European

Economics Notebook

12 April 2015

Lorenzo Codogno

Are Renzis reforms running out of steam?

! No major surprises in Italys Economic and Financial Document (DEF): budget projections are broadly
in line with previous targets and are credible. Still, the improved economic outlook and lower
interest expenditure are not used to improve budget achievements but rather to ease projected
spending cuts. The limited progress on structural spending cuts decreases the leeway for tax
reductions and/or additional costly reform initiatives.
! In fact, some key initiatives are still missing: further improving the business environment and ways to
support credit expansion and alleviate extreme poverty and long-term unemployment. Despite the
reformist stance of the government, a big shake up of the incentive structure in the economy has yet
to come. More needs to be done to change the long-term economic outlook.
! The most difficult bit remains the slow (and poor quality) law making/regulatory activity and the
implementation on the ground of reforms (and especially the labour market one). Reshuffling public
services, and in general reforming the public administration, remains key to structurally lower
current expenditure.

Overview
On Friday the Italian Cabinet of Ministers approved the Economic and Financial Document (DEF), Italys
main planning document (by the way, I should also add that, after 9 years, I am no longer in charge of its
technical preparation). It includes the Stability Programme and the National Reform Programme, both
papers due to be dispatched to Brussels.
There are no major breakthroughs and plenty of continuity: structural reforms, growth-friendly and gradual
fiscal consolidation, support to private and public investment.
After many years of economic recession and budget measures dictated by emergency situations or external
pressure, often with wobbling political majorities in Parliament, the government has now the opportunity
to shift to a more medium-term approach with a view to continue to deeply reform the country and deliver
economic growth. Has it succeeded?
1. Italys key macroeconomic and public finance projections (in brackets last Octobers DBP data)

Real GDP (% change)
Net lending (+)/ borrowing (-)
Primary balance
1
Interest expenditure
2
Structural balance
3
Change in the structural balance
4
Public Debt
4

Public Debt (Octobers DBP data)

2014

2015

2017

2018

2019

0.7 (0.6)
-2.6 (-2.6)
1.6 (2.3)
4.2 (4.5)
-0.5 (-0.6)
0.2 (0.1)
132.5

2016
% of GDP
1.4 (1.0)
-1.8 (-1.8)
2.4 (2.7)
4.2 (4.5)
-0.4 (-0.4)
0.1 (0.5)
130.9

-0.4 (-0.3)
-3.0 (-3.0)
1.6 (1.7)
4.7 (4.7)
-0.7 (-0.9)
0.0 (-0.3)
132.1

1.5 (1.3)
-0.8 (-0.8)
3.2 (3.1)
4.2 (4.2)
0.0 (0.0)
0.3 (0.4)
127.4

1.4 (1.4)
0.0 (0.0)
3.8 (3.4)
4.0 (4.1)
0.1 (0.0)
0.2 (0.0)
123.4

1.3
0.4
4.0
3.8
0.2
0.0
120.0

131.1

133.1

131.6

128.4

124.3

Previous figures bases of the Septembers Update to DEF and Octobers Draft Budgetary Plans (DBP).
2
Cyclically-adjusted and net of one-offs.
3
Based on estimates.
4
Gross of support to other Eurozone countries and payment in arrears of the public administration.

