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Dear Shareholder:

     We are pleased to present the annual report for The Italy Fund Inc.
("Fund") for the year ended January 31, 1998. As of that date, the Fund's net
asset value ("NAV") per share was $14.49 which represented an 18% increase
(including 0.2% from dividends) during the Fund's fiscal fourth quarter. The
Fund underperformed versus the 19.4% rise over the same time period in the BCI
Index (Banca Commerciale Italiana), a widely followed Italian index that
includes all the securities listed on the Milan Stock Exchange.

     For the year ended January 31, 1998, the Fund returned 21.59% on NAV versus
the 31.86% return for the BCI Index during the same period. (Please refer to the
Investment Strategy section on page three as to why the Fund underperformed
versus the Index for most of the reporting period.) As of January 31, 1998, the
Fund's total net assets were approximately $137.7 million.

Our Bullish Long-Term Outlook for Italian Stocks

     We are bullish on Italian stocks over the long term because of:

     -- The outstanding performance of recent privatizations that have created a
true shareholder culture in Italy.

     -- Short-term rates in Italy must converge toward core European rates and
that should make Italian bonds less attractive relative to Italian stocks.

     -- Italian mutual fund inflows remain very encouraging. Italian investors
poured a record 32.5 trillion lire ($18.3 billion) into funds in January 1998,
80% more than the previous monthly record and almost a quarter of 1997's inflow.

     -- Italy's leading banks are considering integrations to increase their
size, creating new investment opportunities.

     -- With the acceptance of a new tax system (IRAP) combined with a pick-up
in economic activity, corporate profits in Italy are estimated to rise by
approximately 25% in 1998 versus 1997 with an additional 15% profit increase in
1999. We think Italian stocks remain relatively inexpensive despite the market's
recent sharp advance.


--------------------------------------------------------------------------------

Special Shareholder Notice

     In 1997, the Directors of the Fund, based upon the recommendation of the
Investment Manager, proposed that the Fund be converted to a non-diversified
fund under the Investment Company Act of 1940 ("1940 Act") in order for the
Fund's portfolio manager to have maximum flexibility in managing the portfolio.
Unfortunately, the Fund was unable to obtain a sufficient number of affirmative
votes of the outstanding shares to approve the proposal, despite the fact that
the shareholders of the Fund who voted clearly favored the proposed change.

     The Fund's Board of Directors is once again recommending that shareholders
approve changing the Fund's sub-classification under the 1940 Act in order for
the Fund's portfolio manager to have maximum flexibility in managing the
portfolio. We are sending you a proxy that describes the proposed change in
greater detail and we ask for your vote prior to the shareholder meeting
scheduled to take place on Wednesday, May 13, 1998.

     Please review the proxy carefully. If you do not plan to attend the
meeting, we ask that you complete, sign, date and return the proxy as soon as
possible in the postage-paid envelope.

     It is important to note that if your broker holds your shares in the Fund,
he or she does not have the discretion to vote on this extremely important
proposal to change your Fund from a diversified to a non-diversified investment
company. Therefore, you are responsible for completing and returning the
proxy/voting instruction card that is being sent to you with the proxy. Remember
that your vote is extremely important!

--------------------------------------------------------------------------------
<PAGE>
 
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     -- Many foreign investors today are still underweighted in Italian stocks
and any renewed interest could have a very positive impact on Italian stock
prices over the long term.

Political Overview

     A majority of mayoral elections held throughout Italy in November recently
underscored some important changes that have taken place this past year. The
center-right coalition won big and the mainstream right parties for the most
part did poorly. Candidates backed by Prime Minister Romano Prodi's coalition
government won key mayoral elections, even in Naples, a city which has not been
generally supportive of the left. These election results were particularly
encouraging for Prodi, who resigned on October 9, 1997 after the Communist party
rejected his appeal for massive budget cuts. (The Prodi government quickly
withdrew its resignation and stayed in power.) On November 1, 1997, the Prodi
government pushed through a pension reform plan that many observers believe is
probably enough to persuade the European Commission that Italy's budget deficit
has been reduced sufficiently to enable it to join the single currency. Although
Italy appears to have secured a place in the European Monetary Union ("EMU"),
further pension reform is needed.

     Italy has been able to meet the Maastricht treaty criteria for admission in
the EMU primarily through new taxes and specifically a special one-time
"euro-tax" that has taken an estimated 1.8 million lire (roughly U.S. $1,000)
from every Italian middle-class family. And while the political odds now favor
Italy's admittance into the EMU, Italy's public-sector debt is still an
extremely large 122% of Gross Domestic Product ("GDP"). If Italy is to ever
fully exploit the benefits of its expected entrance into the EMU, its citizens
and politicians need to be prepared for greater fiscal austerity and serious
political reform.

Economic Overview

     As a moderate upturn in private consumption joined a surge in exports,
major economic indicators showed recently that Italy's economic recovery
gathered steam in the second half of 1997. GDP growth accelerated to about 2% in
the second half of the year following a gain of less than 1% in the first. In
our view, an expected reduction in both interest rates and bank lending rates,
combined with higher-corporate profitability, should boost business capital
outlays and residential investment.

     Therefore, we anticipate GDP growth in Italy to probably accelerate to
about 2 1/4% in 1998, reflecting the gradual and ongoing rebound of private
consumption. In our view, easier monetary policy and the end of massive fiscal
tightening should support the recovery of domestic demand in Italy in 1998.

