ITALY: Concluding Statement of the 2015 Article IV Mission
May 18, 2015
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A Window of Opportunity to Revitalize the Economy
Italy’s economy is emerging slowly from a painful recession. Buoyed by ECB’s quantitative easing (QE), government bond yields have fallen to pre‐crisis lows, despite the recent uptick, and bank and corporate funding costs have declined. Boosted by lower oil prices, a weaker euro, and recent reform efforts, confidence indicators have rebounded. After stabilizing in Q4 2014, real activity expanded in Q1 2015. Supported by stronger exports and higher spending by firms and consumers, growth is projected at 0.7 percent this year and 1.2 percent next year.
Strong policy actions have been instrumental for this turnaround. At the European level, recent policies have supported demand: QE has had a powerful effect on asset prices, including bond yields and the euro; the ECB’s Balance Sheet Assessment has helped resolve some uncertainty about bank balance sheets; and more flexibility in the Stability and Growth Pact (SGP) has allowed the fiscal stance to be fairly neutral in the near term. At the national level, Prime Minister Renzi’s government has advanced important institutional and economic reforms that have also lifted confidence. For instance, the Jobs Act will bring about significant changes to the labor market over time - by making workers more productive and easing their transition across firms and sectors. Tax simplification and judicial reform efforts will help support economic activity and strengthen competition. And a new law to convert the ten largest cooperative banks into joint stock companies has spurred expectations of better governance and efficiency gains in the sector.
But much higher growth is needed to bring down unemployment and debt at a faster pace. Persistent structural weaknesses, including due to incomplete implementation of previous reforms—together with depressed demand, weakened balance sheets, and subdued growth expectations—have been dragging down growth. Real activity and investment are still far from their pre‐crisis levels, and medium‐term growth prospects remain lackluster. Getting the economy to grow faster is vital to reduce unemployment—that remains uncomfortably high (over 12 percent), especially among the youth—and to support public and private sector deleveraging.
There is now a window of opportunity to push ahead with deeper reforms to lift growth. Policy efforts should focus on three areas: (1) tackling the long‐standing productivity problem; (2) supporting bank and corporate balance sheet repair; and (3) rebalancing fiscal adjustment and reducing public debt from its very high level of over 130 percent of GDP. It is encouraging that the government’s agenda includes ambitious initiatives in all these areas. The challenge now is to maintain the reform momentum and bring about real change on the ground.
Reforms to Revive Productivity
A wide‐ranging reform to raise the efficiency of public services is long overdue. This would not only provide better quality services at a lower cost, but more importantly, would help increase private sector productivity. In the current system of fiscal decentralization, only a comprehensive reform that improves efficiency at all levels of government could unlock the private sector growth potential.
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Public administration reform. It should increase the autonomy and accountability of public sector managers; strengthen benchmarking and performance‐based budgeting; and improve mobility of workers and wage differentiation in line with productivity.
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Local public services reform. In many areas, the provision of local services is dominated by monopolies assigned to companies directly owned by (or related to) local governments. The existence of more than 8,000 local public enterprises has been highlighted as a source of inefficiency and a burden on public finances. Hence, reforming local public services and rationalizing local public enterprises would yield significant economic benefits.
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Public tenders. More transparency in tendering procedures and standardization of contracts—particularly for the provision of local public services—can help improve their quality and cost.
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Civil justice reform. A more efficient judicial system is vital for productivity and growth. Building on recent reforms, consideration could be given to rationalizing the type of cases that reach the Supreme Court (Corte di Cassazione); allowing for specialization of the courts; using ad hoc measures to reduce the backlog of pending cases; and developing court performance indicators.
The draft law outlining the broad guidelines of the public administration reform covers some of these areas. And there are ongoing efforts to address many of the issues above. Completing the legislative process and designing the implementing decrees is a necessary first step towards the much-needed overhaul of the public sector.
Consumers will benefit from more competition in product and service markets. Italy has taken significant steps to liberalize product markets since 2008; the swift approval and implementation of the Annual Competition Law would be another step in the right direction. Additional measures in sectors that remain highly regulated such as transport would also help. Efforts to fully implement existing legislation should be strengthened, which would narrow the gap between legislated regulations and perceptions of product market efficiency.
Completing the Jobs Act will create better incentives to hire and train workers. The recently introduced new labor contract with gradually increasing protection lowers dismissal costs, which would improve the reallocation of workers across firms. The extension of the coverage of unemployment benefits and linking unemployment support to job search and training would support workers’ transition between jobs. While this is an important start, the elements of the Jobs Act yet to be implemented are equally important. The planned reform of the current wage supplementation scheme will encourage the transitions of workers from unprofitable to profitable firms. The plan for national coordination of ALMPs—to reduce regional disparities and improve implementation, monitoring and evaluation—should speed up the process of vacancy filling. Outside the Jobs Act, negotiating more contracts at the firm level and allowing greater flexibility in national contracts would allow companies and workers to better adapt to changing conditions and productivity.
