Italy: 2008 Article IV Consultation—Concluding Statement of the Mission
IMF News, November 20, 2008
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- Published: November 20, 2008
The global financial crisis and the near-term outlook
- Dates of statement: November 20, 2008; substantive assessment dated November 19, 2008.
- Key assessment:
- Italy's economy is being increasingly affected by the global financial crisis: equity prices have fallen sharply, spreads on bank and government debt have spiked, and wholesale funding markets have dried up.
- Output contracted sharply in the last two quarters; confidence is around historical lows; exports are slowing; labor market trends are flagging; demand for credit is weakening; and financial conditions are tightening.
- These factors point to negative annual growth in 2008, for the first time in over a decade.
- Near-term projections and risks:
- Output is projected to fall even further in 2009 due to negative carry-over, slowing partner country demand, tight credit conditions, and weak confidence.
- The growth decline is likely to be less severe than in many other advanced economies because of: the relatively solid banking system, strong household balance sheets, a less inflated housing market, and recent industrial restructuring.
- Inflation is projected to fall in line with the growth slowdown and moderation in international commodity prices.
- Negative risks dominate: further global slowdown, falls in consumer confidence, pervasive rigidities, lack of domestic competition, slower industrial restructuring, and limited scope for fiscal response.
Preserving financial stability
- Current strengths and vulnerabilities:
- The financial system has weathered turbulence relatively well: no financial institution failures; CDS spreads for Italian banks remain relatively moderate.
- Supporting factors: relationship-based banking model, broad stable funding base, low leverage ratios, high-quality traditional asset portfolios with little exposure to "toxic" assets, relatively low dependence on wholesale interbank funding, firm regulatory and supervisory environment, strong intervention and resolution frameworks, pre-existing high levels of depositor protection.
- Vulnerabilities: rising funding maturity mismatch as banks rely on shorter-term ECB refinancing and retail bond issues; capitalization for some banks is somewhat lower than peers that received government-sponsored recapitalizations; credit quality will worsen as recession deepens; profitability will be squeezed; largest banks face a more difficult outlook in Central and Eastern Europe.
- Authorities' response:
- Bank of Italy intensified prudential oversight: risk management, liquidity monitoring, stress testing, targeted inspections, disclosure enforcement.
- Government bank support measures (early October): emergency recapitalization scheme, funding guarantee scheme, swap facility, full state underwriting of deposit insurance schemes.
- Recommended additional measures and principles:
- Consider a voluntary government recapitalization scheme available to sound banks, with emphasis on transparency, minimizing market distortions, limiting government involvement in bank decision-making, and a clear exit strategy.
- International experience suggests: (1) operation on commercial terms but not unduly expensive to encourage take-up; (2) dividend policy should reflect the need to shore up confidence and repay government holdings; (3) conditionality consistent with full and quick loss recognition.
- Make the funding guarantee scheme fully operational.
- Continue international coordination on crisis resolution and cross-border supervision; implement the international financial reform agenda including the recent G-20 Declaration, remaining FSF recommendations, and finalizing EC Directives.
- Strengthen longer-term financial sector goals: introduce a personal bankruptcy law; ensure transparency and consumer protection as banks rely more on bond issuance to retail investors; finalize removal of banks from ownership of the Bank of Italy; enhance coordination, efficiency and information sharing among regulators (reconsider the "Authorities" law); enhance Bank of Italy stress testing to incorporate complex inter-linkages.
Responding to the crisis while protecting expenditure-based fiscal consolidation
- Fiscal position and recent trends:
- Structural fiscal balance improved substantially in 2006-07, mainly due to exceptionally strong revenues.
- Overall deficit narrowed to 1.6 percent of GDP in 2007.
- Reflecting the expansionary 2008 budget and waning revenue strength, the overall deficit will likely be close to 2½ percent of GDP in 2008, entailing some loosening in structural terms and a higher expenditure ratio.
- Government program and projections:
- Government's three-year fiscal package targets a broadly-balanced budget by 2011, consistent with SGP undertakings.
- Adjustment plan is expenditure-based and targets a structural consolidation of 0.8 percent of GDP in 2009, and more thereafter, with public debt and spending ratios projected to fall.
- These plans are based on GDP growth rates that rise from 0.5 percent in 2009 to 1.2 percent in 2011.
- Risks to the fiscal outlook:
- Projection of a higher deficit in 2009 due to weaker growth; expenditure ratio would rise further even if nominal spending plans are observed.
- Risks that tax elasticities shift adversely during the downturn and expenditure savings will not be fully realized.
