ### Staff policy recommendations summary - Adopt an evenly-phased structural adjustment over 2017–19 that achieves a small structural surplus (about ½ percent of GDP by about 2019), net of any remaining upfront costs from structural reforms. - Support the adjustment with pro-growth policies: - Reduce inefficient and high primary current spending where feasible. - Broadening the tax base, including rationalizing tax expenditures and reducing the VAT gap. - Consider introducing a modern real estate tax (while noting political sensitivities regarding primary residences). - Lower statutory tax rates on productive factors as fiscal space allows. - Deepen and fully implement structural reforms to boost potential growth and reduce vulnerabilities. - Advance bank balance sheet repair and strengthen resolution frameworks to safeguard financial stability. *Source: _cr16222 - 36. To strengthen the credibility of the adjustment and bring debt down more decisively* ### 48. It is recommended that the next Article IV consultation be held in the usual ### 48. It is recommended that the next Article IV consultation be held in the usual 12-month cycle. ### Real sector: growth, labor, and inflation - GDP growth and output gap: - Real GDP: modest recovery in 2015–16 driven by private consumption and inventory restocking. - Output gap: negative throughout recent years (see Figure 3). - Contributions to GDP growth: - Private consumption and inventory restocking were the main positive contributors. - Investment remained weak. - Labor market: - Unemployment rate: has started to decline. - Long-term unemployment tracked separately at higher levels (right scale in Figure 3). - Employment: modest changes; productivity very weak in services. - Wages continue to outpace productivity growth in services. - Households: - Household savings rate remains low. - Consumption (percent of GDP) and savings rate (percent of disposable income) show constrained household balance sheets. - Prices and inflation: - HICP inflation: very low, partly owing to low oil prices. - GDP deflator and consumer price dynamics: weak inflation environment (see Table 1: GDP deflator and Consumer prices series). - High-frequency indicators: - PMI Manufacturing Output and PMI Manufacturing New orders signal a modest pace of expansion, broadly in line with modest euro area PMIs. - Industrial new orders: domestic and foreign components show modest increases. - Capacity utilization returning to pre-crisis levels. - Business and consumer confidence have recently declined. ### Financial sector: banking stress and market signals - Bank asset quality and capital: - Nonperforming loans (NPLs) in the corporate sector remain very high and have risen through 2015. - Price-to-book ratios for Italian banks substantially below peers (Figure 5). - Regulatory capital to risk-weighted assets (2015): 14.5 (Table 4). - Regulatory tier 1 capital to risk-weighted assets (2015): 12.0 (Table 4). - Market indicators and funding: - European banks' CDS spreads: Italian banks showed elevated but relatively contained CDS spreads. - ECB liquidity support declined as holdings of Italian government securities changed, while Target 2 balance rose. - Deposits are increasing as holders shift out of bank bonds. - Bank equity prices have been under substantial pressure, reflecting asset quality concerns. - Financial soundness indicators (selected, percent unless otherwise noted): - Nonperforming loans to total gross loans: 18.0 (2015). - Nonperforming loans net of provisions to capital: 87.8 (2015). - Return on assets: 0.2 (2015). - Return on equity: 2.5 (2015). - Liquid Assets to Total Assets: 16.8 (2015). - Customer deposits to total (noninterbank) loans: 72.8 (2015). - Foreign-currency-denominated liabilities to total liabilities: 36.6 (2015). ### Fiscal developments: spending, debt, and upcoming redemptions - Fiscal balances and debt (Table 2, percent of GDP unless noted): - General government net lending/borrowing: -2.7 (2008) to projections reaching 0.0 (2020–21). - General government gross debt: 102.4 (2008) rising to 132.9 (2015) then projected to decline to 123.0 (2021). - Primary balance (memorandum): 2.0 (2008) to projected 3.5 (2021). - Structural overall balance (percent of potential GDP): -3.8 (2008), deteriorating and then projected around 0.0 by 2020–21. - Structural primary balance (percent of potential GDP): 1.0 (2008) to projected 3.5 (2021). - Expenditure composition: - Social benefits share high and rising as a percent of GDP; Social benefits (percent of GDP): 19.6 (2008) rising to 23.1 (2015). - Interest expense declining as percent of GDP: 4.9 (2008) to 4.0 (2015), projected trending lower. - Market context: - Sizeable bond redemptions are coming due over the next 12 months (Figure 6 central government bond operations). - Government bond yields have declined significantly, aided by ECB policy. - Selected nominal figures (Table 2, billions of euros): - Revenue (2015): 784.0. - Expenditure (2015): 826.4. - Net lending/borrowing (2015): -42.4 (billion euros). - Interest (2015): 68.4 (billion euros). - Social benefits (2015): 377.6 (billion euros). ### External developments: current account, REER, and capital flows - Current account and trade: - Current account: moved from a deficit to a surplus; 2015 current account surplus: 2.2 percent of GDP. - Trade balance (goods surplus) drove the improvement; goods balance: 3.2 percent of GDP (2015). - Export and import volumes: modest increase in export volumes to the EU; imports rebounded. - Export Unit Value and Import Unit Value: improving terms of trade noted. - External position and NIIP: - NIIP: net liabilities of 24 percent of GDP (December 2015) vs. 7 percent at end 2000. - Gross assets