     According to preliminary estimates from eleven cities, consumer prices rose
0.2% in January from the previous month and year-on-year inflation has remained
at around 1.5% since May 1997. January is usually a bad month for inflation
because of the quarterly or annual revision in a number of prices. The January
1998 Consumer Price Index ("CPI") reflected a seasonal increase in housing,
health and tourism components. In addition, several Italian cities reported
major food price increases -- a trend that began a few months ago. Weak oil
prices kept the CPI's transportation component flat. January's numbers further
confirm that the impact of the value-added tax on the economy instituted in
October will be less than initially feared by the Bank of Italy.

     The 75 basis point (0.75%) cut in official interest rates represents the
first step in the convergence of Italian short-term rates to those of core
European Union ("EU") countries. With Italy likely to join the EMU from the
outset, short-term rates should approach the projected initial euro rate (which
is now well below 4%) by the end of the year. Moreover, as the EMU deadline
looms and short-term interest rates decline, bond yield spreads versus Germany
will in all likelihood gradually narrow in the months ahead.

Investment Strategy

     As noted in our previous shareholder reports, the Fund did better than the
major Italian indices by a wide-margin in 1996, but underperformed sharply in
1997. 


                                       2
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The Fund's underperformance during its fiscal first and second quarters resulted
primarily because of the diversification rule of the 1940 Act. (Please see the
"Special Shareholder Notice" section at the beginning of this letter for more
details.) As a diversified investment company, no more than 25% of the Fund's
total assets may be invested in the securities of single issuers which exceed 5%
of the Fund's total assets. The diversification rule limited the Fund's ability
to invest in Telecom Italia S.p.A. (the principal operator of local,
long-distance and international phone services) and Telecom Italia Mobile S.p.A.
(Europe's largest cellular network provider) and Ente Nazionale Idrocarburi
S.p.A. (ENI, a private diversified energy company). Telecom Italia S.p.A. and
Telecom Italia Mobile S.p.A. were both stocks that strongly outperformed the
indices during this period.

     The Fund's underperformance in its fiscal fourth quarter (i.e., roughly 2%)
was caused by its underweighting in the banking sector, an industry that has
performed exceedingly well. This sector has been pushed to startling heights by
industry consolidation and investor enthusiasm regarding restructuring. However,
in our opinion, the condition of Italy's banking industry does not justify
current valuations. Just because one bad bank combines with another bad bank,
there are no guarantees that the new entity will be healthy and ultimately
successful.

     During the last two months, Banca di Roma and BCI announced ambitious plans
to achieve return on equity ("ROE") targets of about 10% by the year 2000 from
current levels of approximately 7%. While these targets are certainly food for
thought, we believe achieving these goals may be more difficult due to:

     -- A modest reduction in staffing due to union demands

     -- High averages of non-performing loans (i.e., roughly 16% for Banca di
Roma)

     -- Somewhat limited credit expansion due to low GDP growth

     -- Greater competition in the mutual fund industry which would force
management fees down from their arguably excessive 1.5% - 2% levels

     -- Shrinking retail deposit funding from lower rates

     Put simply, and leaving aside consolidation-induced euphoria, it seems
rather difficult to justify the current valuations of Italy's retail banks. In
our view, a strategy of investing in banks located in Northern Italy involved in
privatizations and accumulating assets is a more prudent course of action at
this time.

     As noted at the beginning of this letter, nothing has changed to alter our
positive long-term outlook for Italian stocks. In conclusion, we remain bullish
because of:

     -- The outstanding performance of recent privatizations such as Telecom
Italia, Banca di Roma, the third tranche of ENI and Aeroporti di Roma have
created a true shareholder culture in Italy. In addition, the concept of
enhancing shareholder value is finally being accepted by many Italian companies.

     -- As noted in our "Economic Overview" section, short-term rates in Italy
must converge toward core European rates. With close to a zero rate of inflation
compared to Germany, the short-term interest-rate differential in Italy will
probably narrow from the current 250 basis points (2.50%). Long-term rates could
slightly narrow further from 29 basis points (0.29%) on December 30, 1997 (as
opposed to 600 basis points (6%) two years ago).

     -- Italian mutual fund inflows remain very encouraging. In truth, the
figures for January 1998 were staggering, up roughly 74% year-to-year, of which
73% of this inflow went to bond funds. According to a recent Wall Street Journal
article, Italian investors poured a record 32.5 trillion lire ($18.3 billion)
into funds in January 1998, 80% more than the previous monthly record and almost
a quarter of 1997's inflow. And, as noted in our last shareholder


                                       3
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report, with the value of Italian bond funds at roughly 300 trillion lire (about
ten times the size of the Italian stock funds), the switch by Italian investors
from bond to stock funds should have an extremely beneficial effect on Italian
stock prices over the long term.

     -- As also previously discussed in this letter, Italy's leading banks are
considering integrations to increase their size, in particular, the IMI and S.
Paolo deal expected to occur in 1998 could also include Credito Italiano.
Moreover, Banca Intesa (a product of the merger between Ambroveneto and Cariplo)
and BCI have also stated they are open to mergers with other banks. And while
some current valuations are hard to justify, the consolidation taking place this
year in Italy's banking industry should have a particularly positive effect on
the entire market. In another development, Banca d'Italia has decided not to
allow RAS (part of Allianz in Germany) to increase its 5% stake in Credito
Italiano to 10%. Banca d'Italia is trying to find an Italian solution and is
considering possible mergers with other leading Italian banks.

     -- With the acceptance of a new tax system combined with a pick-up in
economic activity, corporate profits in Italy are estimated to rise by
approximately 25% in 1998 versus 1997 with an additional 15% profit increase in
1999. We therefore think Italian stocks remain relatively inexpensive despite
the market's recent sharp advance.

