Italy is experiencing excessive imbalances. Vulnerabilities relate to high government debt and weak productivity growth, in a context of labour market fragilities and some weaknesses in financial markets, which carry cross-border relevance. Persistent low productivity growth has been a key factor behind Italy’s protracted weak GDP growth, which has dampened government debt deleveraging, dented employment opportunities and impacted banks’ balance sheets. The government debt-to-GDP ratio started to decline in 2021 and is forecast to further decline but remains a risk for fiscal sustainability, the financial sector and economic growth. Despite improvements in the labour market, low participation rates persist. Significant improvements have been achieved in reducing non-performing loans, although the sovereign-bank nexus reinforced over the COVID-19 crisis and remains a challenge. In addition, the banking sector may face challenges as the impact of the phasing-out of temporary support measures in response to the pandemic crisis fully unfolds. The RRP is addressing vulnerabilities, including by spurring competitiveness and productivity. Nonetheless, the growth-enhancing effect of investment and reforms is likely to take time to unfold and crucially depends on swift and sound implementation.

1. Introduction

In 2021, over the previous annual cycle of surveillance under the Macroeconomic Imbalances Procedure (MIP), the Commission identified “excessive macroeconomic imbalances” in Italy. ( ) These imbalances were related to the high level of government debt and weak productivity growth, which have cross-border relevance in a context of labour market and banking sector fragilities. The 2022 Alert Mechanism Report concluded that a new in-depth review (IDR) should be undertaken for Italy with a view to assess the persistence or unwinding of imbalances. ( )

Italy’s economy closed 2021 on a relatively solid footing, despite sizeable headwinds. ( ) Real GDP grew by 6.6% and almost reached pre-COVID-19 levels in the final quarter of 2021, despite rapidly rising infection rates and surging energy prices. Real GDP growth is projected to slow to 2.4% in 2022 and 1.9% in 2023, as high energy prices and supply bottlenecks further exacerbated by Russia’s military aggression against Ukraine continue to take a toll on economic activity. EU-supported investment and the still high stock of accumulated savings provide some safeguards against a severe growth slowdown going forward. The labour market recovered in 2021 on the back of temporary employment. Jobs growth is set to continue in line with slowing economic activity. Inflation is projected to accelerate further this year due to the pass-through of higher energy costs to consumer prices, before falling back in 2023. Energy and commodity prices are expected to remain high throughout 2022 and persisting supply bottlenecks continue to weigh on growth. In view of the extremely high geopolitical tensions related to the war in Ukraine, the outlook remains subject to high uncertainty and substantial downside risks.

This in-depth review presents the main findings of the assessment of imbalances. The assessment is backed by a thematic section on financial sector developments. Spillovers and systemic cross-border implications of imbalances are also taken into account. In addition, assessments of structural issues made in previous IDRs and in the context of fiscal assessments are also considered if relevant. The MIP assessment matrix is published in the 2022 Country Report for Italy. ( )

2. Assessment of macroeconomic imbalances

Assessment of gravity, evolution and prospects of macroeconomic imbalances

Low productivity growth was the main factor behind Italy’s weak growth performance in the decade prior to the COVID-19 pandemic. Over the period 2010-19, hourly productivity growth averaged 0.4% per year compared with an EU average of 1.2%. The capital-labour ratio, as measured by net fixed assets per unit of labour employed, stagnated when measured by hours worked or even gradually declined in terms of headcount employment. The high price for capital (relative to labour) reduced firms’ incentives to invest in equipment and intangible assets, thus encouraging them to remain in labour-intensive traditional sectors. As a result, the key impediments of the Italian economy to higher productivity growth, notably the high share of low-productivity sectors combined with a small average firm size and low investment rates, became entrenched. Hence, the slowdown in productivity can be associated with a declining capital intensity (i.e. less capital deepening) and a slow diffusion of new technologies, such as information and communication technologies (ICT). Productivity remains particularly low in lagging regions.

The policy response to the COVID-19 pandemic offers prospects for structural productivity improvements. Labour productivity in terms of hours worked rose sizeably in 2020, likely influenced by a compositional effect, as the reduction of hours worked in small, less productive firms was relatively more pronounced than in larger, more productive firms with higher capital endowments. This effect partly reversed in 2021, when labour productivity declined and hours worked increased, albeit not yet to the level of 2019. However, increasing investment since 2015, only shortly but sharply interrupted by the pandemic in 2020, and policy measures included in Italy’s Recovery and Resilience Plan (RRP), in conjunction with Cohesion Policy Funds, are expected to spur productivity in the medium term. In particular, substantial investment in skills, innovation and digitalisation as well as reforms of the public administration, the judicial system and insolvency framework are set to contribute to an efficient allocation of physical and human capital. By contrast, the fact that many companies have higher debt than at the outset of the pandemic risks curtailing their ability to invest in productivity-enhancing technology, and school and university closures might have a long-term impact on income and productivity growth. Private and public investment in key areas such as intangibles and education is still relatively low.