and liabilities: 144 and 169 percent of GDP respectively (December 2015). - Gross external debt: 127.3 (2015, billions of euros, Table 3). - Public sector external debt: 67.0 (2015, billions of euros). - Real effective exchange rate (REER): - REER depreciation in 2015 brought values close to 1999 levels; as of May 2016, REER appreciated 1¼ percent over its 2015 average. - EBA REER regression methods give mixed signals: EBA Level REER model suggests 0.6 percent overvaluation; EBA Index REER model suggests -0.6 percent; CA regression yields about 7 percent overvaluation. - Staff assesses a modest real effective depreciation of 0–10 percent would support further adjustment. - Capital and financial accounts: - Financial account posted net outflows of about 3 percent of GDP in 2015, largely reflecting residents' net purchases of foreign assets. - TARGET2 liabilities widened in 2015; QE supports market functioning but vulnerabilities persist due to sovereign refinancing needs and high NPL stock. ### Tables and medium-term projections (selected series from Table 1–3) - Real GDP growth (annual percent change, Table 1): - 2008: -1.1 - 2009: -5.5 - 2010: 1.7 - 2011: 0.6 - 2012: -2.8 - 2013: -1.7 - 2014: -0.3 - 2015: 0.8 - 2016 (proj): 0.8 - 2017 (proj): 1.1 - 2018 (proj): 1.3 - 2019 (proj): 1.2 - 2020 (proj): 0.8 - 2021 (proj): 0.8 - Unemployment rate (percent, Table 1): - 2008: 6.7 - 2009: 7.7 - 2010: 8.3 - 2011: 8.4 - 2012: 10.7 - 2013: 12.1 - 2014: 12.6 - 2015: 11.9 - 2016 (proj): 11.4 - 2017 (proj): 10.9 - 2018 (proj): 10.5 - 2019 (proj): 10.1 - 2020 (proj): 9.7 - 2021 (proj): 9.3 - Current account balance (percent of GDP, Table 3 projections): - 2015: 3.6 (billion euros) / 2.2 (percent of GDP) - 2016 (proj): 3.4 (billion euros) / 2.1 (percent of GDP) - 2017 (proj): 2.9 (billion euros) / 1.7 (percent of GDP) - 2018 (proj): 2.3 / 1.3 - 2019 (proj): 1.6 / 1.2 - 2020 (proj): 1.2 / 1.0 - 2021 (proj): 0.9 / 0.7 ### Overall assessment and policy recommendations - Overall external position (2015): - Broadly consistent but likely still weaker than suggested by medium-term fundamentals and desirable policy settings. - Continued weak productivity growth and the need for balance sheet repair underpin the assessment. - Recent small REER appreciation does not alter the overall assessment for 2015. - Risks and vulnerabilities: - High government debt share in external liabilities and large stock of NPLs make Italy vulnerable to financial contagion and market volatility. - Large sovereign and banking sector refinancing needs increase exposure to tight credit conditions. - Potential policy responses (staff recommendations): - Continued implementation of structural reforms to improve competitiveness and boost potential growth. - Efforts to strengthen bank balance sheets to address high NPLs and restore financial intermediation. - Further progress in medium-term fiscal consolidation to improve competitiveness and maintain investor confidence. - Combined, these measures aim to support growth and employment over the medium term and strengthen the external balance sheet. - Staff assessment on external adjustment gap (2015): - Current account: staff assesses a gap of -2 to 0 percent of GDP for 2015 relative to norms implied by fundamentals and desirable policy settings. - Real effective exchange rate: staff assesses that a modest real effective depreciation of 0–10 percent would support further adjustment. *International Monetary Fund. (Content unit extracted from IMF staff report pages and figures as provided.)* ### Annex I. External Sector Assessment ### Annex I. External Sector Assessment ### FX intervention and reserves level - Background: "The euro has the status of a global reserve currency." - Assessment: "Reserves held by the euro area are typically low relative to standard metrics, but the currency is free floating." - Technical Background Note: "Depending on the measure used, Italy’s REER depreciated by 3-10 percent between 2014 and 2015 (year average on year average)." *Source: _cr16222 - Annex I. External Sector Assessment* ### Annex II. Debt Sustainability Analysis ### Summary judgment - "Italy’s public debt is very high at about 133 percent of GDP and yet to peak." - Debt should start to decline gradually if: the government delivers necessary adjustment toward achieving its target of structural balance; growth and inflation materialize as currently assumed; and accommodative monetary policy ensures continuing low interest rates. - If growth disappoints or contingent liabilities materialize, "debt will keep rising." - "Achieving and maintaining for several years a structural surplus of about ½ percent of GDP should ensure that debt declines steadily." ### 1. Public debt: current position and vulnerabilities - "Debt increased from about 100 percent of GDP in 2007 to 132.7 percent of GDP in 2015." - Italy's debt level is "far above the SGP target of 60 percent." - In nominal terms, Italy's public debt "is the highest in the euro zone." In percent of GDP, "it is the second highest, after Greece." - Gross financing needs: "14–17 percent of GDP." - Debt structure: - "Average maturity is around 6½ years." - "About 70 percent of debt is at fixed interest rates." - Two-thirds of debt is held by domestic investors. - Interest rate pass-through: "a 100 basis point increase in the yield curve is estimated to raise the interest bill by 0.13 percent of GDP in the first year, about 0.3 percent in the second, 0.4 percent in the third year, and 0.5 percent in the fourth year." - ECB support: "During 2015, the ECB’s net purchases of Italian public debt were about €80 billion, compared with gross financing needs of €450 billion." "The purchases are expected to rise in 2016, given further