EUROPEAN COMMISSION Brussels, 26.2.2020 SWD(2020) 511 final COMMISSION STAFF WORKING DOCUMENT Country Report Italy 2020 Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE EUROPEAN COUNCIL, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2020 European Semester: Assessment of progress on structural reforms, prevention and correction of macroeconomic imbalances, and results of in-depth reviews under Regulation (EU) No 1176/2011 {COM(2020) 150 final}



Contents Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Overall findings regarding imbalances, risks and adjustment issues 4.Reform priorities 4.1.Public finances and taxation 4.2.Financial sector 4.3.Labour market, education and social policies 4.4. Competitiveness, reforms and investment 4.5.Environmental sustainability Annex A: Overview Table Annex B: Commission debt sustainability analysis and fiscal risks Annex C: Standard Tables Annex D: Investment Guidance on Just Transition Fund 2021-2027 for Italy Annex E: Progress towards the Sustainable Development Goals (SDGs) References LIST OF Tables

Table 1.1:Key economic and financial indicators - Italy Table 2.1:Assessment of 2019 CSR implementation (*) Table 3.1a:Spillover effects of Italy implementing an investment programme over 10 years - Central scenario Table 3.1:MIP Assessment Matrix Table 4.3.1:Labour market slack LS4 (Nuts2) composition, 2018 Table 4.3.1a:Assessment of barriers to investment and ongoing reforms Table C.1:Financial Market Indicators Table C.2:Headline social scoreboard indicators Table C.3:Labour market and education indicators Table C.4:Social inclusion and health indicators Table C.5:Product market performance and policy indicators Table C.6:Green growth Table E.1:Indicators measuring Italy’s progress towards the SDGs LIST OF Graphs Graph 1.1: Real GDP growth and components Graph 1.2: Potential growth and components Graph 1.3: Labour market developments Graph 1.4: Wages, labour costs and productivity Graph 1.5: Lending volumes and interest rates, private sector

Graph 1.6: Current account balance Graph 1.7: Public finances indicators Graph 2.1: Overall multiannual implementation of 2011-2019 CSRs to date Graph 4.1.1: Drivers of the "snowball” effect on public debt Graph 4.1.2: Italy's sovereign yields Graph 4.1.3: Tax wedge across income levels Graph 4.3.1: Transition rates and share of temporary employment Graph 4.3.2: Early school leavers by NUTs 2 region (%) Graph 4.3.3: Public spending on anti-poverty schemes Graph 4.4.1: Productivity growth per hour worked, 2008-2018 Graph 4.4.2: Evolution of the "ease of doing business indicator" (100=top performer) Graph 4.4.3: OECD Product Market regulation indicator evolution Graph 4.4.4: Regional Competitiveness Index in Italy, 2019 Graph 4.5.1: Green-house gas emissions by sector, 2017 LIST OF Boxes Box 2.1: EU funds and programmes to address structural challenges and to foster growsth and competitiveness in Italy Box 3.1: Public investment and potential spillovers – The case of Italy Box 4.1.1: EUROMOD-QUEST simulation - Shifting taxes from labour to property in Italy Box 4.3.1: Monitoring performance in light of the European Pillar of Social Rights 43

Box 4.4.1: Investment Challenges Box 4.5.1: Policies related to water and waste management in Calabria, Campania and Sicily Executive summary Facing a weak macroeconomic outlook and the challenge of ensuring sustainability, lifting productivity and potential growth is key to reducing Italy's public debt ratio and unwinding its macroeconomic imbalances. Implementing ambitious structural reforms and prudent fiscal policies, and well-targeting investments would support Italy’s digital and environmental transformation, ensuring sustainable growth. As a matter of priority, a revived reform momentum should ensure sound public finances, more effective public administration and justice, a more efficient education system and labour market, a friendlier business environment and a more resilient banking sector ( ). Economic activity in Italy remains weak, despite a gradually improving labour market. After real GDP growth of 0.8% in 2018, GDP expanded by 0.2% in 2019 and is expected to grow by 0.3% and 0.6% in 2020 and 2021. Domestic demand remains subdued, as real disposable income remains below pre-crisis levels and savings have risen. However, the new minimum income scheme introduced in 2019 and the sizeable drop in interest rates are expected to support household spending. Despite showing signs of recovery in 2019, public investment remains below pre-crisis levels. Sluggish productivity growth is still hindering Italy’s economic recovery. A number of downside risks persist, especially concerning the international trading context and domestic stability. While the employment rate remains well below the EU average, particularly for women and young people, it continued to increase in 2019, driven by permanent contracts especially in the North. The unemployment rate declined to 9.8% in Q3-2019 from 10.3% a year earlier. However, wide gaps in employment rates remain between the country’s regions. Italy has made some progress in addressing the 2019 country-specific recommendations( ). There has been substantial progress in: fighting tax evasion, including by strengthening the compulsory use of electronic payments. There has been some progress in: i) ensuring that active labour market and social policies are effectively integrated and reach out to vulnerable groups; ii) focusing investment-related economic policy on research and innovation and the quality of infrastructure; iii) making the public administration more effective; iv) fostering bank balance sheet restructuring; v) improving non-bank financing for smaller and innovative firms. There has been limited progress in: i) shifting taxation away from labour, reducing tax expenditure and reforming the cadastral system; ii) tackling undeclared work; iii) supporting women’s participation in the labour market, through a comprehensive strategy; iv) improving educational outcomes, also through adequate and targeted investment, and fostering upskilling; v) reducing the length of civil trials, by enforcing and streamlining procedural rules; and vi) improving the effectiveness of the fight against corruption, by reforming procedural rules to reduce the length of criminal trials. There has been no progress in: i) reducing the share of old-age pensions in public spending and creating space for other social and growth-enhancing spending; and ii) addressing restrictions to competition, including through a new annual competition law. The Social Scoreboard supporting the European Pillar of Social Rights points to employment and social challenges. Labour market conditions remain difficult. The unemployment rate is still high and employment and activity rates remain low, especially for women. Young people and the long-term unemployed also face particular difficulties. The share of temporary contracts rose in past years, but job creation in 2019 was mainly driven by permanent contracts. Weak labour market conditions also impact social outcomes. While the risk of poverty and social exclusion is declining, income inequality increased in 2018. In-work poverty has been steadily rising and stabilised at high levels in 2018. Access to services such as childcare and healthcare is close to the EU average. However, it varies widely across regions. Regarding the Europe 2020 strategy, Italy has already reached its targets on greenhouse gas emissions reduction, renewable energy, energy efficiency, early school leaving and tertiary education. Limited progress has been made in meeting the targets on the employment rate, R&D investment and poverty and social exclusion. Italy is making progress in achieving the United Nations’ Sustainable Development Goals (SDG). As confirmed by the progress in reaching its Europe 2020 targets (annex A), Italy achieved significant results in climate mitigation (SDG 13). By contrast, achieving SDG 4 (quality of education) will need further efforts in all related areas: basic education, tertiary education and adult learning ( ). The main findings of the in-depth review and the related policy challenges are as follows: Italy’s public debt remains an important source of vulnerability for the economy. Italy’s debt-to-GDP ratio reached 134.8% in 2018 and the Commission forecasts that it will further rise to 136.2% in 2019, 136.8% in 2020 and 137.4% in 2021, amid persistently weak nominal growth and a deteriorating primary balance. The Commission’s debt sustainability analysis points to high risks in the medium and long term, due to the high level of debt and ageing costs. The recent pension reform will generate further costs up to 2028 and, if extended beyond its trial period, could further erode potential growth and debt sustainability. In the short term, sustainability risks appear limited, also thanks to historically low sovereign yields since September 2019, but the need to rollover sizeable amounts of debt, at around 20% of GDP per year, still exposes Italy’s public finances to sudden rises in financial markets’ risk aversion. High debt-servicing costs also reduce the fiscal space to implement growth-enhancing and countercyclical policies.