     -- Many foreign investors today are still underweighted in Italian stocks
today. Therefore, any renewed interest in the Italian stock market from foreign
investors could also have a very positive impact on Italian stock prices over
the long term.

     We have prepared a "Fund Profile" that is available monthly. To get your
free copy of the Italy Fund Profile you can either call (212) 816-6082 or e-mail
us at fund.italy@ssmb.com

     Thank you for investing in The Italy Fund Inc. and your continued
confidence in our management approach. We look forward to serving your
investment needs for many years to come.



Sincerely,



/s/ HEATHER B. MCLENDON                 /s/ MARIO D'URSO
-------------------------               ----------------
Heath B. McLendon                       Mario d'Urso
Chairman of the Board                   President



/s/ REIN W. VAN DER DOES
------------------------
Rein W. van der Does
Vice President and
Investment Officer

February 18, 1998


                                       4
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                      THE ITALY FUND'S SECTORIAL STRUCTURE*
                          JANUARY 31, 1998 (unaudited)

 [THE FOLLOWING TABLE WAS REPRESENTED BY A PIE CHART IN THE PRINTED MATERIAL.]

<TABLE>
<S>                                                      <C> 
                     Automotive                          6.4%
                     Banking                            18.2%
                     Construction                        1.9%
                     Consumer Staples - Food             4.7%
                     Consumer Staples - Retail           4.0%
                     Energy - Exploration                2.8%
                     Energy - International              9.9%
                     Engineering                         1.7%
                     Holding Companies                   1.3%
                     Insurance                          15.8%
                     Miscellaneous                       2.0%
                     Telecommunications - Wireless       6.9%
                     Telecommunications - Telephone     20.3%
                     Consumer Cyclical - Textiles        3.1%
                     Utilities                           1.0%
</TABLE>


                                     
                          BCI INDEX SECTORIAL STRUCTURE
                          JANUARY 31, 1998 (unaudited)

<TABLE>
<S>                                                      <C> 
                     Automotive                          6.2%
                     Banking                            26.1%
                     Construction                        1.9%
                     Consumer Products                   1.7%
                     Energy                             14.4%
                     Engineering                         1.9%
                     Food                                1.8%
                     Insurance                          15.3%
                     Miscellaneous                       2.0%
                     Telecommunications                 26.1%
                     Textiles                            2.2%
                     Utilities                           0.4%
</TABLE>
                                       
*As a percentage of total investments.


                                       5
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THE ITALY FUND INC.

Schedule of Investments as of January 31, 1998
================================================================================
<TABLE>
<CAPTION>
   Shares           Security                                           Value    
--------------------------------------------------------------------------------
================================================================================
COMMON STOCK -- 100%
================================================================================
<S>                                                                <C> 
Automotive -- 6.4%
      181,250  Brembo S.p.A.                                       $  1,941,508
    1,000,000  Pirelli S.p.A.                                         2,631,915
    1,525,000  Sogefi S.p.A.                                          4,238,625
                                                                   ------------
                                                                      8,812,048
                                                                   ------------
Banking -- 18.2%                                                    
    1,700,000  Banca Fideuram S.p.A.                                  8,864,606
      150,000  Banca Popolare di Brescia                              1,663,746
      900,000  Banca Popolare di Milano                               7,394,648
      500,000  Istituto Mobiliare                                   
                 Italiano S.p.A.                                      6,955,774
                                                                   ------------
                                                                     24,878,774
                                                                   ------------
Construction -- 1.9% 600,000 Unicem S.p.A.                          
                 di Risp NC *                                         2,592,985
                                                                   ------------
Consumer Cyclical - Textiles -- 3.1%                                
       55,000  Fila Holding S.p.A. ADR                                1,165,312
       45,000  Gucci Group N.V.-- NY                                
                 Registered Shares                                    1,791,563
      400,000  Ittierre Holding S.p.A. #                              1,234,216
                                                                   ------------
                                                                      4,191,091
                                                                   ------------
Consumer Staples - Food -- 4.7%           
      544,027  Autogrill S.p.A. #                                     2,993,695
    2,212,000  Parmalat Finanziaria S.p.A.                            3,481,301
                                                                   ------------
                                                                      6,474,996
                                                                   ------------
Consumer Staples - Retail -- 4.0%                                   
       50,000  Industrie Natuzzi                                    
                 S.p.A. ADR                                           1,225,000
      500,000  La Rinascente S.p.A.                                 
                 di Risp NC *                                         2,011,646
      260,000  Recordati S.p.A.                                     
                 di Risp NC *                                         1,187,500
    1,000,000  Seat S.p.A. #                                            379,759
    2,702,500  Seat S.p.A. di Risp NC * #                               673,808
                                                                   ------------
                                                                      5,477,713
                                                                   ------------
Energy - Exploration -- 2.8%
      700,000  Saipem S.p.A.                                          3,800,360
                                                                   ------------
Energy - International -- 9.9%
    2,300,000  Ente Nazionale
                 Idrocarburi S.p.A.                                  13,521,309
                                                                   ------------
Engineering -- 1.7%                                                  
      180,000  Danieli & Co.                                          1,227,783
      266,750  Danieli & Co.                                         
                 di Risp NC *                                         1,030,610
                                                                   ------------
                                                                      2,258,393
                                                                   ------------
Holding Companies -- 1.3%                                            
    2,700,000  Holding di Partecipazioni                             
                 S.p.A. #                                             1,835,686
                                                                   ------------
Insurance -- 15.8%                                                   
      450,000  Alleanza Assicurazioni                                
                 S.p.A.                                               5,403,993
      240,000  Assicurazioni Generali                                
                 S.p.A.                                               6,564,547
    3,300,000  Instituto Nazionale                                   
                 Delle Assicurazioni                                  7,312,796
      225,700  Riunione Adriatica                                    
                 di Sicurta S.p.A.                                    2,406,382
                                                                   ------------
                                                                     21,687,718
                                                                   ------------
Miscellaneous -- 2.0%                                                
      200,000  Aeroporti di Roma S.p.A #                              2,576,126
      850,000  Europa Investimenti #+                                   212,117
                                                                   ------------
                                                                      2,788,243
                                                                   ------------
Telecommunications - Telephone -- 20.3%                              
    2,064,440  Telecom Italia S.p.A.                                 14,310,550
    2,724,500  Telecom Italia S.p.A.                                 
                 di Risp NC *                                        13,460,458
                                                                   ------------
                                                                     27,771,008
                                                                   ------------
Telecommunications - Wireless -- 6.9%                                
    1,976,000  Telecom Italia                                        
                 Mobile S.p.A.                                        9,373,467
                                                                   ------------
</TABLE>