ECB easing." ### 2. Baseline projections and key assumptions - Fiscal policy assumption: "the government is assumed to take the measures necessary to achieve structural balance, which was delayed to 2019." - Growth assumptions: - "Real GDP growth is projected at 1.1 percent in 2016, increasing somewhat to 1¼ percent in 2017–18 and declining thereafter to a steady state of 0.8 percent." - "The long-run growth rate includes a dividend, in line with the authorities’ estimate, of about 0.3 percent annually that is assumed to accrue from comprehensive and timely implementation of reforms." - Inflation/deflator: "The GDP deflator is projected to rise above 1 percent in the next few years." Over the medium term, inflation and the deflator are "assumed to remain below the euro area average." - Interest rate and spreads: - "Spreads are assumed to be around 150 bps." - "Yields are expected to rise moderately as monetary policy normalizes very gradually, with the effective nominal interest rate remaining at around 3 percent through 2021." - "Beyond 2021, effective interest rates are projected to increase to around 5 percent." - Illustration: "an effective interest rate of 5 percent, with nominal GDP growth of 2 percent, implies a debt stabilizing primary balance of 3¾ percent of GDP." - Privatization: "In 2016, privatization proceeds of about 0.1 percent of GDP are projected. Going forward, no projection is made." - Debt path under baseline: "debt is projected to peak at 133 percent of GDP in 2016 and declining starting in 2017 to 123 percent in 2021." ### 3. Key risks embedded in the baseline - Primary surplus requirements: "Sizable primary surpluses of 3½–4½ percent of GDP will be needed in the baseline to maintain structural balance for many years." - Historical context: - "Primary surpluses averaged 1¼ percent of GDP during 2001–15." - "Structural primary surpluses have averaged about 3.4 percent during 2012–15." - Projected structural primary surplus change: "structural primary surplus is projected to decline from 4.1 percent of GDP in 2013 to 2.6 percent of GDP in 2016." - Fiscal sensitivity: With a historical scenario "with a primary balance at around 1 percent of GDP, debt would be 20 percentage points higher by 2021 than in the baseline." - Stagnation risks: "real growth and inflation could fall short of what is assumed in the baseline, complicating efforts to reduce debt." - Upside possibilities: "the impact of the authorities’ policies and of ECB monetary easing, euro depreciation and low oil prices for longer could have a larger positive impact than currently expected." ### 4. Stress-test scenarios and outcomes - Standard growth shock: - Assumption: "Real output growth rates are assumed to be lower by one standard deviation for two years starting in 2017, resulting in an average growth of –1.1 percent in 2017–18." - Inflation linkage: "for every 1 percentage point decline in growth, inflation is assumed to decline by 25 bps." - Primary balance path: "The primary balance improves more slowly than the baseline, reaching only 1 percent of GDP by 2021." - Result: "Debt increases rapidly to about 144 percent of GDP and fails to come down over the projection period." - Interest rate shock: - Assumption: "An increase in spreads of 200 bps is assumed." - Macro effects: "Higher borrowing costs are passed on to the real economy, depressing growth by 0.4 p.p." - Interest burden: "The government’s interest bill climbs reaching an implicit average interest rate of 3.6 percent by 2021." - Result: "Debt declines but only very modestly to around 128 percent by 2021." - Contingent liability shock: - Assumption: "a standardized one-time increase in non-interest expenditure of about 10 percent of banking sector assets." - Macro effects: "This is assumed to depress domestic demand, lower growth for two consecutive years by –1.2 percentage points, and lower inflation by 0.3 percent." - Fiscal impact: "The primary balance is assumed to worsen by 12 percent of GDP in 2017." - Result: "Debt rises to 149 percent of GDP, after which it starts declining very modestly. Gross financing needs would be significantly higher." *Source: _cr16222 - Annex II. Debt Sustainability Analysis* ### 5. The discussion can be reframed in terms of tolerance for risk. Achieving and maintaining ### _cr16222 - 5. The discussion can be reframed in terms of tolerance for risk. Achieving and maintaining ### Tolerance for risk and debt dynamics - Achieving and maintaining structural balance will lead to a decline in debt only if nominal GDP growth materializes as assumed and interest rates remain low. - Debt will not decline if growth disappoints, interest rates rise, or other contingent liabilities come onto the public sector balance sheet. - Question posed: In setting the fiscal target, how much is the tolerance for risk in regards to ensuring debt is on a firmly declining path? - Fan chart analysis (Figure A2.1) findings: - Probability of debt not declining below the current level (about 133 percent of GDP) by 2021 is about 13 percent if shocks are distributed symmetrically. - With modest asymmetric shocks to growth and to the primary balance, the probability of debt not falling increases to about 50 percent. - Conclusion: Higher primary balances are needed to stabilize and bring debt down, including when interest rates normalize. ### Debt-stabilizing primary balance under different interest-growth constellations - Note: the structural primary surplus is currently 2.6 percent of GDP - Debt/GDP at 133 percent - Debt Stabilizing Primary Balance (in percent of GDP, under different interest rate-growth constellations) - Nominal growth rate (in percent) versus Nominal interest rate (in percent) — table indicated