Productivity growth has been sluggish despite measures to support it. The productivity gap between Italy and the EU continues to widen. In 2018, labour productivity declined by 0.3%, while in the euro area it grew by 0.5%. This is the result of declining labour productivity in southern regions and in services, as well as slower productivity growth in manufacturing compared to the euro area average. The effectiveness of recent measures to raise productivity growth, including incentives to invest and innovate, has been limited by delays in implementation, policy uncertainty and lack of a comprehensive strategy. More broadly, barriers to investment continue to constrain productivity dynamics and thus growth prospects, in turn hampering the reduction of the public debt-to-GDP ratio. Moreover, the weight of the informal economy in key economic sectors has a negative impact on their productivity. The unemployment rate remains high, although declining, and policies to raise labour market participation are yet to be fully implemented. Slow economic growth, low average educational attainment, skill mismatches, and low activity rates, especially among women, limit employment growth. Youth unemployment remains extremely high. Moreover, the high share of involuntary part-time workers and discouraged workers suggests that labour market conditions remain weak. Strengthening active labour market policies is key for labour market reforms and the minimum income scheme to succeed. However, policies to increase people’s skills and actively integrate jobless people in the labour market should be further developed The banking sector became more resilient, but pockets of vulnerability remain. Italian banks continued to make progress in reducing non-performing loans, but the total stock is still high compared to euro area peers, especially for less significant institutions. Following the recent fall in sovereign bonds yields, pressure on the capital and funding of Italian banks has subsided. However, bank exposure to domestic sovereign bonds remains high, therefore increasing the risk of it feeding back and spilling over to the real economy. The reform of the large cooperative banks has not yet been fully implemented, whereas the reform of small mutual banks has broadly been completed. The reform of the insolvency framework was adopted and is expected to be implemented by August 2020. Access to bank financing can be challenging, especially for smaller firms. Non-bank finance remains underdeveloped, in particular for small and innovative firms. A sustained budgetary-neutral public investment stimulus would substantially improve output and result in small but positive cross-border spillovers. A simulation with the Commission’s QUEST model suggests that an investment programme would have a sizeable effect on real GDP, improve its external position and lower its public debt ratio. However, the potential output effects are greatly dependent on the extent to which public investment is efficient. Other key structural issues analysed in this report, which point to particular challenges for Italy are: The taxation of labour remains high and tax compliance low. Italy’s tax burden on labour is still among the highest in the EU, while value-added taxes are under-exploited, because of the large use of reduced rates. The 2020 budget reduced tax expenditures and the tax wedge on labour. A shift of the tax burden onto property and a revision of outdated cadastral values to bring them closer to market values have not taken place. Several measures have been enacted in recent years to encourage tax compliance, but tax evasion remains very high, especially in specific sectors. Challenges remain in the labour market. Employment growth continues, though at a slower pace. The increase in the number of employees more than compensated for the decrease in the number of self-employed, while the shift from fixed-term to permanent contracts accelerated. The gender employment gap is among the highest in the EU and shows no sign of improving. Labour market slack and undeclared work remain serious concerns. In this context, real wages growth remains close to zero. Collective bargaining at firm or local level continues to play only a limited role, while legislative initiatives on statutory minimum wages are under discussion. Active labour market policies continue to be implemented in the context of the new minimum income scheme, although at a relatively slow pace. Participation in adult learning is very limited, especially for low-skilled and underemployed workers, holding back firms’ competitiveness and productivity growth. Education is a key challenge, especially in southern Italy, hindering the quality of skills. Italy has a much higher rate of early-school leavers and low achievers compared to the EU average, especially in the South. Shortages of secondary education teachers remain a challenge, as does attracting, selecting and motivating them. Compared to the EU average, the percentage of people having completed higher education remains low and the number of scientific/technical graduates is still insufficient. Higher education is underfinanced and understaffed. Despite better employability rates, vocational-oriented higher education is limited in scope. Shortages in basic and advanced digital skills are a serious concern. Measures to enhance vocational training are slowly being implemented. A comprehensive approach to upskilling, reskilling and adult learning is lacking. Social policies remain poorly integrated with other policies, including active labour market policies. While declining, the risk of poverty remains above the EU average, including for children and people with a migrant background. In-work poverty is also a challenge, especially for temporary workers. The southern regions and urban areas are the most affected. Limited access to quality social services increases the risk of poverty. Access to affordable and adequate housing remains a challenge, while the quality of the health services varies greatly across regions. In 2019, the citizenship income replaced the previous income support scheme to fight poverty, but more needs to be done to bring people to work. More efforts are needed to provide childcare and long-term care and promote equal opportunities and work-life balance. The lack of these affects women’s participation in the labour market and the broad demographic trends, in a context of low birth rates and a reduced net migration rate. Productivity growth does not show signs of improving, despite positive investment trends. In the last two decades, Italy’s labour productivity has stagnated, especially due to the poor performance of the services sector. Trends greatly differ depending on geographical area and firm size, particularly in manufacturing. A recovery of fixed investment could support productivity in the future. In this regard, higher levels of firms’ digitisation, investments in research and innovation, a more efficient public sector and adequate skills are key. A comprehensive strategy to support productivity and investment is missing. Measures remain fragmented and temporary, not taking sufficient account of sectoral and geographical aspects. The business environment is improving, but strengthening Italy’s public administration, justice system and anti-corruption framework remains a challenge. The digitisation of public services is progressing. Further efforts are needed to improve public employment, especially at management level. Weak administrative capacity is diminishing the public administration’s ability to invest and carry out policy or enforcement tasks that affect businesses such as market surveillance. In this regard, a comprehensive strategy to strengthen it is missing. Inefficiencies in public procurement also remain often unaddressed. Despite recent improvements, the length of civil trials remains among the highest in the EU. Recent reforms are starting to bear fruit and an enabling law to streamline the civil procedure is under discussion. However, to reduce trial length, there is still ample room to ensure more efficient management of cases and limit unfounded appeals. The anti-corruption framework was strengthened recently, also through the anti-corruption law of January 2019. However, it needs to be completed. Indeed, no regulation sanctions conflict of interest for elected public officials, embezzlement in the private sector remains only partly criminalised, and provisions against lobbying do not apply to members of government and parliament. Moreover, the low efficiency of criminal justice in appeals continues preventing prosecuting corruption effectively. A reform of the criminal procedure and appeal system is still pending. Compliance with single market rules and the removal of barriers to competition would benefit several sectors, particularly services. Services are most affected by low enforcement of single market rules, with negative consequences for individuals and firms. They are also over-regulated, especially the retail sector, regulated professions and the collaborative economy. The lack of competitive processes to manage public services and limited authorisations for using public goods affects the quality and cost of services provided. The implementation of the 2015 Competition Law is delayed, and no new initiatives to address barriers to competition or improve sectoral regulation have been announced. The regional divide remains large and is widening. In the last decade, public spending decreased in the southern regions. The recent possibility for local governments to spend their surpluses without prior authorisation is having positive effects in municipalities with budgetary surpluses. Efforts to reduce the gap in private investment have been modest, especially for research and innovation where national policies actually widened the gap. Large disparities also remain in the quality of governance, the level of labour productivity and competitiveness. In this context, the high unemployment in the South leads to low and high skilled individuals migrating, worsening the local brain drain. Sustainability-related reforms and investment represent an opportunity for Italy. Italy performs above the EU average for resource productivity and investment in the circular economy. It is on track to reach its 2020 climate and energy targets, although more efforts are needed for longer-term goals. Implementing planned policies as laid out in the national energy and climate plan will be needed to reach the 2030 target for greenhouse gas emissions not covered by the EU emissions trading system. Transport emissions have increased strongly over the last five years and constitutes a key challenge for reaching the 2030 target. On the other hand, air quality, sustainable mobility, climate adaptation, prevention of hydrogeological and seismic risks, and water and waste management remain challenges.. Investing in environmental sustainability could be an opportunity for growth and high-skilled employment in the South. The Commission’s proposal for a Just Transition Mechanism under the next multi-annual financial framework for 2021-2027 includes a Just Transition Fund, a dedicated scheme under InvestEU, and a new government loan facility with the EIB. It is designed to ensure that the transition towards EU climate neutrality is fair and could help the most affected regions in Italy to address the social and economic consequences. Key priorities for support by the Just Transition Fund, set up as part of the Just Transition Mechanism, are identified in Annex D, building on the analysis of the transition challenges outlined in this report. 1. Economic situation and outlook Real GDP growth, prospects and risks Output growth has been feeble, as the economy remains stuck in low gear. The Italian economy has been showing few signs of rebounding from its slowdown in 2018, when positive annual average GDP growth was exclusively due to a relatively strong carryover from the previous year. Economic activity slowed further in 2019, especially in the manufacturing sector, where firms trimmed inventories on a massive scale (Graph 1.1). This allowed firms to maintain their export activity, while reducing industrial output in view of lingering trade conflicts and related uncertainties over demand. The weakness in the manufacturing sector has also started spreading to the tertiary sector. Based on quarterly outturn data, real GDP grew by 0.2% in 2019 and is expected to expand by 0.3% and 0.6% in 2020 and 2021 respectively (European Commission, 2020). Graph 1.1:Real GDP growth and components Source: Eurostat A modest pick-up in domestic demand is set to support output growth in the near term. In 2018, household consumption slowed down, in view of an economy at the margin of stagnation. The stagnating real disposable income weighs on consumer spending, which remained subdued in 2019 ( ). In addition, households increased their precautionary savings amid weakening consumer confidence. The impact of the slowing economy on the labour market and thus aggregate incomes is likely to be felt only with a lag. However, the new social benefits introduced in 2019 and targeted at low-income groups ( ), who tend to have a relatively large propensity to consume, are expected to lend some support to household spending. In addition, the sizeable drop in interest rates since September 2019 is likely to free up household resources, by reducing the servicing costs of mortgages and consumer loans, and hence to increase private consumption.