                        See Notes to Financial Statements

                                       6
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THE ITALY FUND INC.

Schedule of Investments as of January 31, 1998 (continued)
================================================================================
<TABLE>
<CAPTION>
   Shares           Security                                           Value    
--------------------------------------------------------------------------------
<S>                                                                <C> 
Utilities -- 1.0%                                                    
      356,000  Italgas S.p.A.                                      $  1,402,086
                                                                   ------------
               TOTAL INVESTMENTS                                     
               AT VALUE -- 100%            
               (Cost -- $87,522,710**)                             $136,865,877
                                                                   ============
</TABLE>

----------
*    Risp NC -- Risparmio Non-Convertible (non-convertible savings shares).
#    Non-income producing security.
+    Restricted security (See Note 4).
**   Aggregate cost for Federal income tax purposes is substantially the same.

                       See Notes to Financial Statements.

                                       7
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THE ITALY FUND INC.

Statement of Assets and Liabilities
January 31, 1998 
================================================================================
<TABLE>
<CAPTION>
<S>                                                                       <C>          
ASSETS:
   Investments, at value (Cost--$87,522,710) ..........................   $ 136,865,877
   Foreign currency (Cost--$554,019) ..................................         552,795
   Cash ...............................................................          47,605
   Dividends and interest receivable ..................................         132,630
   Receivable for securities sold .....................................         371,622
                                                                          -------------
   Total Assets .......................................................     137,970,529
                                                                          -------------

LIABILITIES:
   Management fees payable ............................................         106,472
   Accrued expenses ...................................................         152,363
                                                                          -------------
   Total Liabilities ..................................................         258,835
                                                                          -------------
Total Net Assets ......................................................   $ 137,711,694
                                                                          =============

NET ASSETS:
   Par value of capital shares ........................................   $      95,031
   Capital paid in excess of par value ................................      94,826,379
   Overdistributed net investment income ..............................        (310,826)
   Accumulated net realized loss from security transactions ...........      (6,215,536)
   Net unrealized appreciation of investments and foreign currencies ..      49,316,646
                                                                          -------------

Total Net Assets
   (Equivalent to $14.49 a share on 9,503,089 shares of $0.01 par value
     outstanding; 20,000,000 shares authorized) .......................   $ 137,711,694
                                                                          =============
</TABLE>

                       See Notes to Financial Statements

                                       8
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THE ITALY FUND INC.

Statement of Operations
For the Year Ended January 31, 1998
================================================================================
<TABLE>
<CAPTION>
<S>                                                                <C>         
INVESTMENT INCOME:
   Dividends ..................................................    $  2,325,367
   Interest ...................................................         152,299
   Less: Foreign withholding tax ..............................        (327,148)
                                                                   ------------
   Total Investment Income ....................................       2,150,518
                                                                   ------------

EXPENSES:
   Management fees (Note 2) ...................................       1,072,169
   Directors' fees ............................................         120,002
   Custody ....................................................          89,696
   Audit and legal ............................................          69,999
   Shareholder communications .................................          50,001
   Shareholder and system servicing fees ......................          47,501
   Other ......................................................           7,381
                                                                   ------------
   Total Expenses .............................................       1,456,749
                                                                   ------------
Net Investment Income .........................................         693,769
                                                                   ------------

REALIZED AND UNREALIZED GAIN ON INVESTMENTS
AND FOREIGN CURRENCIES (NOTE 3 ):
   Realized Gain (Loss) From:
     Security transactions (excluding short-term securities) ..       1,229,071
     Foreign currency transactions ............................        (491,263)
                                                                   ------------
   Net Realized Gain ..........................................         737,808
                                                                   ------------
   Change in Net Unrealized Appreciation of Investments
     and Foreign Currencies:
        Beginning of year .....................................      26,279,197
        End of year ...........................................      49,316,646
                                                                   ------------
   Increase in Net Unrealized Appreciation ....................      23,037,449
                                                                   ------------
Net Gain on Investments and Foreign Currencies ................      23,775,257
                                                                   ------------
Increase in Net Assets From Operations ........................    $ 24,469,026
                                                                   ============
</TABLE>

                       See Notes to Financial Statements

                                       9
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THE ITALY FUND INC.

