10 April 2013

Macro-economic Imbalance Procedure in-depth review for Italy

Italy's high government debt, as well as the loss of external competitiveness and its underlying sluggish productivity performance, continue to be the main macro-economic imbalances identified.

While some important measures have been adopted  over the past year to address these imbalances, their full implementation remains a challenge,  and there remains scope for further action in many areas. Meanwhile, the prolonged crisis has weakened the ability of Italy's banking sector to support the required economic adjustment. Long-standing structural weaknesses have reduced Italy's capacity to withstand and absorb economic shocks. Compared to other euro area countries, Italy entered the global crisis with fairly strong private sector balance sheets and a sound banking sector. The crisis however has highlighted the country's long-standing structural weaknesses. Real GDP contracted by more than 7 per cent since the onset of the crisis in mid-2008. The protracted recession is set to bottom out in mid-2013, under the assumption of a stabilisation in financial markets and restored  investor confidence. However, financial conditions remain fragile and growth prospects in the medium term remain subdued.

The high government debt remains a heavy burden for the Italian economy, especially against the background of persistently slow growth, and is a major source of vulnerability. During the past two years, the negative feedback loop between high debt and low growth has increased concerns among investors regarding the sustainability of Italy's high debt. Indeed, the sharp rise in the sovereign risk premium in 2011-12, which increased the pressure arising from structural weaknesses, translated into a higher cost of capital for the private sector, hampering productive investment. Moreover, in the context of banks' high exposure to government debt and a euro area financial market  highly fragmented across national borders, funding problems in the banking sector worsened. In response, a sizeable consolidation effort was undertaken by the government, which entailed significant short-term economic costs as the tax burden was raised and spending was compressed. This has decisively helped to reduce the borrowing cost of the  government since the second half of 2012. However, Italy remains vulnerable to sudden changes in market sentiment, highlighting the need to maintain the budgetary improvement in structural terms in order to put the debt ratio on a steadily declining path. The potential economic and financial spillovers to the rest of the euro area remain sizeable, should financial market turmoil related to the Italian sovereign debt intensify again.

The resilience of the Italian banking sector has severely weakened since mid-2011, undermining banks' ability to support economic activity and adjustment. The loss of access of Italian banks to international wholesale funding following the extension of the euro area sovereign debt crisis to Italy has significantly increased the sector's dependence on Eurosystem refinancing. The double-dip recession in Italy has increased credit risk in the private sector, burdening Italian banks with a large stock of non-performing loans (NPLs), mainly to private companies. In combination with subdued credit demand, this has led to a protracted contraction in credit, while the average cost of new credit remains elevated despite an accommodative monetary policy at euro area level. Low net interest margins, increased NPL provisioning and low cost efficiency all act as a drag on Italian banks' profitability.

Italy is thus confronted with severe adjustment challenges. The improving current account does not alter Italy's need to address the serious productivity and competitiveness challenges which the country faces. However, a particularly unfavourable environment – characterised by a high cost of capital, lack of support from the financial sector and fiscal policy, as well as limited scope to raise investment without increasing the economy's reliance on external financing – constrains the needed adjustment. In this context, improving the allocation efficiency in the Italian economy becomes essential in view of channelling the available resources in both the private and public sector to their most growth-enhancing uses.

Key fiscal measures and structural reforms have been adopted over the past months to address the main challenges of the Italian economy, which need full implementation to bear fruit. Italy has embarked on a wide-ranging strategy to restore fiscal sustainability and improve long-term growth. Together with determined action at the euro area level, this helped to restore some market confidence. To consolidate these benefits and strengthen Italy's resilience against possible renewed financial tensions, Italy's public debt-to-GDP ratio needs to be put on a steadily declining path. To support fiscal consolidation and unleash the country's growth potential, the gains from structural reforms should be secured by ensuring their full implementation and maintaining the reform momentum.

The IDR also discusses the policy challenges stemming from these developments and possible policy responses. While acknowledging the efforts which have already been made since the end of 2011, the IDR highlights a range of domains in which Italy's policymakers could act further to strengthen the adjustment capacity of the Italian economy. These include the strengthening of competition in some product and service markets, the development of a more growth-friendly tax system, the further decentralisation of the wage bargaining framework, the upgrading of the educational sector, and the decisive improvement of public administration efficiency and of the business environment. The IDR also highlights the need to improve the capacity of the Italian banking sector to support the adjustment of the Italian economy.

Finally, regarding Italy's public indebtedness, the IDR confirms the necessity to pursue sustained high primary surpluses in order to put the country's high public debt-to-GDP ratio on a downward path, in full compliance with its budgetary commitments and the reinforced Stability and Growth Pact (SGP).

Full review

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