Firms’ profit margins have been falling, but favourable financing conditions are lending support to business investment. Since the beginning of 2018, gross value added in the industrial sector has been shrinking and profitability in the corporate sector declining, hence affecting firms’ self-financing capacity. Gross fixed capital formation, at 18.1% of GDP in Q3-2019, is still markedly below both the latest peak of 2007 (22%) and the EU average (20.6%). While spending on equipment is almost back to 2007 levels, investment in construction has only recently bottomed out. The share of intangible assets, albeit still low by EU standards, had increased to 2.9% of GDP by 2015 but has stagnated since then. The recovery of private investment is forecast to slow down sizeably, on the back of uncertain demand prospects. By contrast, public investment picked up in 2019, after 9 years of decline, and is expected to support aggregate capital spending. Weak productivity growth, albeit varied across sectors, constrains economic expansion. Labour productivity (real gross value added per hour worked) has been declining since Q2-2018, on the back of weak growth in gross value added. However, labour productivity differs across sectors, with manufacturing and some parts of the service sector registering a noticeable rise in real output per hour worked. Overall, the productivity gap between Italy and the rest of the EU remains pronounced and is widening. Labour productivity in Italy rose on average by 0.5% per year between 2010 and 2018, compared with an EU average of 1.3%. Potential growth is estimated to have picked up moderately in 2019. Potential output declined between 2009 and 2016 due to the negative contributions from labour and total factor productivity (TFP). Supported by rising labour input, growth in potential output is estimated to have turned slightly positive in 2017 and is projected at 0.5% in 2019-2021 (Graph 1.2), sizeably below the EU average (1.6%). Trend TFP growth is estimated to have resumed in 2018 and begun making a positive contribution (Graph 1.2). Graph 1.2:Potential growth and components Source: European Commission. The balance of risks to the growth outlook remains skewed to the downside. As a large exporter, Italy is particularly exposed to the global economy. The latter remains prone to further policy-related shocks caused by, among other factors, trade conflicts, as well as structural shifts in the global manufacturing sector. Also, concerns about future fiscal policy might dent confidence and partly reverse the recent sovereign yield compression. On the upside, easing trade tensions and stronger-than-expected pick-up in global growth would benefit investment and exports. Labour market In the first 9 months of 2019, employment grew despite an almost stagnating economy. Between Q3-2018 and Q3-2019, headcount employment grew by 0.6%, driven by the rise of permanent employees (Graph 1.3). ( ) By contrast, the level of self-employed declined in the same period, while temporary employment remained broadly constant. Employment has been increasing since end-2013, and the employment rate rose to 63.6% in Q3-2019, while the unemployment rate fell to 9.8%, despite a slight drop in the labour force. The average duration of unemployment increased to 27 months, and the share of long-term unemployment over total unemployment rose to 59%, well above the EU average (43.5%). Youth unemployment is slowly falling (28.3% in Q3-2019) but remains one of the highest in the EU, as does the number of young people not in employment, education or training (19.2% in 2018). Graph 1.3:Labour market developments Source: Istat. Employment growth has been concentrated in labour-intensive sectors with low value-added. Most of the 151,200 additional headcount employment registered between Q3-2018 and Q3-2019 was generated in the service sector, mostly administrative and support services, household care and repair, and personal care, and in northern regions. As jobs tend to be created mostly in relatively less productive sectors, employment shifts tend to have a negative impact on aggregate productivity and average wages. Stagnating labour productivity bodes ill for future employment growth. Gross value added in the manufacturing sector has been declining since early 2018, implying a contraction of labour productivity, while the drop in productivity in the services sector was less pronounced. In addition, the number of hours authorised under the Italian short time working scheme (Cassa Integrazione Guadagni) ( ) has increased since the end of 2018, potentially leading to future reductions in employment in the industrial sector. Slack in the labour market remains considerable. Hours worked and employment (expressed in full-time equivalents) are still below the 2007 levels. The increase in total hours worked in the first three quarters of 2019 (0.5%) was largely driven by the growth in additional positions. Since 2010, part-time work has been an important driver of job creation. In the first three quarters of 2019, part-time work increased on average by 2.5% compared to the same period of 2018, while the number of full-time positions remained broadly unchanged. Moreover, involuntary part-time remains widespread, and the pool of discouraged workers is around three million people. The increase in involuntary part-time and temporary employment has been particularly marked in the South. Wages, prices and costs Wages continue to grow at a moderate pace. In 2019, hourly negotiated wages grew by 1.0% on average, driven by increases in the public sector (1.8%). By contrast wages in the private sector grew by 0.8%, where contract renewals are still pending for around 29.4% of employees) ( ). In the fourth quarter of 2019, nominal compensation per employee increased by 0.7% year-on-year, and real compensation by 0.5%. Growth in unit labour costs slightly accelerated in 2018. With the beginning of the slowdown in the manufacturing sector, aggregate unit labour costs started to rise. This is because labour productivity declined in 2018-2019 (-0.1%)(Graph 1.4) and labour costs increased, due to the moderately increasing nominal wage growth and the end of the exemption from social contributions of a rising share of labour contracts ( ). Wage growth is broadly in line with what could be expected based on productivity developments, prices and the unemployment rate. Graph 1.4:Wages, labour costs and productivity Source: Istat. Moderate domestic demand and subdued wage growth suggest only a gradual rise in core inflation. Consumer price inflation (harmonised index of consumer prices - HICP) slowed down to 0.6% in 2019, from 1.2% in 2018. HICP inflation is expected to increase to 1.0% by 2021. Annual HICP core inflation (i.e. excluding unprocessed food and energy) stood at 0.6% in 2019 and is set to gradually pick up, in line with moderate wage growth and the recovery of profit margins. The growth rate of the GDP deflator, on a downward trend since 2010 due to subdued demand and only moderate growth in unit labour costs, is projected to have fallen to 0.6% in 2019 but is forecast to rise to 1.1% by 2021. Inequality and poverty risk Income inequality is among the highest in the EU. The Gini coefficient (of equalised disposable income), already one of the highest in the EU, rose further in 2018, indicating a more uneven distribution of incomes. The tax-and-benefit system, albeit among the least effective in the EU, is mitigating the unequal distribution of market incomes but largely to the benefit of pensioners. The large weight of pensions in social expenditure is reflected in lower income inequality among the elderly. In 2018, the ratio of the total income received by the 20% of the population with the highest income to that received by the 20 % with the lowest income stood at 6.55 for persons under 65 years old, but only at 4.86 for persons aged 65 or above. The risk of poverty is declining, but in-work poverty remains high. Helped by solid employment growth in recent years, the risk of poverty and social exclusion declined to 27.3% in 2018, down from its peak of 30% in 2016. Yet, it remains sizeably above the EU average (21.7%) and above the level registered in 2007 (26%), while regional disparities loom large. By contrast, the rate for those in work who are at-risk of poverty has trended upwards since 2010 and reached 12.3% in 2018, almost 3 percentage points above the EU average. Key reasons are that, despite an improving overall labour market situation, the share of (involuntary) part-time employment has increased, and wage growth has remained subdued. As a result, real gross disposable income was almost 10% lower in 2018 than in 2007 ( ). Financial developments

Government bond yields have fallen sharply on the back of declining sovereign risk premiums. Currently, yields for Italian sovereign bonds are well below the peak levels observed in 2018. Political uncertainty has gradually abated, financial tensions eased and market conditions improved. This was supported by both the ECB’s return to a more expansionary monetary policy stance ( ) and the Italian government’s decisions to make adjustments to their fiscal targets. The sovereign risk premium on Italian government securities, as measured by credit default swaps (CDS), has declined but is still higher than at the beginning of 2018 (Bank of Italy, 2019a) ( ). Vulnerabilities remain as regards the debt rollover risks. The ten-year sovereign bond yield dropped from 2.7% at the beginning of 2019 to below 1% end-August but has again risen above 1.3% by mid-January 2020. The spread vis-à-vis German bonds narrowed by almost 100 basis points over the same period but is still wider than the one for Spanish or Portuguese bonds. The yields on Italian sovereign bonds with maturities of up to 2 years turned negative in summer 2019 and were close to zero in-mid January 2020. In 2019, rating agencies kept Italy's credit rating stable and the outlook unchanged. ( ) The sharp decline in long-term interest rates buoyed share and corporate bond prices. Amid pronounced volatility on global stock markets due to the weakening global outlook and heightened trade policy risks, Italian equity prices gained substantially in 2019. The Milan benchmark stock exchange index increased by 30% between end-2018 and mid-January 2020, with the bank sub-index rising about 22%. Following the reduction in Italy’s sovereign yields, the risk premiums on the two main Italian banking groups, as measured by CDS spreads, have declined and are only slightly higher than the average of the other large European banks. However, the price-to-book ratio of Italian listed banks, a standard metric to gauge their economic value, is below unity and lower than for other European banks’, indicating subdued earnings expectations and elevated risk premiums demanded by investors. Since early 2019, foreign investors have again increased their exposure to Italian assets. After the sharp sell-offs in the second half of 2018, non-resident investors raised their portfolio of Italian government securities by €90 billion until November 2019. In the same period, foreign holdings of bank bonds rose by €9.9 billion. Deposits placed with Italian banks remained stable, and private sector deposits rose by 7.6% in November 2019 compared to the same month of 2018. Since May 2018, deposits from domestic households and non-financial corporations have overall slightly increased. Lending to households is rising at a moderate pace, while lending to firms is decreasing. The growth of lending to households slowed down slightly over 2019, but is still solid for house purchases and consumer credit. On average, loans to the non-financial corporate sector continue to decrease on an annual basis, albeit with large variations across risk classes (Graph 1.5). Graph 1.5:Lending volumes and interest rates, private sector Source: Bank of Italy. The contraction in lending is concentrated among the riskiest firms. By contrast, lending continues to grow for financially sound larger firms (Bank of Italy, 2019a). The cost of new loans, which has been decreasing in recent months, is at historically low levels. Bank lending surveys indicate an easing of credit conditions for firms and households. Meanwhile, credit demand from companies has declined, given firms’ reduced need to finance fixed capital formation or inventories and working capital. Financial conditions are stable but remain vulnerable to adverse cyclical conditions. Firms’ profitability is weakening, but debt repayment capacity remains strong thanks to low interest rates and sounder balance sheet structures than in the past. Moreover, the high average residual maturity of Italy’s public debt slows down the transmission of an increase in government