<TABLE>
<CAPTION>
                                                                    For the Year Ended
                                                                        January 31,
                                                               ------------------------------
Statements of Changes in Net Assets                                1998             1997
=============================================================================================
<S>                                                            <C>              <C>          
OPERATIONS:
   Net investment income ...................................   $     693,769    $     944,515
   Net realized gain .......................................         737,808          168,703
   Increase in net unrealized appreciation .................      23,037,449       23,759,645
                                                               -------------    -------------
   Increase in Net Assets From Operations ..................      24,469,026       24,872,863
                                                               -------------    -------------

DISTRIBUTIONS TO SHAREHOLDERS FROM:
   Net investment income ...................................        (190,062)      (2,280,742)
                                                               -------------    -------------
   Decrease in Net Assets From Distributions to Shareholders        (190,062)      (2,280,742)
                                                               -------------    -------------
Increase in Net Assets .....................................      24,278,964       22,592,121

NET ASSETS:
   Beginning of year .......................................     113,432,730       90,840,609
                                                               -------------    -------------
   End of year* ............................................   $ 137,711,694    $ 113,432,730
                                                               =============    =============
*Includes overdistributed net investment income of: ........   $    (310,826)   $    (917,714)
                                                               =============    =============
</TABLE>

                       See Notes to Financial Statements.

                                       10
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THE ITALY FUND INC.

Notes to Financial Statements
================================================================================

     1.   Significant Accounting Policies

     The Italy Fund Inc. ("Fund"), a Maryland corporation, is registered with
the Securities and Exchange Commission under the Investment Company Act of 1940,
as amended, as a diversified, closed-end management investment company.

     The significant accounting policies followed by the Fund are: (a) security
transactions are accounted for on trade date; (b) securities traded on national
securities markets are valued at the closing price in the primary exchange on
which they are traded; securities for which no sales price was reported on that
date are valued at the mean between the bid and ask price. Securities which are
listed or traded on more than one exchange or market are valued at the
quotations on the exchange or market determined to be the primary market for
such securities. If bid and ask quotations are not available, then
over-the-counter securities will be valued as determined in good faith by the
Board of Directors; (c) securities maturing within 60 days are valued at cost
plus accreted discount, or minus amortized premium, which approximates value;
(d) gains or losses on the sale of securities are calculated by using the
specific identification method; (e) interest income, adjusted for amortization
of premium and accretion of discount, is recorded on an accrual basis; (f)
dividend income is recorded on the ex-dividend date; foreign dividends are
recorded on the ex-dividend date or as soon as practical after the Fund
determines the existence of a dividend declaration after exercising reasonable
due diligence; (g) dividends and distributions to shareholders are recorded on
the ex-dividend date; (h) the accounting records are maintained in U.S. dollars.
All assets and liabilities denominated in foreign currencies are translated into
U.S. dollars based on the rate of exchange of such currencies against U.S.
dollars on the date of valuation. Purchases and sales of securities, and income
and expenses are translated at the rate of exchange quoted on the respective
date that such transactions are recorded. Differences between income or expense
amounts recorded and collected or paid are adjusted when reported by the
custodian bank; (i) the Fund intends to comply with the applicable provisions of
the Internal Revenue Code of 1986, as amended, pertaining to regulated
investment companies and to make distributions of taxable income sufficient to
relieve it from substantially all Federal income and excise taxes; (j) the
character of income and gains to be distributed are determined in accordance
with income tax regulations which may differ from generally accepted accounting
principles. Accordingly, overdistributed net investment income of $110,310 has
been reclassified to paid-in capital at January 31, 1998. Net investment income,
net realized gains and net assets were not affected by this adjustment; and (k)
estimates and assumptions are required to be made regarding assets, liabilities
and changes in net assets resulting from operations when financial statements
are prepared. Changes in the economic environment, financial markets and any
other parameters used in determining these estimates could cause actual results
to differ.

     In addition, the Fund may enter into forward exchange contracts in order to
hedge against foreign currency risk. These contracts are marked to market daily,
by recognizing the difference between the contract exchange rate and the current
market rate as an unrealized gain or loss. Realized gains or losses are
recognized when the contracts are settled.

     At January 31, 1998, there were no open forward foreign currency contracts.

     2.   Management Agreement and Transactions with Affiliated Persons

     Mutual Management Corp. ("MMC"), formerly known as Smith Barney Mutual
Funds Management Inc., a subsidiary of Salomon Smith Barney Holdings, Inc.
("SSBH"), acts as investment manager of the Fund. The Fund pays MMC a fee
calculated at an annual rate of 0.95% of the average daily net assets for all
management and administrative services. This fee is calculated daily and paid
monthly.

     All officers (except one) and one Director of the Fund are employees of
Smith Barney Inc., another subsidiary of SSBH.


                                       11
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THE ITALY FUND INC.

Notes to Financial Statements (continued)
================================================================================

     3.   Securities Transactions

     During the year ended January 31, 1998, the aggregate cost of purchases and
proceeds from sales of investments (including maturities, but excluding
short-term securities) were as follows:

<TABLE>
================================================================================
<S>                                                                  <C>        
Purchases                                                            $21,810,417
--------------------------------------------------------------------------------
Sales                                                                 18,174,227
================================================================================
</TABLE>

     At January 31, 1998, aggregate gross unrealized appreciation and
depreciation of investments for Federal income tax purposes were substantially
as follows:
<TABLE>
================================================================================
<S>                                                                 <C>        
Gross unrealized appreciation                                       $53,483,966
Gross unrealized depreciation                                        (4,140,799)
--------------------------------------------------------------------------------
Net unrealized appreciation                                         $49,343,167
================================================================================
</TABLE>

     4.   Securities Valued by the Fund's Board of Directors

     Certain of the Fund's investments are valued at the direction of the Fund's
Board of Directors; these securities are restricted as to resale and have been
valued in good faith, taking into consideration the appropriate economic,
financial and other pertinent available information pertaining to the restricted
securities. The table below shows the security valued by the Fund's Board of
Directors:

