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The following OECD assessment and recommendations summarise chapter 1 of the Economic Survey of Italy published on 17 June 2009.
Limited exposure of banks did not protect from recession
The depth of the Italian recession has come as a surprise. The authorities were counting on the relatively solid balance sheet of the banking system and its moderate leverage to deflect the adverse problems experienced elsewhere. But while hopes for the financial system itself have so far been borne out, although exposure to some vulnerable countries in Eastern Europe is a risk, Italy has so far nonetheless suffered significantly from collapsing demand, both foreign and domestic. Moreover, several years of low productivity growth and declining aggregate profitability left Italy’s export-oriented economy particularly vulnerable to the slump in world trade.
The underlying fiscal situation, the relatively weak capital position of the banks (even though they do not suffer from a risk of insolvency) and a history of weak trend growth mean that economic dynamism is likely to be slow to recover from the blows it has suffered in the crisis. Room for discretionary fiscal stimulus is restricted for the time being because the downturn implies a widening of the public deficit and an increase in the already high level of public debt. On the positive side, relatively healthy household and corporate balance sheets may allow Italy’s recovery to be on a more solid footing than elsewhere.
The recession focuses attention on the fiscal situation
Gross public debt was around 106% of GDP in 2008. Substantial progress had been made in cutting the ratio of debt to GDP since the mid-1990s, but partly based on one-off tax and revenue measures that were not sustained. After 2006, progress seemed to have resumed, partly as a result of improved tax collection, but without much success in reducing government expenditure. A fiscal programme for 2009-11, finalised in September 2008, aimed to bring the budget into balance by 2012 and debt below 100% of GDP by 2011. Such an ambitious programme was what Italy had needed, though it would have been difficult to achieve even in normal times. But by now, OECD projections suggest that the public deficit will reach 6% of GDP in 2010, with debt over 115% of GDP and rising, even with some effort at fiscal consolidation.
Figure 1. Public debt and interest rates
1. Belgian data refer to 2007
Source: Eurostat and OECD Economic Outlook
This prospect is almost entirely due to the deteriorating outlook for the economy. Real GDP is expected to fall by at least 5% between early 2008 and the trough of the recession. On the revenue side, the buoyancy of tax revenue seen in 2006-7 may have been less directly linked to the financial boom than in other countries; but, as the economy contracts, that part which was due to reduced evasion may become vulnerable. Reduced activity and employment could also hit revenues hard, while on the other hand there should not be a large increase in expenditures because, notwithstanding recent measure to enlarge it, Italy’s social safety net is less well-developed than in many other European countries.
Financial markets pay more attention to fiscal risks
The interest rate differential between Italian and German 10-year public debt widened from 35 basis points in 2007 and stood at between 140 and 150 basis points in March 2009, although the average interest cost of new debt actually fell slightly. With Italy’s high level of debt, the widening differential is a warning that investors are increasingly concerned about fiscal risks, as in other European countries, though fiscal prudence demonstrated so far and overall financial stability may have limited the widening in the spreads. While well short of the levels seen before monetary union, when it was dominated by a significant exchange rate risk, a differential at this level and in combination with the likelihood of significantly lower inflation could over time produce a higher real cost of long term borrowing.
Careful debt management is crucial in uncertain times
About one sixth of existing public debt has to be refinanced every year. With new borrowing to finance the ongoing budget deficit added to this, the government has to sell debt equivalent to over 20% of GDP each year. The sharp increase in the differential with rates in most other euro area countries need not bring severe short term problems as the government would have time to react to signals from rising interest rates and adjust policy. Public debt auctions have remained successful. However, the fact that the usually highly liquid interbank borrowing market ceased to function for a while highlights the risks for the public debt market.
When the economy recovers, fiscal consolidation should resume
Membership of monetary union reduced debt servicing costs greatly, providing a good opportunity to bring debt down very rapidly. Unlike in Belgium, for example, a significant part of this opportunity was wasted, leaving Italy more exposed in the current situation. It is true that several pension reforms since the mid-1990s transformed the very long run outlook for public finances. The magnitude of the further measures needed to offset the fiscal consequences of population ageing is now at a more manageable level than in most countries. But these costs are still significant and the progressive implementation of the pension reform itself will require strong commitment, as it involves longer working lives, higher private pension saving or much lower levels of replacement rates in the long run for future pensioners than today’s pensioners receive. When the economy begins to recover, the government will need to commit itself to a serious medium term programme of debt reduction based on expenditure control and probably further reforms of pension and health care. In the shorter term, the government’s room for fiscal manoeuvre will depend, among other things, on financial markets’ views of Italy’s long term fiscal sustainability.
Some steps to alleviate the immediate crisis have been taken, and the automatic stabilisers are being allowed to work
The government has rightly allowed automatic stabilisers to work. Although the orientation towards underlying consolidation foreseen in the budget planning for 2009-11 has been maintained, a number of mostly budget neutral anti crisis measures have been introduced. For the most part any additional expenditure and tax cuts have been financed by offsetting measures. Many of the measures, though small, are useful in the context of the current recession. Examples include the extension of the mainly company based unemployment insurance scheme to some previously uncovered workers, increased support for low income families, and a reduction in the delay by the public administration in paying its bills. These measures make some contribution to protecting those likely to be worst affected by the recession and redirect expenditure towards areas likely to have a high fiscal "multiplier".
Some measures are likely to have unwelcome side-effects
Support to the car industry risks resource misallocation. This policy was triggered by concern over unfair competition from companies in other countries that have received state loans and other support to a substantially greater degree than in Italy. However, the auto industry is not of systemic importance and, although there has been an impact in lifting car sales in the near term, it is unlikely that such support is the best use of public resources. Measures that essentially shift expenditure from one category to another should be limited to those which make cost-effective improvements in protection for vulnerable parts of society, or satisfy a clear need for structural reform; if this corresponds to expenditure with high fiscal multipliers, so much the better.
How to obtain this publication
The complete edition of the Economic Survey of Italy is available from:
The Policy Brief (pdf format) can be downloaded in English. It contains the OECD assessment and recommendations.
For further information please contact the Italy Desk at the OECD Economics Department at email@example.com.
The OECD Secretariat's report was prepared by Paul O’Brien, Romina Boarini and Enrico Sette under the supervision of Patrick Lenain. Research assistance was provided by Annette Panzera.