yields to the average cost of debt. However, a marked economic slowdown and higher interest rates in light of high public debt could expose financial vulnerabilities. External position Italy’s current account surplus rose in 2019 due to an increasing goods balance. Despite the slowdown in global trade, export growth remained stable and exporting firms broadly maintained market shares. By contrast, imports decelerated sharply, owing to a negative inventory cycle. As a result, the current account balance registered a surplus of 2.9% in the 12-month period up to November 2019 (Graph 1.6). Savings and investment decisions at sector level determine current account fluctuations. Since 2009, the corporate sector, traditionally in a debtor position, has acted as net lender to the economy and its net lending position widened to 0.8% of GDP in 2018. By contrast, households reduced net lending from 2.3% of GDP in 2014 to 1.3% of GDP in 2018. The cyclically adjusted current account surplus is estimated at 2.7% of GDP in 2019. This surplus is estimated to be sufficient to keep Italy’s net international investment position (NIIP) stable and bring it closer to the level that fundamentals suggest (in the absence of valuation effects) ( ). The NIIP is almost balanced. Since the low point in early 2014, Italy’s NIIP improved by €351 billion. As a result, the stock of net external liabilities fell to €55.3 billion (or 3.1% of 2018 GDP) by Q3-2019. That positive trend was helped by persistent current account surpluses and supported by valuation effects. In 2019, the TARGET2 balance improved. In December 2019, the Bank of Italy’s net debtor position in the TARGET2 European payment system stood at €439 billion, down from the €493 billion in August 2018. Graph 1.6:Current account balance Source: Bank of Italy. Public finances: public deficit and debt The government headline deficit is expected to remain broadly stable in 2019 and 2020, leading to a worsening primary balance. After slightly declining from 2.4% of GDP in 2017 to 2.2% of GDP in 2018, the government deficit is projected to have remained stable in 2019 and to marginally increase to 2.3% of GDP in 2020, based on the Commission 2019 Autumn Forecast. The new minimum income and early retirement schemes will lead to a large increase of public spending over 2019-2020, which will only partially be compensated by measures on the revenue side. In 2021, under a no-policy-change assumption (in particular, not considering the increase in VAT legislated as a safeguard clause), the headline deficit is expected to increase to 2.7% of GDP. Given the projected reduction of interest spending (from 3.7% of GDP in 2018 to 3.1% of GDP in 2021), the government primary surplus is expected to decline from 1.5% of GDP in 2018 to 0.4% of GDP in 2021 (Graph 1.7). The structural balance is projected to improve from -2.4% of GDP in 2018 to -2.2% in 2019, and to deteriorate to -2.5% and -2.9% of GDP in 2020 and 2021 respectively. The government debt-to-GDP ratio is expected to continue growing until 2021. In September 2019, Italy’s national statistical institute (ISTAT) and the Bank of Italy published revised data on the country’s public debt, which implied an upward level shift over the recent years. Following the revision, Italy’s debt-to-GDP ratio peaked at 135.4% in 2014, before declining to 134.1% in 2017 and rising again to 134.8% in 2018. The increase in 2018 was due to particularly low real GDP growth and a large stock-flow adjustment (0.7% of GDP), mainly related to fluctuations of the Treasury liquidity reserves and negative developments in the financial markets. The Commission 2019 Autumn Forecast expects Italy’s debt-to-GDP ratio to further rise to 136.2% in 2019, 136.8% in 2020 and 137.5% in 2021, amid persistently weak nominal GDP growth and a deteriorating primary balance (see Section 4.1). Given the track record of recent years, those projections do not consider any proceeds from privatisations, although the government is targeting 0.2% of GDP per year over 2020-2022. Graph 1.7:Public finances indicators Source: European Commission Italy is making progress in achieving the United Nations’ Sustainable Development goals. Over the past 5 years, progress has been relevant in most of the UN Sustainable Development Goals (SDGs), particularly for SDGs 3 (good health and well-being), 7 (affordable and clean energy), 12 (responsible consumption and production) and 16 (peace, justice and strong institutions). By contrast, SDGs 1 (no poverty), 10 (reduce inequalities) and 15 (life on land) present a mixed picture, with some indexes worsening in the short run. Overall, Italy underperforms the EU average in most of the indexes related to SDGs 4 (quality of education), 5 (gender equality), 8 (economic growth) while it performs better than average on SDGs 6 (clean water and sanitation), 11 (sustainable cities) and 12 (responsible consumption). In this context, Italy’s initiative on well-being indicators (based on the well-being evaluation scale - WES) and on SDGs at national and regional level (ISTAT, 2019i) is a European best practice supported by civil society organisations (see ASVIS, 2019). In particular, the former indicators include, together with social indicators on poverty, inequality and gender balance, indicators on the level of CO2 emissions as well as a proxy for soil erosion. Regarding the latter, by summer 2020 Italy’s regions and autonomous provinces are to have approved their own sustainable development strategies for 2017-2030. Table 1.1:Key economic and financial indicators - Italy Source: Eurostat and ECB as of 4-2-2020, where available; European Commission for forecast figures (Winter forecast 2020 for real GDP and HICP, Autumn forecast 2019 otherwise)







2. Progress with country-specific recommendations Since the start of the European Semester in 2011, 68% of all country-specific recommendations (CSRs) addressed to Italy have recorded at least ‘some progress’ ( ). By contrast, 32% have recorded 'limited' or 'no progress' (Graph 2.1). The areas that registered the best performance include measures to improve the business environment and reform the labour market. Good performances have also been recorded in the banking sector and in improving the quality of Italy’s fiscal governance. Graph 2.1:Overall multiannual implementation of 2011-2019 CSRs to date Source: European Commission Concerning public finances and taxation, some progress was made to address the related CSRs. Overall, the budgetary process has been improved, including by introducing regular spending reviews. In recent years, several measures have been adopted to fight tax evasion, including the introduction of compulsory e-invoicing and e-transmission of receipts. Moreover, the 2020 budget has introduced several measures to tackle tax evasion from omitted invoicing, including by encouraging e-payments. On the other hand, repeated tax amnesties may have negatively affected tax compliance. There has been some progress in reducing taxes on labour but none in shifting taxes to other revenue sources, as tax expenditures have been reviewed but not streamlined and the outdated cadastral system has not been reformed. Moreover, while past pension reforms helped improve the long-term sustainability of public finances, the share of old-age pensions in total expenditure is still set to rise mainly due to the early retirement scheme introduced in 2019. As regards labour market and social policies, progress in carrying out reforms was limited. Five years after its adoption, the implementation of the ‘Jobs Act’ reform remains incomplete. Despite recent efforts to make active labour market policies more effective and reinforce public employment centres, performance varies widely among regions and integration and coordination with other social and educational policies remains weak. The employment rate of women remains sizeably below the EU average and family-related social policies still lack proper coordination. While some steps have been taken to facilitate access to childcare services through financial support to families, a comprehensive strategy that combines a more efficient tax system with access to care services and measures to reconcile career and family life is missing. Some progress was registered in improving the business environment and investment conditions. Efforts to simplify administrative procedures continued, but the burden remains high overall. Some progress has also been recorded in increasing the effectiveness and digitisation of the public administration, but a reform of local public services and measures to tackle restrictions to competition are still pending. Public investment remains subdued in Italy, but the strengthened budgetary autonomy of local governments is showing positive signs, and more funds have been earmarked for public investment. Moreover, numerous measures have been introduced in recent years to support private investment, including with a focus on innovation and green expenditure. On the other hand, the investment capacity of the public administration remains weak, R&D expenditure remains low and unequal across regions, and there is still scope for streamlining and stabilising the most efficient incentives. The assessment of this CSR does not take into account the contribution of the EU 2021-2027 cohesion policy funds (). There has been some progress in increasing the efficiency of civil justice and fighting corruption. Civil justice reforms have been passed in recent years, increasing the specialisation and digitalisation of courts, reinforcing alternative dispute resolution and introducing stricter admissibility rules for appeals. That notwithstanding, the time it takes to resolve civil and commercial litigious cases in Italy remains a challenge. Long disposition times for criminal trials also continue to raise concerns at the appeal level. Italy has recently improved its anti-corruption system, through, among other things, a framework to protect whistle-blowers, a stronger role for the National Anti-Corruption Authority and the anti-corruption law of January 2019, which stops the statute of limitations after a first-instance ruling. However, the low efficiency of the criminal justice keeps hindering the prosecution of corruption, in the absence of a needed reform of criminal procedure, especially to tackle the high number of cases at appeal courts. Some progress has been made regarding banks’ balance sheet repair and access to finance. This includes non-performing loans disposals through outright sales and securitisations supported by the government guarantees. The reform of large cooperative banks has not been fully implemented yet, unlike the reform of small mutual banks, which has essentially been concluded. The reform of the insolvency framework, finalised by the government in early 2019, will enter into force in August 2020. Although firms’ financing remains predominantly bank-based, past measures to give firms greater access to capital markets are having some positive effects. The reintroduction of the allowance for corporate equity in the 2020 budget can help address corporate undercapitalisation. By contrast, measures to improve the recourse to venture capital have not been implemented yet. Overall, Italy has made some progress in addressing the 2019 country-specific recommendations( ). Limited progress has been made in shifting the tax burden away from labour, as there was no reduction of the large tax expenditures in value added taxes nor a reform of the outdated cadastral values. No progress has been recorded in reducing the share of old-age pensions in public spending to create space for other social and growth-enhancing spending. Substantial progress has been made in fighting tax evasion, including by encouraging electronic payments. However, the magnitude of the challenge warrants a continuous reform effort. Limited progress has been made in tackling undeclared work, in putting forward a comprehensive strategy to support women’s participation in the labour market and in fostering educational outcomes, upskilling and digital skills. Some progress has been made in improving the effectiveness of active labour market policies and their integration with social policies. Some progress has also been recorded in improving investment conditions, both for public and private investment, and in strengthening administrative capacity. There has been no progress on competition policies, as no new initiatives were put forward and backtracking is still being discussed. Limited progress has been made in reducing the length of civil trials at all instances by enforcing and streamlining procedural rules. Progress is also limited in improving the effectiveness of the fight against corruption by reforming