<TABLE>
<CAPTION>
                                     Number of     Acquisition        1/31/98       Value Per     Percentage of     
     Security                          Shares          Date          Fair Value       Unit          Net Assets          Cost
     --------                        ---------     -----------      ----------      ---------     -------------       --------
<S>                                    <C>           <C>              <C>             <C>              <C>            <C>     
Europa Investimenti ...........        850,000       7/2/91           $212,117        $0.25            0.15%          $623,396
</TABLE>

     5.   Capital Loss Carryforwards

     At January 31, 1998, the Fund had, for Federal income tax purposes,
approximately $6,216,000 of capital loss carryforwards available to offset
future capital gains. To the extent that these carryforward losses are used to
offset capital gains, it is probable that the gains so offset will not be
distributed. The amount and expiration of the carryforwards are indicated below.
Expiration occurs on January 31 of the year indicated:

<TABLE>
<CAPTION>
                                              2002         2004         2005
                                           ----------   ----------   --------
<S>                                        <C>          <C>          <C>     
     Carryforward Amounts ..........       $1,011,000   $5,027,000   $178,000
                                           ==========   ==========   ========
</TABLE>

     6.   Concentration of Risk

     Because the Fund concentrates its investments in securities issued by
Italian corporations, its portfolio may be subject to special risks and
considerations not typically associated with investing in a broader range of
domestic securities. In addition, the Fund is more susceptible to factors
adversely affecting the Italian economy than a fund not concentrated in these
issuers to the same extent.


                                       12
<PAGE>
 
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THE ITALY FUND INC.

Financial Highlights
================================================================================

     Set forth below is per share operating performance data for a share of
common stock outstanding throughout each year; total return and ratios to
average net assets are also provided. This information has been derived from
information provided in the financial statements and market price data for the
Fund's shares.

<TABLE>
<CAPTION>
                                                    1998             1997             1996           1995             1994(1)
=============================================================================================================================
<S>                                            <C>              <C>              <C>             <C>             <C>         
Net Asset Value, Beginning of Year .........   $      11.94     $       9.56     $       9.82    $       9.84    $       8.43
                                               ------------     ------------     ------------    ------------    ------------
Income (Loss) From Operations:
   Net investment income ...................           0.07             0.10             0.15            0.09            0.12
   Net realized and unrealized gain (loss) .           2.50             2.52            (0.39)           0.06            1.72
                                               ------------     ------------     ------------    ------------    ------------
Total Income (Loss) From Operations ........           2.57             2.62            (0.24)           0.15            1.84
                                               ------------     ------------     ------------    ------------    ------------
Dilution in NAV From Rights Offering .......           --               --               --              --             (0.32)
                                               ------------     ------------     ------------    ------------    ------------
Offering Expenses Charged to Paid-in Capital           --               --               --              --             (0.03)
                                               ------------     ------------     ------------    ------------    ------------
Less Distributions From:
   Net investment income ...................          (0.02)           (0.24)           (0.02)          (0.17)          (0.07)
   Capital .................................           --               --               --              --             (0.01)
                                               ------------     ------------     ------------    ------------    ------------
Total Distributions ........................          (0.02)           (0.24)           (0.02)          (0.17)          (0.08)
                                               ------------     ------------     ------------    ------------    ------------
Net Asset Value, End of Year ...............   $      14.49     $      11.94     $       9.56    $       9.82    $       9.84
                                               ============     ============     ============    ============    ============
Market Value, End of Year ..................   $     12.125     $     10.000     $      8.250    $      8.750    $     12.375
                                               ============     ============     ============    ============    ============
Total Return, Based on Market Value ........          21.53%           24.49%           (5.51)%        (27.90)%       40.54%#
                                               ============     ============     ============    ============    ============
Total Return, Based on Net Asset Value .....          21.59%           28.27%           (2.43)%         (3.68)%         33.04%
                                               ============     ============     ============    ============    ============
Net Assets, End of Year (000's) ............   $    137,712     $    113,433     $     90,841    $     93,347    $     93,518
                                               ============     ============     ============    ============    ============
Ratios to Average Net Assets:
   Net investment income ...................           0.61%            0.97%            1.12%           0.85%           1.30%
   Expenses(2) .............................           1.29             1.42             1.42            1.69            1.69

Portfolio Turnover Rate ....................             16%              47%              58%             42%             46%

Average commissions per share paid on
   equity transactions(3) ..................   $       0.01     $       0.01     $       0.00*           --              --
</TABLE>

----------
(1)  Per share amounts have been calculated using the monthly average shares
     method, rather than the undistributed net investment income method, because
     it more accurately reflects the per share data for the period.
(2)  During the years ended January 31, 1997 and January 31, 1996, the Fund
     earned credits from the custodian which reduced service fees incurred. If
     the credits are taken into consideration, the ratios of expenses to average
     net assets would have been 1.42% and 1.41%, respectively. Prior year
     numbers have not been restated to reflect this credit.
(3)  As of September 1995, the SEC instituted new guidelines requiring the
     disclosure of average commissions per share.
#    The total return for the year ended January 31, 1994, adjusted for the
     effect of the rights offering completed in January of 1994 is 45.85%
     (unaudited). * Amount represents less than $0.01.


                                       13
<PAGE>
 
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THE ITALY FUND INC.