but values excerpted in figure area include: - For nominal interest rate 0 and nominal growth rates (0 to 5): 0, 1.3, 2.6, 4.0, 5.3, 6.7 (arranged vertically in the source) - For nominal interest rate 1 and nominal growth rates (0 to 5): -1.3, 0.0, 1.3, 2.6, 4.0, 5.3 - For nominal interest rate 2 and nominal growth rates (0 to 5): -2.6, -1.3, 0.0, 1.3, 2.6, 3.9 - For nominal interest rate 3 and nominal growth rates (0 to 5): -3.9, -2.6, -1.3, 0.0, 1.3, 2.6 - (These values are presented in the source figure as the debt-stabilizing primary balances across nominal interest and growth combinations.) - Implication: Given structural primary surplus of 2.6 percent of GDP, maintaining or increasing primary balance is necessary under less favorable interest-growth constellations. ### DSA baseline scenario key statistics and projections (Figure A2.3) - As of June 01, 2016 - Sovereign spreads and debt indicators: - EMBIG (bp): 125 - 5Y CDS (bp): 129 - Nominal gross public debt: - 2014: 111.5 - 2015: 132.5 - 2016: 132.7 - 2017: 132.9 - 2018: 132.4 - 2019: 130.8 - 2020: 128.6 - 2021: 125.9 - 2021 (alternate line): 123.0 - Public gross financing needs: - 2014: 22.9 - 2015: 32.2 - 2016: 26.5 - 2017: 20.4 - 2018: 16.9 - 2019: 16.4 - 2020: 16.1 - 2021: 14.0 - 2021 (alternate line): 14.9 - Growth, inflation, interest, and ratings: - Real GDP growth (in percent): - 2014: -0.5 - 2015: -0.3 - 2016: 0.8 - 2017: 1.1 - 2018: 1.3 - 2019: 1.2 - 2020: 0.8 - 2021: 0.8 - 2021 (alternate line): 0.8 - Inflation (GDP deflator, in percent): - 2014: 1.7 - 2015: 0.8 - 2016: 0.8 - 2017: 0.5 - 2018: 0.6 - 2019: 0.9 - 2020: 1.1 - 2021: 1.2 - 2021 (alternate line): 1.3 - Nominal GDP growth (in percent): - 2014: 1.2 - 2015: 0.5 - 2016: 1.5 - 2017: 1.6 - 2018: 1.9 - 2019: 2.1 - 2020: 1.9 - 2021: 2.0 - 2021 (alternate line): 2.2 - Effective interest rate (in percent) 4/: - 2014: 4.4 - 2015: 3.6 - 2016: 3.2 - 2017: 3.1 - 2018: 3.0 - 2019: 2.8 - 2020: 2.8 - 2021: 2.7 - 2021 (alternate line): 2.8 - Ratings: - Moody's: Baa2 / Baa2 (years shown) - S&Ps: BBB- / BBB- - Fitch: BBB+ / BBB+ - Change in gross public sector debt (cumulative and annual): - Cumulative change (2014–2021): -9.8 - Annual changes: - 2014: 3.2 - 2015: 3.5 - 2016: 0.2 - 2017: 0.2 - 2018: -0.5 - 2019: -1.6 - 2020: -2.2 - 2021: -2.7 - 2021 (alternate line): -2.9 - Identified debt-creating flows (2014–2021 cumulative: -8.8): - Primary deficit (levels, percent of GDP): - 2014: -1.0 - 2015: -1.4 - 2016: -1.4 - 2017: -1.5 - 2018: -1.8 - 2019: -2.4 - 2020: -3.1 - 2021: -3.4 - 2021 (alternate line): -3.5 - cumulative (2014–2021): -15.7 - Primary (noninterest) revenue and grants (percent of GDP): - 2014: 45.4 - 2015: 48.0 - 2016: 47.7 - 2017: 47.1 - 2018: 45.9 - 2019: 45.7 - 2020: 45.9 - 2021: 45.8 - cumulative (2014–2021): 276.2 - Primary (noninterest) expenditure (percent of GDP): - 2014: 44.4 - 2015: 46.6 - 2016: 46.3 - 2017: 45.6 - 2018: 44.1 - 2019: 43.3 - 2020: 42.8 - 2021: 42.4 - cumulative (2014–2021): 260.5 - Automatic debt dynamics (2014–2021 cumulative: 7.1) and interest rate/growth differential (same numbers): - 2014: 3.5 - 2015: 4.0 - 2016: 2.2 - 2017: 2.0 - 2018: 1.4 - 2019: 0.9 - 2020: 1.0 - 2021: 0.9 - 2021 (alternate line): 0.8 - Real interest rate contribution (2014–2021 cumulative: 14.8): - 2014: 2.9 - 2015: 3.6 - 2016: 3.2 - 2017: 3.4 - 2018: 3.1 - 2019: 2.5 - 2020: 2.1 - 2021: 1.9 - 2021 (alternate line): 1.8 - Real GDP growth contribution (2014–2021 cumulative: -7.7): - 2014: 0.6 - 2015: 0.4 - 2016: -1.0 - 2017: -1.4 - 2018: -1.6 - 2019: -1.6 - 2020: -1.1 - 2021: -1.0 - 2021 (alternate line): -1.0 - Exchange rate depreciation: 0.0 for projection years shown (no material exchange rate contribution in projections). - Other identified debt-creating flows (cumulative -0.1) and Privatization Receipts (negative) cumulative -0.1. - Contingent liabilities: 0.0 across projection years. - Other debt flows (incl. ESM and Euroarea loans): small negative entries like -0.2 in early years; cumulative 0.0 for projections. - Residual, including asset changes (cumulative -1.0): - 2014: 1.1 - 2015: 1.3 - 2016: -0.2 - 2017: -0.2 - 2018: -0.2 - 2019: -0.2 - 2020: -0.2 - 2021: -0.2 - cumulative for projections: -1.0 - Footnote assumptions and definitions are preserved as in the source (public sector = general government; effective interest rate defined as interest payments divided by debt stock excluding guarantees; automatic debt dynamics formula and components detailed). ### Realism of baseline assumptions and alternative scenarios (Figure A2.4) - Alternative scenarios underlying assumptions (selected): - Baseline scenario underlying assumptions: - Real GDP growth: 2016: 1.1; 2017: 1.3; 2018: 1.2; 2019: 0.8; 2020: 0.8; 2021: 0.8 - Inflation: 2016: 0.5; 2017: 0.6; 2018: 0.9; 2019: 1.1; 2020: 1.2; 2021: 1.3 - Primary Balance: 2016: 1.5; 2017: 1.8; 2018: 2.4; 2019: 3.1; 2020: 3.4; 2021: 3.5 - Effective interest rate: 2016: 3.1; 2017: 3.0; 2018: 2.8; 2019: 2.8; 2020: 2.7; 2021: 2.8 - Historical scenario underlying assumptions: - Real GDP growth: 2016: 1.1; 2017: -0.5; 2018: -0.5; 2019: -0.5; 2020: -0.5; 2021: -0.5 - Primary Balance: 2016: 1.5; 2017: 1.2; 2018: 1.2; 2019: 1.2; 2020: 1.2; 2021: 1.2 - Effective interest rate: 2016: 3.1; 2017: 3.0; 2018: 2.9; 2019: 2.9; 2020: 3.0; 2021: 3.1 - Constant Primary Balance scenario underlying assumptions: - Primary Balance held at 1.5 across 2016–2021; other variables same as baseline real GDP growth and inflation sequences. - Composition of public debt and public gross financing needs are shown across scenarios with projected series for gross nominal public debt and public gross financing needs. ### Stress tests and macro-fiscal shock results (Figure A2.5) - Stress tests cover: Primary Balance