Italy’s high level of public debt remains a risk for fiscal sustainability, the financial sector and economic growth. The high sovereign financing needs to roll over existing debt and to service interest payments make Italy strongly dependent on financial markets’ risk perceptions, with potential spillovers to the domestic financial sector, given its high exposure to the sovereign. The low interest rate environment, the growing average maturity of outstanding debt and the Eurosystem’s increased purchases of government securities have reduced fiscal sustainability risks, but sovereign financing conditions are expected to become less favourable with a less accommodative stance of monetary policy. Furthermore, high debt servicing costs limit the scope for growth-enhancing expenditure. The Commission’s fiscal sustainability assessment shows that Italy faces high fiscal sustainability challenges over the medium term and medium challenges over the long term. ( ) However, the reforms outlined in Italy’s RRP are expected to have a substantial positive and persistent growth impact in the coming years, which, ceteris paribus, should strengthen debt sustainability.

Italy’s government debt started to decline in 2021, albeit from a high level. Italy’s public debt ratio in 2019 stood at 134.1% of GDP, high in a euro area comparison, partly due to persistently weak growth. The pandemic-related emergency policy measures and the sharp drop in GDP raised the debt ratio to 155.3% of GDP in 2020. The subsequent economic recovery boosted economic output and government revenues and public debt fell back to 150.8% of GDP in 2021. Italy’s public debt ratio is projected to gradually decline to 146.8% of GDP by 2023 along with the expected economic growth, low financing costs and lower primary deficits. The expected budgetary improvements stem from a gradual phasing out of emergency measures and the projected economic growth, which are expected to more than offset the deficit increasing impact of permanent measures introduced in recent years.

The labour market continues to face structural challenges with low participation rates, regional and gender disparities, and high youth unemployment. Participation rates, especially among women, have been rising from albeit very low levels in the years prior to the pandemic and are about 13% below the EU average (15 to 64 years). The unemployment rate of women in 2021 was about two percentage point higher than for men (10.6% vs 8.7%). Youth unemployment dropped from its 2014 peak of 42.7% to 29.7% in 2021, owing largely to the increase in temporary employment of young people. The employment rate (15-64 years) records a substantial regional gap, between 66.4% in the North and 44.8% in the South (Mezzogiorno).

The labour market weathered the pandemic shock but recent job gains are largely driven by temporary employment. Headcount employment, in particular jobholders with permanent contracts, were effectively protected by short-time work schemes and the drop in employment was contained in 2020. The job market recovered in 2021, with surging temporary employment (9.7%) being the main pillar of employment growth. The unemployment rate fell between 2019 and 2021 from 9.9% to 9.5%. However, activity and employment rates, in particular of women and young people, remain markedly below the EU average. Moreover, the size of the shadow economy in Italy, albeit on a falling trend, was estimated at 11.3% of GDP in 2019 ( ) reflected by widespread undeclared work. Looking ahead, jobs growth is forecast to continue, as policy measures favour a more efficient functioning of the labour market and are also expected to lift labour supply and promote labour market transitions.

In 2021, the banking sector restored its profitability and made significant progress in reducing legacy non-performing loans. Banks’ profitability recovered to pre-pandemic levels, registering a return-on-equity of 5.8% in Q3 2021, mainly due to lower loan-loss provisions. Since Q4 2020, the CET1 ratio for Italian domestic banks slightly declined to 15.4 % in Q3 2021, but remained above the pre-pandemic level of 14%% in 2019. The legacy stock of non-performing loans (NPLs) continued to decline, with the gross NPL ratio falling to 4% in Q3 2021, from 5.6% in Q3 2020 and from the pre-pandemic level of 6.7% (at the end of 2019). However, the rising share of loans that show a significant increase in credit risk (Stage 2 loans) underlines the need for close monitoring. Moreover, the full impact ( ) of the pandemic on asset quality will likely become visible only with a certain time lag, once state-support measures are being fully phased-out and granted moratoria have expired. Following three prolongations, 83% of approved moratoria had expired by 31 December 2021 and the total volume of loans with non-expired moratoria (i.e. legislative and voluntary moratoria granted by banks) amounted to EUR 44 billion. Risks also persist that potential second-round effects on economic growth from Russia’s unprovoked invasion of Ukraine could lead to further vulnerabilities associated with private sector debt (see box 2.1).