Independent Auditor's Report
================================================================================

The Shareholders and Board of Directors of The Italy Fund Inc.:

     We have audited the accompanying statement of assets and liabilities,
including the schedule of investments, of The Italy Fund Inc. as of January 31,
1998, the related statement of operations for the year then ended, the statement
of changes in net assets for each of the years in the two-year period then
ended, and the financial highlights for each of the years in the three-year
period then ended. These financial statements and financial highlights are the
responsibility of the Fund's management. Our responsibility is to express an
opinion on these financial statements and financial highlights based on our
audits. The financial highlights for each of the years in the two-year period
ended January 31, 1995 were audited by other auditors whose report thereon,
dated March 10, 1995, expressed an unqualified opinion on those financial
highlights.

     We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements and financial
highlights are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. Our procedures included confirmation of securities owned as of
January 31, 1998, by correspondence with the custodian. As to securities sold
but not yet delivered, we performed other appropriate auditing procedures. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

     In our opinion, the financial statements and financial highlights referred
to above present fairly, in all material respects, the financial position of The
Italy Fund Inc. as of January 31, 1998, the results of its operations for the
year then ended, the changes in its net assets for each of the years in the
two-year period then ended and financial highlights for each of the years in the
three-year period then ended, in conformity with generally accepted accounting
principles.


                                   /s/ KMPG PEAT MARWICK LLP


New York, New York
March 14, 1998


                                       14
<PAGE>
 
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THE ITALY FUND INC.

Quarterly Results of Operations (unaudited)
===============================================================================
<TABLE>
<CAPTION>
                                                                                      Net Realized
                                                                                      and Unrealized              Net Increase
                                                                                      Gain (Loss) on             (Decrease) in
                                    Investment              Net Investment            Investments and              Net Assets
                                      Income                 Income (Loss)           Foreign Currencies          From Operations
                             -----------------------  ------------------------   ------------------------   ------------------------
Quarter Ended                    Total     Per Share      Total      Per Share       Total      Per Share      Total       Per Share
-------------                -----------   ---------  ------------   ---------   ------------   ---------   -----------    ---------
<S>                          <C>             <C>      <C>              <C>       <C>              <C>       <C>              <C>  
April 30, 1993 ...........   $    208,399    $0.03    $    (22,200)    $0.00     $   (633,996)    $(0.10)   $  4,646,508     $0.73
July 31, 1993 ............      1,164,578     0.19         946,601      0.14         (673,685)    (0.10)       2,566,981      0.41
October 31, 1993 .........        231,050     0.04         (51,313)    (0.01)        (330,679)    (0.05)       1,139,682      0.17
January 31, 1994 .........        163,184     0.03        (104,964)    (0.01)      (1,350,029)    (0.21)       4,843,089      0.53
April 30, 1994 ...........        262,201     0.03          37,867      0.01          376,390      0.04       21,587,589      2.27
July 31, 1994 ............      1,568,187     0.17         933,702      0.10        2,317,766      0.24      (12,011,879)    (1.26)
October 31, 1994 .........        275,691     0.03          19,893      0.00          578,197      0.06       (6,426,246)    (0.68)
January 31, 1995 .........        396,171     0.04        (152,088)    (0.02)      (2,089,977)    (0.22)      (1,682,024)    (0.18)
April 30, 1995 ...........        252,540     0.03         (74,178)    (0.01)      (1,556,369)    (0.16)      (6,441,384)    (0.68)
July 31, 1995 ............      1,539,509     0.16       1,141,497      0.12       (1,724,100)    (0.18)       4,471,408      0.47
October 31, 1995 .........        287,963     0.03         (81,879)    (0.01)        (172,867)    (0.02)      (6,926,030)    (0.72)
January 31, 1996 .........        282,141     0.03         145,834      0.02         (210,636)    (0.02)       6,579,545      0.69
April 30, 1996 ...........        176,114     0.02        (188,803)    (0.02)      (1,589,084)    (0.16)      (1,777,887)    (0.18)
July 31, 1996 ............      1,944,252     0.20       1,539,905      0.16        2,953,107      0.31        4,493,012      0.47
October 31, 1996 .........         57,105     0.01        (336,620)    (0.04)       3,116,522      0.33        2,779,902      0.29
January 31, 1997 .........        144,366     0.02         (69,967)    (0.01)      19,447,803      2.05       19,377,836      2.04
April 30, 1997 ...........        106,945     0.01        (238,794)    (0.03)     (11,469,551)    (1.21)     (11,708,345)    (1.24)
July 31, 1997 ............      1,945,510     0.20       1,591,023      0.17        8,346,576      0.88        9,937,599      1.05
October 31, 1997 .........         18,406     0.00        (364,305)    (0.04)       5,549,880      0.59        5,185,575      0.55
January 31, 1998 .........         79,657     0.01        (294,155)    (0.03)      21,348,352      2.24       21,054,197      2.21
</TABLE>


                                       15
<PAGE>
 
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THE ITALY FUND INC.

Dividend Reinvestment and Cash Purchase Plan (unaudited)
================================================================================

     Pursuant to the Fund's Dividend Reinvestment and Cash Purchase Plan
("Plan"), a shareholder of the Fund whose shares are registered in his own name
will automatically be a participant in the Plan and will have all distributions
automatically reinvested in additional shares of the Fund by First Data Investor
Services Group, Inc., ("First Data"), as dividend-paying agent under the Plan,
unless the shareholder informs First Data that he elects to receive
distributions in cash. Distributions with respect to shares registered in the
name of a broker-dealer or nominee ("Nominee"), which holds shares for others
(that is, in "street name"), may be reinvested by the Nominee in additional
shares under the Plan, but only if the service is provided by the Nominee and
the Nominee makes an election on behalf of the shareholder to participate in the
Plan. Investors who own Fund shares registered in street name should consult
their Nominee for details regarding reinvestment. Shareholders who do not
participate in the Plan will receive all distributions in cash paid in dollars
by check mailed directly to the shareholder by First Data as dividend paying
agent.

