04 July 2013

IMF: 2013 Article IV consultation with Italy

The risks to the outlook are tilted to the downside. Policy slippages, including at the European level, could undermine market confidence in the sovereign, intensify funding pressures on the banks, and tighten credit. A prolonged recession would further increase banks’ non-performing loans (NPLs), especially for the weak SME and construction sectors, and raise concerns about the country’s fiscal position. Outside Italy, a slowdown in the emerging market economies or market turmoil could jeopardise an export-led recovery and push up sovereign and private interest rates.

Italy’s growth prospects over the medium term will strengthen only with the implementation of comprehensive reforms. The eurozone crisis hit Italy hard, but the seeds of Italy’s low growth pre-date the crisis and follow from its stagnant productivity, difficult business environment, and over-leveraged public sector. Accelerating reforms to address these structural weaknesses will be crucial to limit the risks of long-term unemployment, especially for the youth, and raise Italy’s trend growth.

Italy is set to reach its target of structural balance this year. The sizeable fiscal adjustment in 2012 weighed heavily on growth but was crucial for Italy to exit the EU Excessive Deficit Procedure. Achieving one of the highest primary surpluses in the euro area last year was a key factor in strengthening policy credibility and confidence. This will allow fiscal policy to target a structural balance this year which will provide automatic flexibility to the economic cycle if needed.

A rebalancing of fiscal adjustment is urgently needed to support growth. Effective implementation of the government’s efforts to accelerate the payment of arrears, up to the amount of €40 billion over the next 12 months, could significantly ease firms’ credit constraints. The renewed efforts to legislate the Delega Fiscale are also welcome and should improve the efficiency of the tax system. But more can and should be done quickly to support growth, by rebalancing the composition of adjustment towards expenditure cuts and lower taxes:

Spending reviews. Over recent years, primary expenditure declined by nearly 2 per cent in nominal terms. Efforts to cut spending should continue with the budget starting in 2014, by implementing a more comprehensive spending review focused on improving the efficiency of public spending and finding additional savings to lower taxes.

Broadening the tax base. The spending reviews should be undertaken jointly with a systemic review of tax expenditures. The property tax on primary residences should be maintained for equity and efficiency reasons, and the review of cadastral values accelerated to ensure fairness. Stepping up efforts to combat tax evasion, including through better use of anti-money laundering tools, and increasing the inheritance tax would also raise revenue and more fairly distribute the tax burden.

Lower marginal tax rates on labour and capital. Savings from the above measures would help achieve the government’s objective of reducing the high tax on labour (4 percentage points of GDP higher than the euro area average) to boost employment and raising the allowance for corporate equity returns (ACE) to spur investment.

Public investment. Measures are being taken to speed up public infrastructure investment. If space allows, a modest, well-targeted increase in public infrastructure investment could catalyse private spending.

Vulnerabilities from the high public debt underscore the importance of a high primary surplus. Despite the strong fiscal effort in 2012, the public debt ratio is projected to be significantly higher than a year ago, primarily due to the weak economy and also the clearance of public arrears. To reduce vulnerabilities to an economic shock and support confidence in the sustainability of the public finances, the authorities could consider gradually building a structural surplus buffer above the balance in the new fiscal rule after 2014—once the economic recovery is firmly underway.

The recession has eroded Italian banks’ asset quality and profitability. The ratio of non-performing loans has almost tripled since 2007, while provisioning coverage has declined. Lower sovereign yields have boosted banks’ trading gains, but core profitability remains weak, as rising loan losses have absorbed nearly all operating profits. In contrast to other large countries in Europe, bank credit continues to contract and lending rates remain high, especially for SMEs.

Ensuring adequate capital and liquidity buffers would strengthen bank lending. Italian banks have bolstered their capital positions in recent years. The stress test results of the IMF’s Financial Sector Assessment Programme (FSAP) found the overall level of capital in the system as a whole to be well above regulatory minima and sufficient to absorb the additional requirements of Basel III. But given the low level of profitability, in an adverse macro-economic scenario, the extra capital buffers would be quickly depleted. Targeted action to improve bank profitability and efficiency and to strengthen capital plans where needed would shore up the defenses of Italian banks and strengthen their lending capacity.

Full press release

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