Shock; Real GDP Growth Shock; Real Interest Rate Shock; Real Exchange Rate Shock; Combined Shock; Contingent Liability Shock. - Selected underlying assumptions under stress scenarios (examples from figure): - Baseline underlying assumptions repeated: Real GDP growth 1.1 (2016), 1.3 (2017), 1.2 (2018), 0.8 (2019–2021); Inflation 0.5 (2016) rising to 1.3 (2021); Primary balance rising to 3.5 by 2021; Effective interest rate declining to ~2.8 by 2021. - Primary Balance Shock path (primary balance): 2016: 1.5; 2017: 1.5; 2018: 1.8; 2019: 2.4; 2020: 3.1; 2021: 3.4 (matching baseline in some years). - Real GDP Growth Shock path (example): Real GDP growth 2016: 1.1; 2017: -1.1; 2018: -1.2; 2019: 0.8; 2020–2021: 0.8; Primary balance under this shock: 2016: 1.5; 2017: 0.5; 2018: -0.2; 2019: 0.5; 2020: 0.9; 2021: 1.0 - Contingent Liability Shock example: Primary balance path includes a sharp drop in 2017 (e.g., 2017: -9.8 in one line), with effective interest rate responses shown up to 3.6 or 3.2 depending on scenario. - Graphical stress test outcomes indicate large increases in gross nominal public debt and gross nominal public debt as percent of revenue under adverse shocks; public gross financing needs rise substantially under stress scenarios. ### Policy recommendations and progress (Appendix: Progress Against IMF Recommendations) - Reforms and actions since 2015 Article IV (selected entries and next steps): - Product markets: - Action: Annual Competition Law approved by Chamber of Deputies in October 2015 and under discussion in the Senate. - Next steps: Strengthen several provisions, ensure annual process of adopting pro-competition laws, consider enhancing competition in local public service provision, transport, legal and professional services, and full implementation of existing legislation (e.g., retail sector). - Public services: - Action: Enabling law for public tenders approved January 2016; simplifies and rationalizes public procurement and introduces more soft law instruments and strengthens Anti-Corruption Authority. - Next steps: Further improve tendering procedures and standardization of service contracts. - Judicial system: - Actions: DL 83/2015 (converted in law 132/2015) extended possibility that the losing party pays court fees; reform project on civil procedure establishing penalties for frivolous litigation; Strasbourg Program 2.0 under implementation. - Next steps: Monitor progress; legislative delegation on civil procedure pending approval by Parliament; reform contemplates a single judge in appeal cases. - Structural reforms to improve business environment: - Actions: Enabling Law on reforming the Public Administration (L 124/2015) approved August 2015; some implementing decrees approved January 2016. - Next steps: Advance reforms on skill-mix, streamline procurement, rationalize local public enterprises, further implementation. - Labor market: - Actions: Independent monitoring committee for Jobs Act; NASPI and additional schemes introduced May 2015; National Employment Agency established January 2016; legislative decrees on parental benefits adopted June 2015. - Next steps: Monitor take-up of new contracts, effectiveness of National Employment Agency, boost female labor participation, promote firm-level bargaining with social partners proposal by end 2016. - Rebalancing the budget and fiscal stance: - Actions: 2016 budget reduced tax burden on labor and firms; safeguard clause for 2016 was eliminated and partially offset by spending cuts; significant flexibility under the SGP approved (about 0.85 percent of GDP). - Next steps: Build a primary surplus buffer over the medium-term by targeting a 1/2 percent of GDP structural surplus; implement evenly-phased structural adjustment over 2017-19 to achieve structural surplus of about 1/2 percent of GDP. - Public financial management: - Actions: Legislative decrees approved to make spending reviews integral to regular budget in a multi-annual planning framework. - Next steps: Complete reform of the state budget process and implement the new framework with spending targets starting with the 2017 budget; make budgetary framework more binding with enforceable multi-annual expenditure ceilings. - Tax evasion: - Actions: Information sharing improved; ongoing work on guidance for financial institutions to report transactions related to tax evasion. - Next steps: Implementation and follow-up of improved reporting for money-laundering transactions related to tax evasion. - Tackling NPLs and banking sector: - Actions: New asset classification framework introduced January 2015; period for tax deductibility of loan losses shortened to a year (DL 83/2015, converted into law 132/85); insolvency framework reforms including online tools adopted in Decree law n.59 (May 3rd, 2016); initiatives introduced GACS and Atlante fund. - Next steps: Systematic asset quality assessment for banks not subject to ECB comprehensive assessment; increase tax deductibility of loan losses (no further action needed per source); monitor implementation of insolvency reforms and on-line tools; require banks to produce comprehensive NPL strategies with operational targets; consider centralized, system-wide, state-backed AMC if consistent with EU state aid rules and fiscal space. - Corporate governance and supporting SMEs: - Actions: Memorandum between Treasury and ACRI on foundations' portfolio diversification; reforms forcing largest Popolare banks to convert to joint stock companies by end 2016; mutual bank reform requiring consolidation under joint-stock companies with at least €1 billion in equity in 18 months; measures to liberalize funding and securities issuance for SMEs; DL 59 (May 2016) introduced new security interests over enterprise assets. - Next steps: Ensure reforms implemented decisively; supervisors to lead consolidation of smaller banks; monitor secured transactions reform and registry infrastructure; monitor effectiveness of measures for SMEs and further encourage market funding sources. *Source: IMF staff.