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On the budgetary side, the key targets are in line with those presented back in October. On the one hand,
with projected GDP growth at 0.7% this year and 1.4% next year and lower interest expenditure, it would
be difficult to argue against the need for an accelerated structural adjustment as required by Brussels and
projected by the trend scenario (almost unchanged-policy scenario), especially in consideration of public
debt hovering around 132% of GDP. On the other, deep economic reforms, a still-fragile economic
environment and a large output gap would argue for flexibility and a more gradual approach. With this
document the Italian government has effectively asked for a more gradual path towards balanced budget,
confirming 2017 as the year in which balanced budget is achieved instead of an early 2016 achievement, as
trend projections would have suggested.
A still-large output gap and the estimated effects of structural reforms are used to justify the modest 0.1pp
reduction in the structural balance in 2016. Whether this is accepted in Brussels remains to be seen.
Flexibility needs to be for real growth-enhancing reforms and there is little fresh information in the
document: the government is effectively using reforms already announced over the past year and partly
already delivered.
The 0.4 projected difference in net borrowing in 2016 (from -1.4 to -1.8%) is used to reduce spending cuts
that were due to be 1.0% of GDP (16bn) and targeted to avoid the projected increase in VAT (safeguard
clause). Spending cuts are now projected at 10bn or 0.6% of GDP. Please note that the improved macro
projections and lower interest rates are cyclical by definition, while reduced spending cuts affect
structurally the outlook for public finances. There is a clear perception that the government is running out
of easy ways to cut current expenditures. In order to move to the next phase there is a need for deep
reforms of the public administration and restructuring in the way services are provided to citizens.
Admittedly, these take time and are politically difficult, but most of the past reform initiatives in the public
sector are still on paper. On top of it, Renzi hinted at a tesoretto, i.e. some money left aside for future
initiatives to the tune of one decimal point of GDP (this does not clearly emerge from the document).
The reality is that, without further reduction in structural spending, the financing of new initiatives is in
danger. And financing is badly needed for a number of reasons.
Renzis government has defeated scepticism by delivering in just about a year a major labour market
reform combined with a reduction in labour taxation on workers and firms, product market reform
initiatives, an on-going deep constitutional reform which is likely to improve law making and stability, and
many other bits and pieces. Even the sacred caws have been touched with a far-reaching reform of
cooperative banks, when previous attempts had repeatedly been blocked by powerful lobbies cross-cutting
political parties. Chapeau to Renzi!
But the road to salvation is still paved with a lot more reform initiatives. It is now time to set priorities
clear. In my view, there are at least 3 major areas where urgent and costly intervention is needed.

Business environment yet to be significantly improved
To me the first one should be a sharp improvement in the business environment. With a still tentative
recovery underway, it is crucial to introduce the right incentives and send a clear message to businesses: it
is time to start investing and hiring again!
The business environment has improved in recent years but a lot remains to be done: according to Doing
Business, the World Bank publication, Italy ranks only 56th among the countries on record. Even taking
into account recent progress, still-not-fully-recorded reforms and some uncertainty on the measurement,
there is still plenty of room for improvement. This has to come from streamlining of bureaucracy,
improving the public administration, simplifying the tax code, reducing the many layers of regulation and
procedures, reducing corporate subsidies and unjustified welfare spending, and further liberalising and
reforming product markets.

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Delegated law proposals on the tax reforms, although already partly introduced with a piecemeal
approach, still have to find their way into actual full implementation. Product market reforms and
improvement in the business environment usually do not cost lots of money, but reforming the public
administration and reviewing the tax system may well require sizeable additional financing, at least in the
transition phase.

Lack of credit growth can constrain recovery if not properly addressed
The next priority, in my view, should be to address the lack of credit growth. This is mostly due to the build
up of non-performing loans in banks balance sheets. It wont certainly be politically popular to help banks
after such a severe recession, but it is necessary to re-establish proper credit flows in support of economic
activity, and especially productive investment. This can be done in different ways: introducing tax breaks to
increase banks provisioning, reforming insolvency and recovery procedures, increasing guarantees to
reduce risks for banks, especially related to SMEs loans, and seriously considering one-off ways to favour
the cleaning-up of balance sheets while respecting state aid legislation (so-called bad banks). On this
latter issue there has been some flip-flopping recently by the Italian government and there is a need for
clarification. Not addressing the problem will likely result in slow credit growth, holding back economic
recovery and reducing the effect of the credit channel of ECBs quantitative easing. The document does not
say much on this issue.