     The number of shares of common stock participants in the Plan receive in
lieu of a cash dividend is determined in the following manner. Whenever the
market price of Fund shares is equal to or exceeds the net asset value of Fund
shares at the time such shares are valued for the purpose of determining the
number of shares equivalent to the cash dividend or distribution, participants
will be issued shares of the Fund at the greater of (i) net asset value per
share or (ii) 95% of the then current market value. If net asset value exceeds
the market price of Fund shares at such time, or if the Fund should declare a
dividend or other distribution payable only in cash, First Data will buy Fund
shares in the open market, on the New York Stock Exchange or elsewhere, as soon
as practicable after the record date for the dividend or distribution, until it
has expended for such purchases all of the cash that would otherwise be payable
to the participants. The number of purchased shares that will then be credited
to the participants' accounts is based on the average per share purchase price
of Fund shares so purchased, including brokerage commissions. Additionally, if
the market price exceeds the net asset value of Fund shares before First Data
has completed its purchases, First Data is permitted to cease purchasing shares
and the Fund may issue the remaining shares at the greater of (a) net asset
value or (b) 95% of the then current market price.

     Participants in the Plan have the option of making additional semi-annual
cash payments to First Data in any amount from $100 to $3,000 for investment in
Fund shares. First Data uses all funds so received (as well as any dividends and
capital gains distributions received in cash) to purchase Fund shares in the
open market on or about February 15 and August 15 of each year.

     Plan participants are not subject to any charge for reinvesting dividends
or capital gains distributions. Each Plan participant will, however, bear a pro
rata share of brokerage commissions incurred with respect to First Data's open
market purchases of Fund shares in connection with the reinvestment of dividends
or capital gains distributions.

     The automatic reinvestment of dividends and capital gains distributions
does not relieve Plan participants of any income tax that may be payable on the
dividends or capital gains distributions. A participant in the Plan is treated
for federal income tax purposes as having received, on the dividend payment
date, a dividend or distribution in an amount equal to the cash that the
participant could have received instead of shares.


                                       16
<PAGE>
 
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THE ITALY FUND INC.

Dividend Reinvestment and Cash Purchase Plan (unaudited)(continued)
================================================================================

     A shareholder may terminate participation in the Plan at any time by
notifying First Data in writing. A termination will be effective immediately if
notice is received by First Data no less than 10 days before any dividend or
distribution record date. Otherwise, the termination will be effective, with
respect to any subsequent dividends or distributions, on the first day after the
dividend or distribution has been credited to the participant's account in
additional shares of the Fund. Upon termination and according to a participant's
instructions, First Data will either (i) issue certificates for the shares
credited to a shareholder's Plan account together with a check representing any
fractional shares or (ii) sell such shares in the market.

     Information concerning the Plan may be obtained from First Data at
1-800-331-1710. 

                                   ----------

     Notice is hereby given in accordance with Section 23(c) of the Investment
Company Act of 1940, as amended, that from time to time the Fund may purchase
shares of its common stock in the open market.

Tax Information (unaudited)
================================================================================

     For Federal tax purposes the Fund hereby designates for the fiscal year
ended January 31, 1998:

     The total amount of income received by the Fund from sources within foreign
countries and possessions of the United States was $0.2607 per share
(representing a total of $2,477,666). The total amount of taxes paid by the Fund
to such countries was $0.0344 per share (representing a total of $327,148).

     The above figures may differ from those cited elsewhere in this report due
to differences in the calculations of income and capital gains for Securities
and Exchange Commision (book) purposes and Internal Revenue Service (tax)
purposes.


                                       17
<PAGE>
 
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                               THE ITALY FUND INC.

--------------------------------------------------------------------------------

INVESTMENT MANAGER AND                  OFFICERS                  
ADMINISTRATOR                           Heath B. McLendon         
                                           Chairman of the Board  
Mutual Management Corp.                                           
388 Greenwich Street                    Mario d'Urso              
New York, New York 10013                   President              
                                                                  
ADVISORY BOARD                          Lewis E. Daidone          
                                           Senior Vice President  
Andrea Farace                              and Treasurer          
Pierre Henchoz                                                    
Dott. Pietro Manes                      Rein W. van der Does      
                                           Vice President         
DIRECTORS                                  and Investment Officer 
                                                                  
Heath B. McLendon                       Irving P. David           
Paolo M. Cucchi                            Controller             
Alessandro C. di Montezemolo                                      
Dr. Paul R. Hardin                      Christina T. Sydor        
George M. Pavia                            Secretary              
Mario d'Urso                                                      

--------------------------------------------------------------------------------


                                       18
<PAGE>
 
                                                             THE ITALY FUND INC.

==========================================================================[LOGO]

--------------------------------------------------------------------------------
This report is intended only for the shareholders of The Italy Fund Inc. It is
not a Prospectus, circular or representation intended for use in the purchse or
sale of shares of the Fund or of any securities mentioned in this report.
--------------------------------------------------------------------------------

--------------------------------------------------------------------------------
Comparisons between changes in the Fund's net aset value per share and changes
in The Banca Commerciale Italiana Index should be considered in light of the
Fund's investment policy and objectives, the characteristics and quality of the
Fund's investments, the size of the Fund and variations in the Lira/Dollar
exchange rate. This Index generally reflects ordinary shares (as opposed to
savings shares).

--------------------------------------------------------------------------------

                               THE ITALY FUND INC.
                              388 Greenwich Street
                            New York, New York 10013
                                  (212)816-4605
                                  FD01090 3/98

                                                                Annual
                                                                Report
                                                                January 31, 1998