* ### 1. The staff report identified a vote by the U.K. electorate to leave the European ### _cr16222 - 1. The staff report identified a vote by the U.K. electorate to leave the European ### Immediate market and financial-sector developments - Equity and bank market moves since the U.K. referendum: - FTSE MIB fell by 9 percent. - Bank equity prices declined by about 25 percent (and are down for the year by over 50 percent). - Bank CDS spreads widened by about 23 bps to 281 bps. - Government bond market: - Spreads over Bunds on the 10-year government bond widened by 5 bps. - Yields have declined to 1.23 percent. - Liquidity: - So far, no major liquidity pressures have been observed. ### Growth outlook and staff assessment of Brexit impact - Revised growth projections and risks: - Staff’s preliminary assessment: growth could remain just under 1 percent in 2016 and at about 1 percent in 2017. - Staff notes heightened uncertainty and increased downside risks to investment and growth despite relatively limited direct trade and financial exposures vis-à-vis the U.K. ### Banking sector capital-raising developments (recent cases) - Veneto Banca: - Unable to attract enough investment in public offering that ended on June 24, 2016. - Atlante purchased about 98 percent of the €1 billion capital increase and is set to become the bank’s controlling shareholder. - Banco Popolare: - Completed successfully a €1 billion capital increase on June 23 that was required by the SSM in advance of the planned merger with Banca Popolare di Milano. ### Staff appraisal and policy advice (summary) - Staff view: - Recent developments do not alter the thrust of the staff appraisal. - Advice remains valid amid heightened downside risks. - Policy priorities recommended by staff: - Comprehensive pro-growth reforms, including to foster competition in product and services markets. - Measures to accelerate bank balance sheet repair. - Growth-friendly fiscal measures to lower debt. - Objective: support growth and job creation while building buffers. ### External Sector Assessment — Overall assessment and background (selected findings) - Net international investment position (NIIP): - NIIP deteriorated since joining the Euro area: net liabilities of 24 percent of GDP (December 2015) vs. 7 percent at end 2000. - Gross assets and liabilities in 2015: 144 and 169 percent of GDP respectively. - External debt represents about ¾ of gross external liabilities; about half of external liabilities is owed by the public sector. - Outlook and assessment: - Modest current account surpluses forecast over the medium term should gradually shrink Italy’s net liability position as a share of GDP. - Assessment: overall external sustainability is not a major concern given the current account’s shift into surplus, but Italy remains vulnerable to financial contagion due to large stock of government debt. - Overall positional assessment for 2015: - External position in 2015 was broadly consistent but likely still weaker than suggested by medium-term fundamentals and desirable policy settings. - Staff assesses that a modest real effective depreciation of 0–10 percent would support further adjustment and address economic imbalances over the medium term. - Potential policy responses: - Continued implementation of structural reforms. - Efforts to strengthen bank balance sheets. - Further progress in medium-term fiscal consolidation to improve competitiveness and maintain investor confidence. ### Current account (CA) — background and assessment - Background: - CA averaged a deficit of 1¼ percent of GDP in the decade following euro adoption. - Starting in 2013 moved into balance; by 2015 registered a surplus of 2.2 percent of GDP (1.9 percent in 2014). - Trade surplus reached 3.2 percent of GDP in 2015. - Declining investment accounted for ⅔ of the improvement in the CA since 2010; higher public saving contributed most of the rest. - Assessment: - EBA model cyclically-adjusted level stood at 1.1 percent of GDP in 2015 and was about 1.8 percent of GDP below the norm implied by medium-term fundamentals and desirable policy settings. - Staff assesses a CA gap of -2 to 0 percent of GDP for 2015. ### Real effective exchange rate (REER) — background and assessment - Background: - Stagnant productivity and rising labor costs led to gradual REER appreciation since joining the Euro area. - In 2015, fall in euro contributed to a sizable depreciation of the REER, bringing its value close to 1999 levels. - As of June 2016, the REER has appreciated 1 percent over its 2015 average. - Technical note: Depending on measure, Italy’s REER depreciated by 3–10 percent between 2014 and 2015 (year average on year average). - Assessment: - EBA regression methods suggest REER overvaluation estimates in 2015: 0.7 percent (EBA Level REER model) and –0.4 percent (EBA Index REER model). - CA regression method yields an overvaluation of about 7 percent. - Staff’s balanced view: modest real effective depreciation of 0–10 percent would be supportive. ### Capital and financial accounts; FX and reserves - Financial account and flows: - Portfolio and other-investment inflows typically financed past CA deficits; modest net FDI outflow. - Financial account posted net outflows of about 2 percent of GDP in 2015, reflecting residents’ net purchases of foreign assets even as foreign investment in Italian portfolio securities continued. - TARGET2 liabilities, accumulated by banks