Unemployment and poverty may also impinge on economic performance and social cohesion
Youth unemployment reached 42.6% in February. 12.6% of households are in relative poverty and 7.9% in
absolute poverty according ISTATs estimates for 2013, which are likely to have increased significantly since
then. As a result, there are high risks of producing a lost generation and the already evident deep social
problems may endanger social cohesion (and thus also impinging on the currently stable political situation
and the reform process).
Needless to say that the best way to address poverty is through employment, but there is also a need to
maintain employability and human capital. Therefore, immediate attention should be given to active labour
market policies (linking them with the passive side) and measures to reduce extreme poverty, such as the
refinancing of the already existing social card and assistance programmes. Strikingly, the government said
that initiatives to fight poverty are to be unveiled in June, effectively missing the opportunity to present
them in the context of the DEF.

No reduction in spending without deep restructuring
To finance these initiatives, the government should further reduce current public expenditure and not ease
the pressure on spending cuts. It is also time to move from one-off spending reviews to a full-fledged
performance budgeting approach, to give certainly and stability to public spending plans and flexibility to
budgeting, and allow a value-for-money reassessment of all current expenditures with a view to rethinking
the way services are provided to citizens. Even in this area there seems to be little fresh information on
how the government intends to pursue.
Finally, the Renzi government made implementation of reforms legislated by previous governments a
priority. Still, the backlog of yet-to-be-implemented measures is large. Some reforms can be implemented
with the stroke of a pen, but others need secondary legislation, regulations and the public administration
actually delivering on the ground. Parliament is currently engulfed with legislative initiatives by the
government that are waiting in a queue. This has been one of Italys main deficiencies in the past. Final
approval and implementation must then become the paramount objective. Above all is the implementation
of the labour market reform for which the timing is now right to rip the full benefits in the economic
upswing. To sum up: implementation, implementation, implementation.

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Digging into the details
1) Economic projections are prudent. The combination of low oil prices, a weakening of trade-weighted
euro and the QE of the ECB should be a powerful mix and allow the Italian economy to start a
convincing recovery. Yet, despite a surge in survey indicators, hard data are still rather soft and 2015
started on a low basis. Therefore, it is appropriate to make cautious projections. GDP projections at
0.7% in 2015, 1.4% in 2016 and 1.5% in 2017 are reasonable. The carry over of 2014 GDP into the
current year is -0.1pp and 1Q15 GDP growth is likely to post only a modest gain. This will inevitably
impinge on the result for the whole year, which is unlikely to exceed 1%. On the assumption of a nice
acceleration in 2H15, GDP growth could easily exceed the 1.4% pencilled by the Italian government in
2016. Still, a lot of uncertainty remains on potential growth and how much production capacity can be
activated after such a prolonged and deep economic recession. Let me remind you that Italys GDP is
still about 9% below pre-crisis levels. At any rate, the government decided to go for reasonable and
prudent economic projections, and correctly so in my view.
2) The government claims it has avoided the increase in taxation (VAT) and other taxes related to the
safeguard clauses. The safeguard clauses had been introduced to give the government time to reduce
current spending while giving certainty to fiscal consolidation, but plans to reduce spending have not
yet been detailed. This will be done in the context of the budget in the autumn. Still, in the box on
pag.44 the government included spending cuts that are still to be legislated (or even decided),
replacing the safeguards clauses (VAT increases) with spending cuts. This accounting shift does not
change the overall budget numbers but it allows the government to show a declining tax burden as a
percentage of GDP (from 43.1% in 2016 to 41.6% in 2019).
3) Please also note that the structural improvement in 2015 is only 0.2pp and that the structural balance
is -0.7%. Moreover, the assessment of compliance with fiscal rules will be based on EU Commission
figures, which may not give full credit to past budget measures and economic/fiscal projections. A
difference of a couple of decimal points is well within the range of possibilities and this may trigger
non-compliance, especially if the required flexibility for structural reforms and investment is not
accepted. No safety margin has been left here, although cautious macroeconomic and fiscal projections
may allow for some buffers.
4) The decline in public investment stopped in 2015. This allows the government to call for the so-called
investment clause to get extra flexibility on the budget for the extra public investment to be
delivered in 2016. Transparency and effectiveness of public infrastructure works remains a delicate
issue in Italy. Important steps have already been undertaken to reduce corruption and increase value-
for-money monitoring. There is no doubt, however, that the real challenge will be to achieve a
sustainable recovery in private investment, which has reached historical lows as a percentage of GDP.
5) There is no way that Italy can respect the debt rule in 2016 as this would probably call for a fiscal
correction in the order of 2pp of GDP. It would not be desirable anyway, given the still fragile economic
recovery. Brussels effectively accepted a waiver for 2015 on the basis of relevant factors, but it may
become increasingly difficult to argue in favour of slow fiscal adjustment once the output gap starts
narrowing more convincingly. Timing here is crucial. The economy should be allowed to strengthen
first. In any case, Italy is sufficiently close to a balanced budget that avoiding a more stringent
correction in 2016 would effectively close the structural balanced-budget issue for the time being on
current projections. But this will likely not be sufficient to comply with the debt rule in 2016-2019.
Taken at face value, the debt rule would imply that Italy will have to target a structural surplus.
6) Safeguard clauses account for 1.0% of GDP in 2016 (de-facto automatic VAT increases to allow time to
figure out spending cuts). The government claimed that the improvement in the economy makes for
0.4 out of the 1.0% needed, and thus the required spending cuts decline to 0.6% of GDP. The
improvement in the economic outlook is a meagre 0.1pp for 2014 (from 0.6 to 0.7%) and 0.4pp for
2016 (from 1.0 to 1.4%). But this does not make for an improvement in the primary balance. Thus,
savings mainly come from the reduced interest expenditure. But the message here is that, because of