procedural rules to reduce the length of criminal trials. Some progress has been made in fostering bank balance sheet restructuring, by improving efficiency and asset quality through non-performing loans disposals, and diversifying funding. There has also been some progress in improving non-bank financing for smaller and innovative firms. Upon request by a Member State, the Commission can provide tailor-made expertise via the Structural Reform Support Programme to help design and implement growth-enhancing reforms. Since 2017, support has been provided to Italy for 36 projects. In 2019, several projects were delivered on the ground. The Commission, for example, provided an action plan for the accrual-based accounting reform in Italy’s public administration and is now supporting its implementation. In 2018, the Commission supported the establishment of Zones of Economic Interest in the South. In 2019 the Commission further helped defining the governance structure of the three already-established zones as well as the central government’s oversight and monitoring. Work has also started on improving data collection and courts’ organisation as regards insolvency and enforcement; strengthening the system of active labour market policies; developing a model to improve evaluation of VAT and excise policies; further improving national coordination of efforts to prevent corruption; and improving both central and local management of European Structural and Investment Funds. Table 2.1:Assessment of 2019 CSR implementation (*) Italy Overall assessment of progress with 2019 CSRs: some progress CSR 1: Ensure a nominal reduction of net primary government expenditure of 0.1% in 2020, corresponding to an annual structural adjustment of 0.6% of GDP. Use windfall gains to accelerate the reduction of the general government debt ratio. Shift taxation away from labour, including by reducing tax expenditure and reforming the outdated cadastral values. Fight tax evasion, especially in the form of omitted invoicing, including by strengthening the compulsory use of e-payments including through lower legal thresholds for cash payments. Implement fully past pension reforms to reduce the share of old-age pensions in public spending and create space for other social and growth-enhancing spending. (MIP relevant) Some progress ·Not assessed: The compliance assessment with the Stability and Growth Pact will be included in Spring when final data for 2019 will be available. ·Limited progress in shifting taxation away from labour, in reducing tax expenditure and in reforming the cadastral system. ·Substantial progress in fighting tax evasion, including by strengthening the compulsory use of electronic payments. ·No progress in reducing the share of old pensions in public spending. CSR 2: Step up efforts to tackle undeclared work. Ensure that active labour market and social policies are effectively integrated and reach out notably to young people and vulnerable groups. Support women’s participation in the labour market through a comprehensive strategy, including through access to quality childcare and long-term care. Improve educational outcomes, also through adequate and targeted investment, and foster upskilling, including by strengthening digital skills. (MIP relevant) Limited progress ·Limited progress in stepping up efforts to tackle undeclared work ·Some progress in ensuring that labour market and social policy are effectively integrated and reach out to vulnerable groups ·Limited progress supporting women’s participation in the labour market ·Limited progress in improving educational outcomes and fostering upskilling, including by strengthening digital skills CSR 3: Focus investment-related economic policy on research and innovation, and the quality of infrastructure, taking into account regional disparities. Improve the effectiveness of public administration, including by investing in the skills of public employees, by accelerating digitalisation, and by increasing the efficiency and quality of local public services. Address restrictions to competition, particularly in the retail sector and in business services, also through a new annual competition law. (MIP relevant) Some progress ·Some progress in focusing investment-related economic policy on research and innovation and quality of infrastructures ·Some progress in improving the effectiveness of public administration including investing in skills, accelerating digitalisation and increasing the efficiency of local public services ·No progress in addressing restrictions to competition CSR 4: Reduce the length of civil trials at all instances by enforcing and streamlining procedural rules, including those under consideration by the legislator. Improve the effectiveness of the fight against corruption by reforming procedural rules to reduce the length of criminal trials. (MIP relevant) Limited progress ·Limited progress in reducing the lengths of civil trials ·Limited progress in improving the effectiveness of the fight against corruption CSR 5: Foster bank balance sheet restructuring, in particular for small and medium-sized banks, by improving efficiency and asset quality, continuing the reduction of non-performing loans, and diversifying funding. Improve non-bank financing for smaller and innovative firms. (MIP relevant) Some progress ·Some progress in fostering bank balance sheet restructuring ·Some progress in improving non-bank financing for smaller and innovative firms Source: European Commission (*)The assessment of CSR 3 does not take into account the contribution of the EU 2021-2027 cohesion policy funds. The regulatory framework underpinning the programming of the 2021-2027 EU cohesion policy funds has not yet been adopted by the co-legislators, pending inter alia an agreement on the multiannual financial framework (MFF) Box 2.1: EU funds and programmes to address structural challenges and foster growth and competitiveness in Italy Italy is one of the countries benefiting most from EU support. The financial allocation from the EU cohesion policy funds ( I ) for Italy amounts to €53.2 billion in the current Multiannual Financial Framework equivalent to around 0.4% of its GDP annually. As of the end of 2019, Italy lagged behind in its implementation of cohesion policy compared to the EU average: Italy allocated to specific projects some €42.2 billion (79% of the total allocation planned against 88% for the EU) and spent €17.2 billion (about 32.0% against 38% for the EU)( II ). EU cohesion policy funding heavily supports structural challenges in Italy. The cohesion policy programmes for Italy have allocated €9.1 billion for smart growth, €9.5 billion for sustainable growth and sustainable transport and €14 billion for inclusive growth. In 2019 following a performance review( III ), €2.26 billion were made available for Italy. In addition, €782 million have to be reprogrammed by Italy within the priority areas listed above. EU cohesion policy funding is contributing to major transformations of the Italian economy. EU cohesion policy funding together with the Connecting Europe Facility are supporting the development of key infrastructure within the TEN-T core network, with €1.8 billion and €1.6 billion respectively. By 2019, investments driven by the EU Funds had ensured broadband access for more than 15,700 additional households; 4,600 enterprises and 523 start-ups had also received support, generating 1,533 new jobs. For research and innovation, EU cohesion policy funds allocate €3.3 billion to support R&D, innovation in firms, and training for innovative skills. Around 5 million people participated in training initiatives and more than 1 million people found employment after 6 months. The Youth Guarantee and the Youth employment initiative supported 676,000 young people, and more than half of them are already in employment (ANPAL, 2019). EU funding has addressed poverty and social exclusion by strengthening the capacity of the social and employment services to accompany the process of active inclusion. The ESF has supported the participation in employment and social inclusion initiatives of more than 444,000 persons with migrant or foreign background or from minorities, and 107,600 persons with disabilities. EU funds helped to reduce greenhouse gas emissions by 48,253 tons of CO2 and to reduce primary energy consumption for public buildings by 43,288,552 Kw/year. The funds also improved health services for more than 1.5 million persons. A good performance was also observed in the tourism industry and especially in the valorisation of natural heritage and cultural assets with an additional 962,818 visits per year and an increase in particular in non-Italian visitors, including in the “Mezzogiorno”. EU funding helps to mobilise significant private investment. At the end of 2018, €3.5 billion( IV ) from the European Regional Development Fund had been programmed for funding in the Italian operational programmes (regional and national). The amounts committed in the funding agreements totalled about €2.8 billion (80%) and €430 million (12%) were paid to the final recipients. Of the €2.8 billion committed, €1.1 billion are loans; €546 million guarantees and €351 million are equity. Agricultural and fisheries funds and other EU programmes also help to address development needs. Together with the European Agricultural Fund for Rural Development (EARDF) support, with €20.9 billion, and the European Maritime and Fisheries Fund (EMFF) support, with €979 million, Italy benefits from other EU programmes. Horizon 2020 provided €3.9 billion for R&D and innovation, including €703 million for SMEs. EU funds already invest substantial amounts on actions in line with the Sustainable Development Goals (SDGs). In Italy, the European Structural and Investment Funds support 13 out the 17 SDGs and up to 95% of the expenditure is contributing to those. 3. Overall findings regarding imbalances, risks and adjustment issues The 2020 Alert Mechanism Report concluded that a new in-depth review should be carried out for Italy to assess if imbalances are unwinding, persisting or aggravating, while taking stock of the corrective policies implemented. In February 2019, Italy was identified as having excessive imbalances (European Commission, 2019d). The identified imbalances and legacy issues relate to high public debt, low productivity growth, and high rate of unemployment and non-performing loans. This section summarises the findings of the Macroeconomic Imbalance Procedure in-depth review contained in various sections of this report ( ). Imbalances and their gravity At 134.8% of GDP in 2018, high public debt remains an important source of vulnerability for the economy. In the medium and long term, the Commission’s debt sustainability analysis ( ) points to high risks, related to Italy’s high level of debt and ageing costs. In the short term, given the current interest rate environment, sustainability risks are considered low. However, sizeable debt rollover needs (around 20% of GDP per year) expose Italy’s public finances to sudden increases in financial market risk aversion. Furthermore, high debt-servicing costs reduce the fiscal space for growth-enhancing and countercyclical policies. Subdued productivity growth, particularly in services and for smaller firms, limits competitiveness and potential growth. In 2018, GDP growth continued to be driven by increases in employment. Aggregate labour productivity continued to decline in 2018 (‑0.3% versus +0.5% in EA19) and productivity growth is expected to remain subdued in 2019-2020. The decline in labour productivity in some Southern regions and in services contributed to the subdued aggregate evolution of productivity. On the other hand, productivity in manufacturing rose since 2000, but more slowly than in peer countries. TFP rose slightly in 2018 (0.3 pps. versus 0.6% in the EA19), but is still lower than in 2000. Persistent structural barriers, including to investment, constrain Italy’s productivity dynamics and growth, hampering in turn the reduction of the public debt-to-GDP ratio. Employment continued to increase in 2019, but the unemployment rate remains high. Despite weak economic activity, employment growth continued in the first three quarters of 2019, when total headcount employment grew by 0.6 % compared to the same period of 2018. However, hours worked grew at a slower pace and were still below the 2007 levels. Unemployment dropped below 10 %, amid a shrinking labour force and persistently high inactivity rates. Youth unemployment also trended downwards but, at a rate of 28.3% in the third quarter of 2019, remained among the highest in the EU. Moreover, high shares of involuntary part-time and discouraged workers suggest a still large slack in the labour market.