over 2011-12, widened in 2015 reflecting Bank of Italy liquidity creation within Eurosystem asset purchase program. - Assessment: - While supported by QE, Italy remains vulnerable to market volatility given large refinancing needs of sovereign and banking sectors and potentially tight credit conditions from high stock of NPLs. - FX intervention and reserves: - Background: the euro has the status of a global reserve currency. - Assessment: Reserves held by the euro area are typically low relative to standard metrics, but the currency is free floating. ### Statement by Mr. Carlo Cottarelli — key points and authorities’ views - General: - Authorities are firmly committed to meet challenges identified by staff; many policy actions have been implemented and some completed. - Implementation has started and been completed for many policy actions; results may take time to materialize. - Real sector — short-term growth: - Italy’s GDP growth rate in the prior year: 0.8 percent. - Staff projects growth of 1.1 percent in 2016; authorities note this implies rapid closing of the growth gap vis-à-vis the euro area. - Medium-term growth: - Staff envisages medium-term potential growth of 0.8 percent absent further reforms (including a 0.3 percentage point boost from past structural reforms). - Authorities’ long-term growth projections: 1.3-1.4 percent. - Bank of Italy research estimate: 0.2 percentage points contribution from services sector reforms already implemented. - Authorities cite official projections on cumulative macroeconomic impacts of implemented reforms: - 2.2 higher GDP level by 2020. - 3.4 percent by 2025. - 8.2 percent in the long-term. - Staff’s view that growth would be 0.5 percent in absence of recent reforms is questioned by authorities given pre-crisis IMF staff estimate of potential growth at 2 percent. - Labor market and social indicators: - Unemployment rate reduced to 11.5 percent last May. - Youth unemployment reduced by more than 4 percentage points compared with a year earlier. - Positive signs in female employment creation. - Authorities adopted a Social Act to fight poverty allocating €1 billion as of 2017. - Jobs Act has been implemented (authorities contest wording implying it is still “being implemented”). - 2016 plans include focusing on reform of second-level bargaining to make agreements effective and able to derogate to the national contract for production and work organization matters. - Fiscal policy — trends and context: - Structural primary balance improved from -0.1 in 2009 to 4.1 percent in 2013. - Authorities used Stability and Growth Pact flexibility starting in 2013 to balance consolidation and support recovery. - Headline deficit targeted at 2.3 percent in the current year; described as one of the lowest among the G7. - Authorities argue staff’s assessment of fiscal easing based on structural balance changes is partly misleading due to very low staff estimates of potential output growth in 2016 (staff’s Table 1: potential GDP growth in 2016 is just 0.1 percent). - Authorities caution that staff-recommended fiscal consolidation would likely have negative sizable impact on GDP and debt dynamics. - Public expenditure restraint — authorities’ points: - Reduction in wage bill is structural: public employment declined by some 250,000 units and average public/private wage ratio remains about 1.22 (vs. advanced economies average of 1.05). - Public consumption stabilized in nominal terms after earlier increases; public consumption deflator averaged 0.7 percent in 2010-2015. - Reform of procurement already implemented to sustain savings. - Savings achieved in health care and pension spending owing to increased retirement age. - Prior to cuts, capital expenditure as a share of GDP was nearly 1 percentage point higher than in Germany, implying room for structural savings. - Italy’s increase of primary expenditure between 2009 and 2015 was below 2 percent (whole period); comparisons cited for other countries show higher increases. - Judicial sector reforms — outcomes reported by authorities: - Judicial offices rationalized: from 1,398 to about 650; 750 units closed. - Backlog of civil trials reduced from 6 to 4.5 million since 2009. - Time to issue telematic cease-and-desist orders now 23 to 31 days (down from 42-50 days a year earlier). - 22 specialized firms’ tribunals established at regional level; 11 competent for foreign firms. - 80 percent of trials at firms’ courts settled within a year in 2012-2014 period. - Other fiscal reforms and administrative actions: - Public administration reform legislative path expected to be completed before the summer break. - Payment time by public administration reduced to 115 days in 2015 (from almost 200 days in 2010) per Bank of Italy estimates. - A decree approved for rationalization and reduction in the number of publicly-owned enterprises, setting minimum size and performance standards. - Privatization: Poste Italiane is in the process of being privatized; Eni, Enel and Finmeccanica are listed companies subject to market discipline and regulation. - Authorities note Italy is in better shape on long-term public finances due to comprehensive and fully implemented pension reforms, with related chart comparisons cited. *Italic: IMF staff report sections and Mr. Carlo Cottarelli statement, July 1–6, 2016.