On September 12, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation¹ with Italy.

The economy is struggling to emerge from a balance sheet recession. GDP contracted in the first half of the year but business surveys and resilient exports suggest a gradual increase in economic activity in coming quarters. Against the background of significant economic slack, inflation fell well below one percent and unemployment reached 12.3 percent. Sovereign spreads narrowed but financing conditions remain very tight for the corporate sector (especially for small and medium enterprises, SMEs) and non-performing loans (NPLs) continue to increase. Growth is expected to pick up to 1.1 percent in 2015 as credit conditions normalize and the effects of the easing measures by the European Central Bank (ECB) are felt. Risks are still tilted to the downside and include geopolitical tensions and the possibility of stagnation and low inflation

Prime Minister Renzi has outlined a bold reform agenda—firm implementation is now essential to create jobs, increase productivity, and lift potential growth from a low estimate of about ½ percent. The first phase of the labor market reform focused on increasing flexibility at the margin and future measures will explore a contract with gradually increasing protection and improve active labor market policies. Reforms in the judicial system and the public administration are in progress and competition-enhancing reforms are to be legislated soon. Implementing structural reforms simultaneously would be self-reinforcing and generate significant growth synergies.

The nominal budget deficit is expected to be around 3 percent of GDP this year. In structural terms, a deficit of 0.8 percent of GDP is expected. Public debt will peak this year at about 136 percent of GDP and is projected to decline thereafter. The passage of the delega fiscale establishes a framework for simplifying and improving the tax system and will be an important tool to achieve a growth-friendly fiscal rebalancing.

Executive Board Assessment²

Executive Directors noted that the Italian economy has yet to emerge from a prolonged recession and prospects remain uncertain with downside risks. Unemployment remains high and inflation has declined further. Meanwhile, tight credit conditions, weak corporate balance sheets, and deeply-rooted structural rigidities continue to weigh on domestic demand. Directors considered that the high level of public debt has magnified these challenges.

Against this backdrop, Directors agreed that deep structural changes are needed to unleash Italy’s growth potential, secure a recovery, and address debt overhang issues. They welcomed the bold policy agenda set out by the new government. The proposed changes to the labor market, the judicial system, the public sector, and the electoral law are important steps for supporting future growth.

Directors stressed the urgency of labor market reforms to reduce duality and increase flexibility, building on recent gains. They saw the benefits of options such as simplified labor contracts with gradually increasing protection, and decentralized wage setting to promote firm-level wage bargaining and better align wages to productivity.

Directors welcomed initiatives to improve the business climate. They emphasized in particular the importance of judicial reforms, aimed at improving court efficiency and facilitating corporate restructuring. Directors supported continued efforts to enhance competition, especially in the retail and service sectors, and to strengthen the anti-corruption legal framework.

Directors agreed that cleaning up banks’ bad loans remains an immediate priority. They encouraged more provisioning and write-offs, development of a private market for distressed debt, and an enhanced insolvency regime. Directors supported steps to improve corporate governance and promote diversification of financing sources through deeper capital markets.

Directors saw a broad strategy to reinvigorate the small- and medium-sized enterprise sector as a complement to financial sector reforms. They encouraged the authorities to provide restructuring support for viable but distressed firms, and facilitate a smooth exit for those that are not viable. Directors noted that steps to strengthen collateral enforcement would help support new financing.

Directors commended the Italian authorities for the remarkable fiscal consolidation over the past few years. Going forward, they underscored the need for fiscal policy to strike a balance between securing near-term growth and setting the debt ratio on a downward path over the medium term. In this regard, they agreed that the priority for growth-friendly adjustment should be to create space for lowering marginal tax rates through spending savings and lower tax expenditures. At the same time, Directors considered that, given the environment of low growth, high real interest rates, and large financing needs, it would be prudent to build up a structural balance buffer once the recovery firmly takes hold. Directors supported ongoing fiscal reforms, notably the planned expenditure review, efforts to fight tax evasion, and the intention to introduce a medium-term expenditure framework.