Italian banks continued to make significant progress in reducing Non Performing Loans (NPLs), but the legacy stock remains high. The gross NPL ratio at system level declined from 8.4 % at end-2018 to 8.1 % in the second quarter of 2019. However, the legacy stock of bad loans and unlikely-to-pay exposures remains high compared to EU peers, especially for less significant banks. Following the easing of market tensions and the reduction in sovereign bond yields, Italian banks have recently reduced their exposure to domestic sovereign debt. However, they remain substantially exposed to their sovereign, implying a home bias and risk of feedback loops. Despite recent improvements in banks’ balance sheets, lending to households rose only moderately, while lending to firms has come to a halt. Simulations show that a stimulus to public investment would likely entail positive spillovers to the rest of the euro area. An increase in public investment, financed in a budget-neutral way (Box 3.1), is estimated to lift Italy’s GDP sizeably, even when using a cautious assumption for the growth-enhancing impact of capital spending. Spillovers to other euro area Member States are non-negligible, at least in the first years after the initial investment stimulus. Evolution, prospects and policy responses Italy’s debt-to-GDP ratio is projected to further rise under a no-policy change assumption. The ratio increased from 134.1% in 2017 to 134.8% in 2018 and is projected by the Commission 2019 Autumn Forecast to reach 137.4% in 2021, due to weak nominal GDP growth and lack of fiscal effort. Between May 2018 and July 2019, sovereign yields shifted upward, experiencing high peaks and strong volatility. Despite a substantial decline since August 2019, they remain sensitive to increases in financial market risk aversion. The pension provisions introduced in 2019 will cause additional costs up to 2028 and, if extended, they would worsen the medium-term debt sustainability. Furthermore, those measures could negatively affect potential growth. Several measures have been adopted to fight tax evasion, including by encouraging electronic payments. Measures to boost productivity have been taken, but their impact is limited by policy uncertainty and the lack of a comprehensive strategy. In early 2019, Italy passed a new anti-corruption law, which could contribute to a more supportive business environment. On the other hand, further announced revisions to the public procurement code create uncertainty for investment planning. The impact of incentives to promote investment and innovation has had a positive effect, but streamlining and stabilisation could increase their efficiency. Funds for public investment have been increased, but the efficiency of the public sector remains low, notably in its capacity to invest. Better capital allocation, including through non-bank finance, could help to increase investment and productivity. The implementation of policies to raise labour market participation remains incomplete. Activity rates, in particular of women and young people, are markedly below the EU average. A reform of active labour market policies was part of both the 2015 “Jobs Act” and the recently introduced minimum income scheme. In that context, steps have been taken to strengthen public employment services, including through staff reinforcements. However, the job placement capacity remains weak. Moreover, measures to strengthen women’s participation in the labour market remain insufficient. Banks have continued to reduce NPLs and address sovereign risk. Besides improving their internal workout capacity, banks benefited from the prolongation in May 2019 of a state-guaranteed securitisation scheme for another 24 months. To shield their capital base from the impact of higher sovereign yields, banks have pursued a rebalancing of part of their sovereign bond portfolios to the held-to-collect category. Given the comparatively favourable conditions, the pace of balance sheet restructuring should be kept, in particular for less significant banks, in order to further strengthen financial stability and facilitate the provision of credit to the economy. Overall assessment Italy’s imbalances are not expected to unwind in the near term, although the situation in the banking sector and in the labour market has improved. The public debt-to-GDP ratio rose in 2018 and is expected to further rise in the coming years due to low nominal GDP growth and lack of fiscal consolidation. The new social schemes introduced in 2019 will further weigh on public finances in 2020, and the pension provisions will worsen the public spending bias towards old-age pensions. On the other hand, progress has been made in fighting tax evasion and corruption. Productivity remains subdued, mainly due to the negative contribution of services. Public investment increased from a very low level, but more efforts are needed to raise administrative capacity. Investment is still hampered by an unstable policy setting. The unemployment rate continued to fall but remains high. Measures to increase labour market participation, in particular of women, are not yet complete but go in the right direction. The situation of banks has considerably improved, with a further reduction of NPLs. However, the stock of NPLs remains high, especially for small and medium banks, while firms’ limited recourse to non-bank finance leaves them vulnerable to banking shocks. Overall, a sustained reform agenda accompanying the reduction of public debt, with an improvement of its composition (notably towards adequate investment) and structural reforms is crucial to support a virtuous cycle for the unwinding of imbalances. Box 3.1: Public investment and potential spillovers – The case of Italy Following the 2019 Country specific recommendations on investment-related economic policy the European Commission QUEST (1) model is applied to simulate the domestic and cross border impact of an investment stimulus of 1% of GDP sustained over 10 years. Public investment in Italy as a share of GDP has been almost continuously shrinking since 2010, implying a substantial investment gap (European Commission, 2018a). A sustained reversal of the previous declining trend is expected to support growth and imply positive spillovers on neighboring countries. The simulation assumes that additional investment is financed in a budgetary-neutral way, in this case through an increase in consumption taxes. The output elasticity with respect to the public capital stock for the central scenario is assumed to be 0.12, which roughly corresponds to the median estimate in the empirical literature. Two additional scenarios are considered, applying a higher (0.17) and lower output elasticity (0.07), thus reflecting a high-efficiency and a low-efficiency scenario (in ‘t Veld, 2016). Monetary policy is assumed to retain its accommodative stance at the zero lower bound (ZLB) for the first two years and gradually normalize afterwards. A sustained public investment stimulus would create sizeable output effects in Italy and positive cross-border spillovers. Compared with a rise in public consumption or lower tax rates public investment spending tends to have a higher output multiplier. The output effect of the increase in public investment is sizeable, due to the longer-term impact of public investment on growth and the capital stock (Table 1). The fact that the additional investment is financed via a rise in consumption taxes weighs on private consumption and dampens the overall output effect. By contrast, the debt-to-GDP ratio declines throughout the simulation period due to the positive growth effect and the external position improves. A lower real interest rate (inflation in the euro area increases while nominal interest rates remain constant) and higher demand from Italy lead to positive spillovers to the rest of the euro area. At the ZLB, the ECB does not react to higher euro area wide inflation with an increase of the nominal interest rate. This implies that the real interest rate falls, inducing a rise in private demand. Table 3.1a:Spillover effects of Italy implementing an investment programme over 10 years - Central scenario Source: European Commission. The efficiency of public investment has a significant bearing on output effects. Compared to the central scenario, output effects differ widely, especially after the initial years of the investment stimulus. While additional public investment increases domestic real GDP by 0.6% by 2029 in the low-efficiency scenario compared to the baseline, real GDP is 1.7% higher in the high-efficiency scenario. This confirms the view that alongside the quantity of the public capital stock the quality of public infrastructure and the way in which a public investment programme is implemented is equally important (Busetti et al., 2019). ____________________ Table 3.1:MIP Assessment Matrix (Continued on the next page) Table (continued) Source: European Commission 4. Reform priorities 4.1.Public finances and taxation 4.1.1.Public debt, debt sustainability analysis and fiscal risks Weak nominal GDP growth and a worsening primary balance are expected to cause an increase in the government debt-to-GDP ratio. Based on the Commission 2019 Autumn Forecast, the government debt-to-GDP ratio is expected to have increased in 2019 by 1.4 percentage points. The real implicit cost of debt is set to have marginally increased due to an upward level shift in sovereign yields observed between May 2018 and July 2019, while real GDP growth has declined to close to zero. The positive and widening difference between the two indicators leads to a large and debt-increasing “snow-ball” effect. Furthermore, a lower GDP deflator is expected in 2019 and the government primary balance is projected to have declined as a share of GDP by 0.2 percentage points. In 2020 and 2021, the “snow-ball” effect, although still debt-increasing, is set to progressively shrink, thanks to recovering real GDP growth and a declining real implicit cost of debt. The GDP deflator is also projected to slightly recover. However, the primary balance is expected to decline more markedly as a share of GDP, by 0.3 and 0.6 percentage points in 2020 and 2021 respectively. Overall, Italy’s debt-to-GDP ratio is projected to increase by 0.6 percentage points in both 2020 and 2021.