* ### 3. Financial sector ### 3. Financial sector ### Overview - The Italian banking system weathered the 2008-09 global financial crisis better than others but was significantly affected by the deep and prolonged euro area recession in 2011-12. - Important resilience-enhancing efforts pursued in recent years: - CET1 was at 12.3 percent at end-2015, higher by around 0.4 percentage points than at end-2014. - Further strengthening is being pursued in 2016 to comply with the ECB request following the supervisory review and evaluation process of end-2015. - The leverage ratio – calculated as the ratio of tier 1 capital to total non-risk-weighted assets – is higher than the European average. - Major reforms (as described by the staff report and the SIP) have been adopted in a coordinated effort to foster consolidation, enhance governance, and support profitability. - Authorities emphasize caution: no easy or simple fix exists; rushed solutions risk undermining financial stability. ### Non-Performing Loans (NPLs) - Key stock and flow figures (billions of euro at end-2015): - Total NPLs gross stock (A): 360 - Of which: bad debt: 210 - Provisions already booked (B): 163 - Net stock (A)-(B): 197 - Net bad debt after provisions: 87 - Memo: Real estate collateral: 85 - Memo: Other collateral: 37 - Context and interpretation: - At end-2015 the stock of gross NPLs amounted to around € 360bn (18.1 percent of total loans; this is the figure reported in the staff report). - A large portion of gross NPLs refers to borrowers’ difficulty not leading to insolvency; bad loans (actual insolvency) amount to € 210bn. - Net of provisions, bad loans decrease to € 87bn (4.8 percent of total loans). - Provisioning and collateral (real estate collateral € 85bn; personal guarantees € 37bn) represent strong protection against losses on NPLs. - Reforms to speed recovery and foreclosure: - New out-of-court mechanism (“patto Marciano”) allows transfer of property collateral to the lender if debtor defaults (provided collateral is not the debtor’s residence). Applicable to new loans and existing contracts via renegotiation where bankruptcy is not already in place. - Repossession under “patto Marciano” could take only a few months (6-8 months) instead of more than three years (already reduced from four years by the 2015 reform). - Measures could apply to younger bad loans (recorded less than two years). - If renegotiations take place for around half of potentially outstanding contracts, the bid-ask gap would decrease by about 15 per cent. - Recent trends and market measures: - Flow of new NPLs: Q1 2016 = 2.9 percent of total loans (as against 3.7 in 2015 and 4.8 in 2014), the lowest level since Q2 2008. - Stock of NPLs declined as a ratio of total loans in Q4 2015 and Q1 2016 — a turning point has now been reached. - State guarantee scheme for securitized bad debts (Gacs) could raise sale prices by making senior tranches more attractive to investors. - Atlante, a private fund, can concentrate on the riskiest securitization tranches; buying bad debts at higher prices could produce attractive returns and help grow the market in non-performing assets. - Policy cautions and trade-offs: - Forcing fast and generalized sales in an illiquid NPL market would result in sale prices much lower than book value, causing sizeable immediate losses and potentially a renewed credit squeeze with adverse effects on recovery and nominal growth. - Excessive acceleration in write-offs would drag on profitability and impair banks’ access to debt and equity capital markets, reducing capacity to support economic recovery. - Despite high NPL stocks, the credit market is functioning: loans to households have been growing; contraction for nonfinancial firms has almost fully receded; bank loans expanded in better-performing sectors (e.g., manufacturing). Credit availability problems are concentrated in microenterprises and weaker sectors (construction and real estate services). ### Profitability and banking structure - Profitability: - Italian banks’ ROE in 2015: 3.1 percent (up from -0.3 percent in 2014). - 2015 outcome curtailed by a 4.8 percent increase in operating expenses due to extraordinary contributions (€ 2.3bn) paid into the National Resolution Fund in December for the resolution of four banks. - Average cost-to-income ratio for Italian banks is only slightly above the EU average (in line with the UK, below Germany and France). - Authorities emphasize efficiency gains, cost containment, income diversification, and business model adjustments. - Consolidation and structure: - Staff highlights need for consolidation given around 640 banks; authorities agree. - Number of banks declining: almost 800 at end-2008 to 640 (current figure). - Number of branches declined to around 30,000 (11 percent less than in 2008). - ECB banking structure report: ratio of branches to population in Italy is close to the European average (higher than Germany, lower than France and Spain). - Further adjustments may occur in banks and branches, leveraging technology and digitization. ### Resolution framework - Legal and operational status: - Italian legal framework is fully compliant with the BRRD and fully operational. - Responsibility for resolution matters for significant banks rests with the Single Resolution Board, which takes resolution decisions upon ECB’s ascertainment of failure/likely failure, leaving very little room for national discretion. - Authorities’ stance and critique: - Authorities are fully committed to applying the resolution framework (as shown in the resolution of the four banks) but highlight weaknesses in the framework. - They call for assessing the degree of flexibility of the BRRD during the directive review scheduled by June 2018. - The IMF’s last GFSR also highlighted the need to apply new rules (including on state aid) with flexibility and caution during the changeover, when public intervention is no longer admissible but banks may lack sufficient buffers to absorb losses without systemic instability. *Source: _cr16222 - 3. Financial sector* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16222.pdf_