- Debt ratio likely to rise further, reflecting the gap between the still-high average interest rate on government debt and falling growth rates, higher deficits, and possible bank support operations.
- Policy guidance on fiscal stance:
- Macroeconomic considerations point to scope for reducing the extent of the planned structural consolidation in 2009, in line with coordinated international fiscal response, but Italy is ill-placed for an aggressive fiscal response because of large debt, spiking spreads over Bunds, and the prospect of higher global debt issuance.
- Measures to address the crisis should support longer-term fiscal objectives: preserve and fully implement reductions in current spending while considering timely, temporary and targeted measures.
- Possible temporary/targeted measures: extending one-off outlays for vulnerable groups (for example, using the social card or extending tax rebates to the less-well off), bringing forward planned infrastructure maintenance, reducing government payment delays.
- Public infrastructure spending could support short-term demand and longer-term growth if implemented rapidly, transparently, and efficiently, with due regard to fiscal risks—the recent spending review contains useful recommendations.
- Consider deferring the measure limiting interest deductibility for banks and reconsider its modalities.
- Use the crisis to make faster progress on reforming the welfare system.
- Responses should avoid being piecemeal and should maintain a credible path to the medium-term objective.
- Fiscal framework reforms underway and recommended deepening:
- Progress: streamlined budget process, legislated three-year adjustment program, advanced key budget decisions, more transparent documentation, somewhat more flexible budget execution, measures to contain cost of public employees, comprehensive plan to reduce administrative burden, measures to improve cost effectiveness in education, draft law on fiscal federalism with Parliament.
- Recommended actions:
- Deepen budget system reform: enhance realism of baseline projections (especially wages and investment), ensure fiscal targets reflect agreements with subnational governments, overhaul the 1978 budget law, streamline legislation affecting spending programs, increase flexibility in civil servant management, enhance transparency of budget documentation, make the spending review process permanent and extend to all ministries.
- Pursue prudent fiscal federalism: implement transparent formula-based equalization transfers, robust independent regime for monitoring fiscal targets, harmonized accounting, greater civil service mobility, increase regional and local revenue autonomy (including a comprehensive review of property taxation), coordinate move to benchmark costing with budget reforms; if reforms risk higher spending or tax burden, consider bolder cost-saving reforms including streamlining the structure of subnational governments.
- Better manage public sector assets: accelerate divestment, minimize drain on the public purse, focus on enhancing competition; ensure full transparency of any bank-support operations and government guarantees; produce timely consolidated accounts for the nonfinancial public sector.
Enhancing competitiveness and productivity for a sustainable exit from the crisis
- Diagnosis:
- The real economic crisis is the decline in productivity over the last decade, leading to stagnating incomes, rising unit labor costs, a significant competitiveness gap, and tepid growth.
- The crisis presents an opportunity to pursue productivity-enhancing measures to kick-start a supply-side transformation, supported by medium-term fiscal consolidation.
- Structural reform priorities and recommendations:
- Expand and revitalize the structural reform agenda rather than postpone it.
- Adopt recommendations of the Anti-trust Authority and OECD, focusing on:
- Further liberalizing retail trade and (especially professional) services.
- Continuing deregulation efforts in the energy market.
- Strengthening the role of competition bodies in formulating policy.
- Eliminating cross-vetoes for infrastructure projects of national interest.
- Use public discussion documents and expert committees to strengthen public acceptance of reforms.
- Labor market reforms:
- A second generation of labor market reforms is needed: Italy's employment rate remains among the lowest in Europe.
- Reforms should: strengthen the link between wages and productivity, allow wages to better respond to regional differences, and make permanent contracts more flexible.
- Broaden and streamline the social safety net, particularly the unemployment benefit system, to support redundancies and create scope for increasing flexibility of permanent contracts; finance these changes by reducing replacement rates and eliminating piecemeal measures.
- Carefully weigh extension or broadening of "detaxing" overtime and bonus-related pay, and evaluate expenditures on active labor market policies for cost effectiveness and employment impact.
- Labor market reform, together with employment growth and real wages, would benefit from early product market reforms.
- Leverage international initiatives:
- Government's new national reform program aligns priorities for the next three years with the revised Lisbon Agenda's objectives.
- All levels of government should follow through, work to reduce the large transposition deficit, and aim for ambitious transposition of the EU Services Directive by the end-2009 deadline.
- Resist protectionism, including barriers to foreign ownership of Italian firms, as such tendencies are likely to undermine economic prospects and are contrary to the recent G-20 declaration.
Concluding statement of the IMF mission on Italy's 2008 Article IV Consultation.