Government sovereign yields have declined substantially compared to the end of 2018 but remain sensitive to sudden increases in financial market risk aversion. The large size of Italy’s public debt makes investors very sensitive to perceived risks, including the government’s fiscal policy and its stance towards European fiscal rules. After substantially increasing in May 2018 (from around 130 to 290 bps), the 10-year sovereign spread versus German bonds peaked at 320 bps in October and November 2018 during the discussions on Italy’s 2019 budget, before declining in January 2019 after the amendments to the budget law. Similarly, the spread widened again in May 2019 during the discussions on Italy’s stability programme, before declining in July thanks to the mid-year budget. Also in light of the fiscal policy announced by the incoming government, by September 2019, the spread returned to early 2018 levels and the yields on 10-year government bonds recorded an historical low level (0.8%), before increasing to around 1.0% by January 2020. Graph 4.1.1:Drivers of the "snowball” effect on public debt Source: European Commission Graph 4.1.2:Italy's sovereign yields Source: Bloomberg The share of government securities held by foreign investors is recovering from the drop in 2018. In 2018, foreign investors divested part of their government securities, reducing their share of outstanding securities to 32.1% from 35.6% in 2017. However, starting from January 2019, their share progressively recovered, reaching 35.1% by October 2019. Conversely, Italian banks reduced their exposure only marginally (Section 4.2). The Commission’s debt sustainability analysis points to high risks in the medium and long term. The indicator for short-term developments (S0) points to low risks, mainly thanks to the financial-competitiveness indicators. However, the fiscal component of the short-term indicator is above the indicative threshold for high risk, also due to the high public debt and gross financing needs. In fact, in the short term, the sizeable rollover needs related to Italy's government debt, around 20% of GDP per year, expose its public finances to sudden increases in financial market risk aversion. In the medium term, the Commission’s indicator (S1) points to high risks, as the high level of government debt would require a substantial fiscal effort to bring its ratio to 60% by 2034. The Commission’s debt sustainability analysis confirms this finding (see Annex B). In the long term, the Commission’s indicator (S2), although improved compared to the 2019 Country report (European Commission, 2019a), points to medium risks, in light of the fiscal effort required to stabilise the debt-to-GDP ratio, also taking into account the cost of ageing. A more comprehensive debt sustainability analysis, which also takes into account the vulnerabilities related to the high level of debt, points to high risks. The provisions implemented in 2019 will further increase pension expenditure in the coming years. The 2019 budget and a following implementing decree broadened possibilities for early retirement, including through a new early retirement scheme (“Quota 100”). The scheme is currently accessible until 2021, and allows retiring at age 62 with 38 years of contributions. Overall, the government estimates that pension expenditure, which is already among the highest in the EU as a share of GDP (15.6% in 2018), will further increase as a consequence of the reform by 0.1% of GDP in 2019, 0.3% of GDP in 2020 and 0.4% of GDP in 2021 (MEF, 2019a). Updated projections from the Economic Policy Committee - Ageing Working Group suggest that the reform will cause additional costs also in the following years, amounting to 0.4% of GDP in 2022 and gradually declining to 0.1% of GDP per year by 2028. If extended beyond their trial period, the new pension measures would cause even higher and longer-lasting costs, worsening debt sustainability in the medium term. Furthermore, these measures could negatively affect labour supply and potential growth (see Section 4.3). The 2020 budget law confirmed the new pension measures and extended to 2020 the temporary early retirement schemes for women and for vulnerable workers (“APE sociale”). 4.1.2.fiscal framework and composition of public expenditure Public investment and social expenditure are expected to increase over the coming years. Together with the recent pension provisions, the new minimum income scheme will increase social transfers in cash over the coming years. Although the time needed to process applications to the scheme led to savings in 2019 compared to the government’s initial cost estimates, the full yearly costs of 0.3% of GDP will materialise from 2020. Based on the government’s estimates, social transfers other than pensions will increase by 8% in 2019, 3.6% in 2020 and 1.3% in 2021. Public investment is also expected to progressively recover as a share of GDP, after a continuous decline over the past years (see Section 4.4). Interest spending is set to continue decreasing, as past government securities are rolled over in the current low-rate environment. However, the upward shift in Italy’s sovereign risk premiums observed from May 2018 to September 2019 offsets part of the potential savings. Yearly spending reviews help reducing expenditure growth, but improving spending-efficiency needs a medium-term approach. The government assessment of the first spending review conducted under the new budgetary framework for budgetary year 2018 concluded that the overall target of saving €1 billion had been reached. However, it also highlighted that ministries tended to reach such targets by cutting or postponing spending programmes and only partially through efficiency gains. Additional spending reviews have been carried out for budgetary years 2019 and 2020, but, as the saving targets were assigned to the ministries with a delay, the effects on the quality of public expenditure could be suboptimal. Furthermore, the spending reviews only affect the central government, while no equivalent process exists at the regional or local level despite accounting for around 30% of public expenditure. Italy is quite advanced in reporting the environmental impact of its budget (green budgeting). Since 2000, Italy has been publishing an annex to its budgetary plans which details planned expenditure on environmental protection and on resource management (“ecobilancio”). Since 2010, a similar document (“ecorendiconto”) reports the budgetary execution of the same expenditure items. Furthermore, Italy’s budgetary documents include an annex reporting on recent trends and expected progress with respect to 12 indicators on fair and sustainable well-being. These indicators include poverty, inequality, gender balance and emissions of greenhouse gases. Additional yearly reports from the Finance Minister to the Parliament consider the evolution of these indicators in the light of the latest Budget Law. Finally, the Ministry of Environment is mandated to publish every year a ‘Catalogue of harmful and favourable subsidies to the environment’ and a report on the state of natural capital. The reform of fiscal relations between the central, regional and local governments (“fiscal federalism”) has not been completed. The reform, launched in 2009 (Law 42/2009), aims at allocating resources to subnational governments based on objective criteria, while encouraging efficiency in public spending. Revenue-sharing systems would ensure full financing of the “essential levels of services” provided by subnational governments, based on “standard needs”. Dedicated funds would provide partial financing of the other functions, to which subnational authorities should also contribute with own taxes and through greater efficiency. However, the key parameters have not been defined yet for metropolitan cities, provinces and regional functions other than healthcare, and the completion of the reform has been systematically postponed and is currently planned for 2021. In their current form, proposals for regional differentiated autonomy may have an impact on regional disparities. In 2017, three regions started negotiations with the central government to acquire additional competencies, as allowed by Italy’s Constitution following the 2001 reform. The negotiations led to two subsequent sets of draft agreements in 2018 and 2019. However, the corresponding financial arrangements might have implied higher costs for the central government or fewer resources for the other regions in the medium term. The central government is currently envisaging adopting a framework law before continuing the negotiations. However, the draft law discussed with the regions in November 2019 does little to ensure the budget neutrality of the reform, including with respect to other regions, and does not set common criteria to grant additional autonomy. Moreover, any additional regional autonomy should not be considered before having set the standard financing of regions, as designed by the fiscal federalism reform. 4.1.3.taxation Italy’s tax structure still weighs heavily on labour. Revenues from all the main tax categories are above the EU average as a share of GDP, resulting in a high tax-to-GDP ratio (41.8% in 2018, EU average at 39.2%). The high revenues from indirect taxes are driven by stamp taxes and the regional tax on productive activities, an Italy-specific tax which results in high yields from other taxes on production, while revenues from value-added tax (VAT) are rather low. Taxes on labour are particularly high, as confirmed by revenues above the EU average as a share of GDP (21.0% in 2018 against 19.6% in the EU), and by one of the highest implicit tax rates on labour in the EU (at 42.7% in 2018 against 36.2% in the EU). The tax wedge on labour is among the highest in the EU across income categories (Graph 4.1.3). For low-income earners, this is due to the relatively strong weight of social security contributions. At the same time, social security contributions are capped only at a high income level, ensuring an effective progressivity of the tax system. The value-added tax is underexploited due to the extended use of reduced rates. VAT revenues are comparatively low, at 6.2% of GDP in 2018 against an EU average of 7.1%. This is due to the high level of tax evasion (resulting in a VAT compliance gap of 23.8% in 2017, far above the EU arithmetic average of 11.2%) and to the extended use of reduced rates and exemptions (reflected in high rate and actionable exemption gaps, at 12.8% and 8.4% in 2017 versus 9.6% and 3.4% in the EU, respectively) (CASE, 2019). In fact, while the standard VAT rate (22%) is slightly above the EU average (21.5%), a comparatively large basket of goods and services is taxed at the super reduced rate (4-5%) or reduced rate (10%), although such reductions do not always appear justified on economic, social or environmental grounds. This results in an effective tax rate among the lowest in the EU, at 10.2% (CASE, 2019). There is scope to increase revenues from recurrent property taxes and to update the corresponding tax base. Recurrent taxes on properties used as main residence were dropped in 2014, leading to a substantial revenue-loss. This exemption is not justified on efficiency grounds, as recurrent property taxes are a more growth-friendly source of revenue compared to taxes on labour. Simulations show that a tax shift from labour to property would provide stronger incentives to work with a positive impact on economic growth (Box 4.1.1). In order to ensure a fair taxation, cadastral values should be systematically reviewed and updated. Given that the last evaluation of properties for tax purposes occurred in the 1970s, cadastral values today bear little link to their market values. The linear increase of cadastral values implemented in 2012 did not correct distortions, as values have evolved very differently since the last evaluation depending on the geographical area, the building typology and degree of urbanisation. Despite creating a digital platform with necessary information to update cadastral values, there are currently no plans to reform the cadastral system. The 2020 budget reduces labour taxes and income tax expenditures. The 2020 budget includes a fund to reduce the tax wedge on labour by around 0.2% of GDP in 2020 and 0.3% of GDP from 2021. Based on decree-law n. 3 from February 2020, the additional resources will be used to increase the employees’ income tax credit introduced in 2014 (MEF, 2020). In its current form, the tax credit amounts to €80 per month for workers with a yearly income between €8,000 and 24,600, and gradually declines reaching zero for incomes of €26,600 or more. Under the announced new system, the bonus will increase to €100 per month for workers with yearly income between €8,000 and 28,000, will gradually decline to €80 per month for workers with yearly income of €35,000 and then to zero for yearly incomes above €40,000. As for tax expenditures, the 2020 budget introduces a progressive limit on personal income tax deductions above a specific income threshold. Graph 4.1.3:Tax wedge across income levels Source: OECD, European Commission

Note: Figures refer to a single earner without children in 2018 The higher income tax credit provides positive work incentives, but a comprehensive reform to shift taxes away from labour is still needed. According to the government, the reform will increase the number of beneficiaries of the tax credit from 11.7 million to about 16 million. Based on an EUROMOD () simulation, the reform would lower the median effective marginal tax rate from the current 75% to 39% for incomes between €24,600 and €26,600. However, in the higher phase-out income range (between €35,000 and €40,000) it would reach 63%, 14 pps higher compared to the baseline ( ). Based on the labour supply model described in Box 4.1.1, participation rates would rise by 2.3% for women and 0.9% for men, and total hours worked by 2.6% and 0.9% for women and men, respectively. The simulation suggests that gains in disposable income would mainly affect households between the third and the ninth income decile, with no impact on income inequality as measured by the Gini index.