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better-than-expected economic growth and interest payments the government is reducing the
projected structural spending cuts. In my view, the government should have maintained the 1.0%
structural reduction in expenditure and use the extra savings for reform initiatives and for tax
reductions. The reality is that it is increasingly more difficult to reduce current expenditure without
deep reforms of the public administration, the way services are provided to citizens etc.
7) This also makes the claim for fiscal flexibility in exchange of structural reforms weaker. The government
said that 0.4 out of the 0.5 structural fiscal adjustment required for 2016 is absorbed by the request for
flexibility due to structural reforms. Moreover, please note that the flexibility allowed for reforms may
be given in bad times but are more difficult to be allowed when the economy is recovering.
8) Debt-to-GDP is projected to peak in 2015 and then gradually decline thereafter. This is based on the
assumption of a moderate economic recovery and a GDP deflator that moves from 0.7% in 2015 to
1.7% in 2016, thereby allowing nominal GDP growth to reach about 3.0% and maintain at least a
3.0/4.0% nominal pace thereafter. Needless to say that this is not assured. Medium-to-long term
projections are also based on the assumption that interest rates will move up only very gradually
(forward rates are affected by QE-related downward distortions). Italy is dangerously walking on a
tightrope. Avoiding entering bad equilibrium heavily relies on the possibility to enhance potential
growth quickly, and on speeding up the reform process.
9) In my view, the key issue for the long prosperity of the economy is to reduce current expenditure
sizeably, so as to make room for reform initiatives and a reduction in taxation, thereby enhancing
potential growth. As I argued above, there is also a need for urgent spending on social programmes and
active labour market policies to maintain employability and avoid the scarring effect of long-term
unemployment, and especially youth unemployment. The only way to achieve this is setting up efficient
performance budgeting procedures.

Bottom line: a balanced outlook but also a missed opportunity to be bolder
Fiscal targets are confirmed and the listing of all reforms introduced by the current government in just a
year is really impressive. Still, it would have been better to push ahead with structural spending cuts to
make extra room for urgently needed spending to (1) favour an improvement in the business environment,
(2) facilitate the transmission of monetary policy through the credit channel, (3) alleviate extreme poverty
and improve employability.
The key issue for fiscal sustainability and sustainable growth remains the implementation of the still
massive backlog of structural reforms, a big shake up of the incentive structure for economic agents, and
new political momentum for reforms. Job not yet done Mr Renzi!





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