Balance Sheet Repair to Help Investment
The protracted downturn has taken a heavy toll on Italian firms and banks. For a large number of firms, particularly small and medium‐sized enterprises (SME), the outlook is difficult as profits have declined and debt burden has increased since 2008. For banks, nonperforming loans (NPLs) have reached a record level of 18 percent of loans (with the vast majority stemming from the corporate sector) becoming an issue of systemic importance. In turn, balance sheet weaknesses have exacerbated the downturn. Loans to SMEs continue to be scarce and expensive.
A broad-based strategy to strengthen bank and corporate balance sheets will support recovery. It will free up resources for new lending to productive firms and sectors.
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Accelerate provisioning and write‐offs. As part of this strategy, supervisory actions that effectively introduce time limits for write-off of vintage NPLs can play an important role in encouraging banks to deal faster with the problem and reduce the NPL stock over time.
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Improve further the insolvency regime. Additional reform efforts to rationalize and streamline procedures will facilitate the swift exit of nonviable firms and restructuring of viable firms. The reforms could address remaining gaps in pre‐insolvency and reorganization procedures, including obstacles to debt/equity swaps; accelerate the start of insolvency procedures; increase the flexibility in the sale of assets; reduce litigation within the insolvency process; and establish qualifications for insolvency practitioners.
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Restart the NPL market. As part of an overall strategy, an active distressed debt market could play an important part in tackling the NPL problem. Private AMCs should be encouraged, including through regulatory measures and tax incentives for NPL disposals. If properly designed, a centralized, system‐wide, state‐backed AMC that is consistent with EU state aid rules could jumpstart the market for bad assets.
Foster restructuring or resolution of distressed SMEs. Establishing standard criteria for bank assessments of the viability of SMEs and introducing guidelines for creditor-led restructuring could accelerate the process of dealing with distressed SMEs.
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Promote alternative sources of financing. The positive measures taken to facilitate SMEs’ access to capital markets and liberalize the credit market should be fully implemented.
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Enhance the use and enforcement of collateral. Efficient collateral enforcement mechanisms could expand the availability and lower the cost of credit. Introducing contracts based on fiduciary arrangements, and expanding the possibilities for out‐of‐court enforcement, will allow a quicker recovery. Reforming the secured transactions law and improving the registry for collateral will expand access to finance.
Fiscal Rebalancing to Support Growth and Reduce Public Debt
Fiscal policy faces the twin challenges of supporting growth and reducing debt. After years of difficult but necessary adjustment, Italy’s primary surplus is among the highest in the euro area. The protracted recession has contributed to a steady rise in the debt‐to‐GDP ratio. This has limited the room for fiscal policy to cushion the effects of the downturn.
To support growth, fiscal rebalancing needs to continue through more efficient spending and lower taxes. The labor tax cuts in the 2015 budget are welcome, but labor and capital remain heavily taxed. The ongoing spending reviews are essential to identify possible efficiency gains in areas such as procurement, transfers to public enterprises, and health, building on the measures already taken. Decisive implementation will help meet the deficit target and make space for further reduction of the tax burden, supporting higher growth. In addition, a modest structural surplus over the medium term will reduce debt faster, providing valuable insurance against changes in market sentiment, and helping comply with EU fiscal rules.
In the near term, the planned modest consolidation of ¼ percent of GDP is appropriate, given still‐subdued growth and high debt. The re‐indexation of pensions in accordance with the Constitutional Court ruling should not modify the fiscal stance both this year and going forward. The safeguard clause should be fully offset by spending cuts—to avoid damaging tax hikes while building fiscal buffers. A modest use of the flexibility under the Stability and Growth Pact could support the structural reform program and create room for further tax cuts.
Faster privatization would reduce debt, but progress remains disappointing. The recent sale of ENEL shares is a positive step. Taking advantage of favorable market conditions, privatization targets should be more ambitious.
Mutually Reinforcing Reforms to Lift Italy’s Potential
Comprehensive policy actions to advance structural reforms, strengthen balance sheets, and rebalance fiscal adjustment would be mutually reinforcing. Lowering the tax wedge and repairing bank and corporate balance sheets will boost jobs and investment in productive sectors and firms. And the Jobs Act will help workers transition more easily to these new job opportunities. The resulting productivity gains will be amplified by more efficient public sector and more competitive market for products and services. Now is the time to press ahead full force with the reform agenda.