The design of energy taxes in Italy does not promote the transition to clean technologies. Revenues from environmental taxes in Italy are above the EU average (3.3% of GDP in 2018, as against 2.4% in the EU), driven by taxes on energy (2.6% of GDP, 1.9% in the EU). However, taxes and levies on electricity are currently higher per unit of energy compared to other energy carriers such as natural gas and heating oil. Among fossil fuels, there is still a favourable tax treatment of diesel compared to petrol. Overall, the government estimates that environmentally harmful subsidies amounted to €19.3 billion in 2017 (1.1% of GDP). The 2020 budget progressively reduces tax incentives on the most polluting company cars and on transport diesel for the most polluting vehicles. Corporate taxation continues to be subject to frequent changes. The 2020 budget extends temporary tax incentives for new equipment investment until 2022 and reintroduces the allowance for corporate equity (“ACE”). However, several other measures affecting corporate taxation have been adopted but then withdrawn before being implemented. This concerns the harmonisation of taxation between self-employed workers and small firms, for which first a specific tax regime and then a flat-rate regime were both planned and then abrogated before entering into force. Similarly, ACE was replaced in 2019 by two subsequent tax regimes providing structural incentives to investment, which were abolished before entering into force, when the 2020 budget re-introduced ACE. Half of the companies surveyed in 2017 considered the lack of stability of the tax legislation as a major obstacle to investment in Italy (Eurobarometer 2018). Tax evasion is still widespread in Italy. In its annual report (MEF, 2019b), the government estimates the total tax gap at €109.1 billion in 2016 (9.4% of GDP), with relatively small fluctuations recorded in recent years. The categories most affected are income taxes paid by self-employed workers and corporations (2% of GDP), VAT (2.1% of GDP) and employer social security contributions (0.5% of GDP). Most of the gap is related to undeclared income (83% of the average propensity to evade over 2012-2017), while only a small part concerns mistakes or omitted payments for declared income (17%). The share of value added which remained undeclared in 2016 is particularly high in professional services (16.3%), retail, wholesale, transports, warehouses, hotels and restaurants (12.4%) and constructions (11.9%). Several measures have been taken to encourage tax compliance. Electronic invoicing and the electronic transmission of receipts have become compulsory for all transactions since 2019 and 2020 respectively. These measures will improve the quality and timing of the information available to the tax administration, discouraging in particular omitted payments for declared income. The 2020 budget pursues the fight against tax evasion, including by encouraging electronic payments. The 2020 budget includes several measures to fight omitted declarations, including encouraging traceable means of payment, particularly important in light of the high share of cash transactions in Italy. A fund (0.2% of GDP from 2021) has been created to reward consumers who pay via electronic means. However, an efficient use of resources needs incentives to be targeted at the sectors most exposed to tax evasion. Other measures encouraging electronic payments include lower limits for cash payments ( ), a special lottery for consumers paying with electronic means and the possibility to deduct expenditures from personal income taxes only if they have been paid with traceable means. The 2020 budget also introduces disincentives to undue compensation of tax credits, shifts VAT and social security liabilities (“reverse charge”) from subcontractors to the main contractors and several measures against excise duties and VAT fraud in the fuel sector. Furthermore, Tax Agency staff was increased to be able to intensify tax audits. The 2020 budget increases taxes on gambling and introduces a tax on digital services. After the increase implemented in 2019, the 2020 budget streamlines and further raises taxes on gambling, including by increasing the withholding tax on the winnings. Control mechanisms are also strengthened in order to prevent illegal gambling and tax fraud. While taxes on gambling provide positive disincentives, it is also important that additional mechanisms be put in place to avoid addiction and compulsive gambling. The 2020 budget also introduces a new tax on beverages with a high content of added-sugar. Box 4.1.1: EUROMOD-QUEST simulation - Shifting taxes from labour to property in Italy Reintroducing property taxes on owner-occupied properties could raise substantial revenues in Italy, even if low-value properties and low-income pensioners were exempted. The reintroduction of the property tax (IMU) has been simulated in three different scenarios using EUROMOD ( V ). All scenarios apply the rates currently used for non-exempted owner-occupied properties (luxurious properties). In scenario 1 (SC1), IMU is reintroduced on all residential properties; in scenario 2 (SC2), properties with annual cadastral income below €600( VI ) are exempted; in scenario 3 (SC3), the exemption also applies to pensioners with a yearly taxable income below €24,600( VII ). The additional revenues would amount to €8.6 billion (0.5% of GDP), 5.2 billion (0.3% of GDP) and 4.1 billion (0.2% of GDP), respectively. Using the additional revenues for reducing taxes on labour would improve distributional outcomes and increase incentives to work, supporting economic growth. The share of house-owners and the average cadastral values are relatively high at the bottom of the income distribution and increase only mildly with income (Graph 1a). Therefore, although reintroducing taxes on all residences (SC1) would imply a bigger tax increase for high-income households in absolute terms, low-income households would lose a higher share of their disposable income, causing a small increase in income inequality. Exempting low-value properties (SC2) and eventually low-income pensioners (SC3) would almost neutralise this effect ( VIII ). Furthermore, using the additional fiscal space to reduce the tax burden on labour could produce positive results. As an example, the additional revenue from scenario 2 is used to reduce social security contributions paid by employees with yearly income below €24,600 (SC2.1). Such a tax shift would have a slightly positive distributional effect, with a marginal decrease in the Gini index by 0.05%. Furthermore, the labour force participation rate would rise by 1.6% and total hours worked by 2.3% for women and 0.8% for men on average, with stronger increases for low-income workers (Graph 1b) ( IX ). Based on a QUEST analysis (see Box 3.1 on the model), 5 years after the tax shift real GDP would be higher by almost 0.1% compared to the baseline, thanks to higher employment and private consumption. Despite a decline in housing investment due to the property tax increase, the effect on investment would be overall positive after 7 years (Graph 1c). Thanks to higher revenues, the government debt-to-GDP ratio would be 0.3 percentage points lower compared to the baseline after 10 years. After 10 years, the positive impact on GDP would be double without considering the statistical impact from lower imputed rents, which are recorded as part of GDP. Source: European Commission Joint Research Centre and DG ECFIN, based on EUROMOD / EU-SILC and QUEST. 4.2. Financial sector Recent banking sector developments Following sustained efforts to de-risk balance sheets, asset quality has significantly improved. Banks have continued cleaning up their balance sheets by disposing of a large amount of NPLs (roughly €20 billion in the first 10 months of 2019, mostly bad loans) through outright sales and securitisations( ). The further development of the secondary NPL market is also evident in terms of pricing, especially for uncollateralised positions. As a result, the stock of gross NPLs stood at €177 billion in June 2019, 21% less than in June 2018, with an NPL coverage ratio of 52.5% (euro-area average: 47.7%). Banks have also continued strengthening their internal workout capacities, while the inflow of new NPLs stood at 1.2% at end-September 2019, below pre-crisis levels. Pockets of vulnerability remain, as asset quality improvements are not homogeneous among banks. The system-wide gross NPL ratio fell to 8.1% in June 2019, down from 10% a year earlier and from 16.8% at the peak level in Q3-2015. However, the gross NPL ratio is still significantly above the euro area average of 3.4%, and many banks still exhibit double-digit gross NPL ratios, in particular second-tier banks and less significant institutions, which had gross NPL ratios of 10.3% in June 2019. While past market volatility did not have a significant negative impact on NPL outright sales, including on pricing, downside risks for disposal of NPLs remain, given the weakening economic cycle. Furthermore, the potential re-emergence of heightened market volatility could make the use of the Guarantee on Securitisation of Bank NPLs scheme less attractive for credit institutions due to higher fees on State guarantees. The resolution of unlikely-to-pay loans has gradually gained momentum in recent years. So far, most of the decrease in the legacy NPL stock has been due to disposals of bad loans (sofferenze). The more complex unlikely-to-pay (UTP) asset class requires restructuring of the underlying asset, which may entail, among other things, granting operating and financial support to borrowers during the turnaround. Due to the significant volume of UTPs in bank balance sheets (some 43% of the total NPL stock in June 2019), the secondary market for distressed debt has margin to further develop in terms of transactions, specialised asset servicing companies and IT platforms. The fact that the divestments (€5 billion) and special servicing of UTP loans recorded an upward trend in 2018, is encouraging. Yet banks would need to reinforce their internal workout capacities for UTP loans. The decline in sovereign spreads has taken pressure off Italian banks’ capital and funding. Lower sovereign yields since November 2018, coupled with measures to mitigate the impact of sovereign spread volatility, have enabled banks to contain the erosion of their capital buffers. However, Italian banks continue to hold a significant amount of government bonds. The recovery in government bond prices has allowed banks to reverse the trend observed since mid-2018. Meanwhile, banks slightly reduced their holdings of Italian government securities to €334 billion (9.7% of total assets) in September 2019 compared to April. However, this share exceeds markedly the euro-area average (3.2%), with smaller banks often being more exposed than larger ones. Banks have taken measures to reduce the sensitivity of their capital to changes in the value of domestic sovereign bonds. To shield their capital buffers, credit institutions have largely rebalanced their portfolios of government securities towards the held-to-collect category (valued at amortised cost), which reached 62% of total holdings at the end of September 2019. Still, the Bank of Italy estimates that an upward shift in the government yield curve (by 100 basis points as of the June 2019 level) would reduce the common equity Tier 1 (CET1) ratio of banks (both significant and less significant) on average by 30 basis points. After an erosion in the first half of 2018, Italian banks’ capital buffers recovered as of the first half of 2019, with the average CET1 standing at 13.5%, up by 70 basis points relative to Q2-2018 but still some way off the 14.8% average CET1 ratio of euro-area peers. Renewed market volatility could affect banks’ cost of funding and credit provision to the economy. Beyond capital losses, this impact could materialise through higher funding costs, impaired market access, and lower collateral valuation or credit ratings. Moreover, the impact of higher sovereign spreads on banks’ funding cost tends to be passed on to households through a rise in the pricing of new loans. Heightened market volatility throughout 2018 resulted in a 30 basis points rise in the margin on fixed-rate mortgage loans from September 2018 to January 2019, with the cost gap between them and variable-rate loans also going up by 10 basis points over the same period. By contrast, this transmission mechanism has been less pronounced for the new loans granted to firms, due to the increased competition among banks. Improving profitability in a low interest rate environment remains challenging. Profitability in the first half of 2019 was up year-on-year, with an annualised return-on-equity of 8.3%, mostly supported by lower provisions and operating costs for loan loss. Moreover,in the first half of 2019 the contribution of net fees and commission income to banks’ total income was well above the euro area average (37.2% and 30.1%). Despite cost-cutting efforts and the observed improvement in Q2-2019, some banks are still struggling with high cost-to-income ratios. Therefore, they need to make further progress downsizing their branch networks and headcount, while maintaining the above-average contribution of net fees and commissions to total income. The liquidity position of banks has remained adequate, supported by significant Eurosystem financing. The system-wide liquidity coverage ratio reached 1