Since the beginning of the pandemic, Italian banks had increased their exposure to domestic sovereign. According to ECB data, Italian banks' holdings of Italian sovereign debt increased by EUR 71 billion since December 2019 and reached a peak at EUR 710 billion in September 2020, ( ) before falling back to EUR 671 billion by December 2021. Sovereign exposure of the Italian banking sector remains high and sovereign debt accounted for 21.3% of total banking sector assets in December 2021. The 10-year sovereign bond yield increased by around 160 bps in the first four months of 2022 continuing the increasing trend since summer 2021. Bank of Italy estimates that the impact on banks’ capitalisation of an upward shift in the sovereign yield curve would be limited. ( ) However, the risks associated with the increased share of public guarantees on banks’ balance sheets amplifies the sovereign-bank nexus, as illustrated in the thematic chapter. Finally, the Italian financial system remains predominately bank-based and despite some progress in recent years, access to non-bank finance remains underdeveloped and concentrated in northern regions.

Italian banks’ exposure to Russia is contained but is amongst the highest in the EU, with total claims representing about 1.2% of Italian GDP. According to the latest EBA dashboard (Q1-2022), the exposure of Italian banks to Russian counterparts amounted to EUR 21.8 billion or 28.6% of the total EU exposure towards Russian counterparts at the end of December 2021. Italian banking groups increased operations on the Russian market since 2015, but are currently re-assessing their exposure to Russia (and Ukraine) and considering options to mitigate the risks associated with this exposure. However, the exposures to Russia appear small relative to the total assets and loan books of parent groups exposed to Russia. Even a full write-off of banks’ investments in their Russian subsidiaries in an extreme scenario is expected to have only a moderate impact on the capital buffer at the group level (see also Box 2.1).

Assessment of MIP relevant policies

Italy has started to implement its Recovery and Resilience Plan and, if fully implemented, the measures are expected to spur competitiveness and productivity. The enabling law to reform the judicial system adopted in 2021 is set to enhance the efficiency of the judicial system provided further implementing steps foreseen in the RRP proceed on schedule. Moreover, additional resources are being deployed to clear the backlog of cases before the courts. The timeliness and greater predictability of legal decisions should make the Italian economy more attractive for foreign investment. Similarly, the measures on public procurement reform adopted in 2021 and the envisaged revision of the code of public procurement by 2022 are conducive to simpler and faster procedures for awarding public contracts and ultimately to the improvement of the business environment. A public administration reform planned for 2022 under the RRP has the potential to strengthen administrative capacity and reform public employment at all levels of government. Similarly, the government intends to remove barriers to competition in selected sectors in 2022 and has implemented the Transizione 4.0 tax credit in 2021, as part of RRF-supported measures to favour the digitalisation of business.

Reforms, including those in the Recovery and Resilience Plan, are expected to improve the efficiency of revenue collection and public spending in the medium term. The government maintained its emergency support for households and firms and further stepped up public investment in 2021. The reforms and investments included in Italy’s Recovery and Resilience Plan are expected to help reduce the debt ratio by supporting GDP growth, enhancing revenue collection and tailoring spending. With the 2022 Budget, the government reduced the personal income tax rates for middle-income earners and the draft delegation law of October 2021 sketched out a general tax reform. Past reforms to bolster tax compliance have already mitigated the still high revenue losses from tax evasion. The RRP measures planned for 2022 are expected to further improve tax collection. On the expenditure side, the RRP envisages reinforcing spending reviews and completing the reform of fiscal federalism to increase transparency and encourage spending efficiency across all government levels. By contrast, the large number of guarantees granted during the pandemic increased the government’s contingent liabilities and hence the risk of higher public spending in the next years. In addition, pension expenditure is projected to grow until 2026, in part due to the temporary early retirement scheme for the period 2019-2021 and prolonged to 2022 with stricter eligibility criteria, before the provisions of the 2011 pension reform are set to slow pension spending.

The RRP includes measures to increase participation rates and the government has extended the social safety net. The National programme for the Guaranteed Employability of Workers (GOL) and the National Plan for New Skills, adopted in 2021, have the potential to raise labour market participation and facilitate jobs transitions while reducing hysteresis effects, regional disparities and skill mismatches. Similarly, the 2021 reform of university degrees easing access to some professions as well as the envisaged 2022 reform of the orientation services in upper secondary schools are expected to facilitate students’ transition from education to the labour market. However, lowering the entry barriers to the labour market more effectively, particularly for women, requires strengthening the provision of affordable quality early childhood education and care, as well as counteracting the effects of labour market segmentation on young people. The reform of the social safety net included in the 2022 budget law and detailed in the Decreto Sostegni Ter extends inter alia the sectorial coverage of short-time work schemes. While this measure is welcome, the reform does not fully address one of the major structural shortcomings of short time work schemes’, namely the focus on the protection of specific jobs instead of workers. The impact of the reform will in part depend on the strengthening of regional public employment services as part of the GOL reform. The adoption of the three-year plan 2020/2022 to combat labour exploitation in the agricultural sector (Piano triennale di contrasto allo sfruttamento lavorativo in agricoltura e al caporalato 2020/22) and the RRP-sponsored National Plan tackling undeclared work across all economic sectors set to be adopted in 2022 might contribute to reduce irregular employment and the size of the shadow economy.