EUROPEAN COMMISSION Brussels,7.3.2018 SWD(2018) 210 final COMMISSION STAFF WORKING DOCUMENT Country Report Italy 2018

Including an In-Depth Review on the prevention and correction of macroeconomic imbalances

Accompanying the document COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2018 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(2018) 120 final}





Contents Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Summary of the main findings from the Macroeconomic Imbalance Procedure in-depth review 4.Reform priorities 4.1.Public finances and taxation 4.2.Financial sector 4.3.Labour market, education and social policies 4.4. Investment and competitiveness 4.5. Sectoral policies Annex A: Overview table Annex B: Macroeconomic Imbalance Procedure Scoreboard Annex C: Standard tables References LIST OF Tables Table 1.1:Key economic, financial and social indicators - Italy Table 2.1:Summary table on 2017 CSR assessment14

Table 3:Macroeconomic Imbalance Procedure Assessment Matrix (*) - Italy Table 4.2.1:Italian banking system key indicators Table B.1:The MIP scoreboard for Italy (AMR 2018) 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 LIST OF Graphs Graph 1.1: Real GDP and components Graph 1.2: Real investment and components Graph 1.3: Regional contributions to national GDP growth (left-hand side) and potential growth and contributions (right-hand side) Graph 1.4: Labour market indicators: Employment (left-hand side) and unemployment (right-hand side) Graph 1.5: Price and wage dynamics Graph 1.6: Credit growth and lending rates Graph 1.7: Current account balance 9 Graph 1.8: Italy's public finance indicators Graph 2.1: Overall multiannual implementation of 2011-2017 CSRs to date

Graph 3.1: Drivers of 'snowball effect' on public debt Graph 3.2: Evolution of Italy's public debt-to-GDP ratio under different debt sustainability analyses Graph 3.3: Productivity growth and gross value added Graph 4.1.1: Evolution of real general government primary expenditure (left-hand side) and composition of primary expenditure by COFOG functions (right-hand side) Graph 4.2.1: Benchmarking the Italian Banking System 30 Graph 4.3.1: Permanent, temporary and self-employed, cumulative change 2014-2017 Graph 4.4.1: Italy’s export market shares, exchange rate and cost competitiveness indicators Graph 4.4.2: Non-residential tangible and intangible investment in Italy and the rest of the euro area, constant prices Graph 4.4.3: Share of debt in companies facing financial stress Graph 4.4.4: Return to skills (numeracy) Graph 4.4.5: Time needed to solve civil and commercial litigious cases Graph 4.5.1: Overall restrictiveness of business services, 2016 Graph 4.5.2: European quality of government index - best and worst performing regions per country Graph 4.5.3: Ultra-fast Broadband coverage and penetration in 2017 (% of households) LIST OF Boxes Box 2.1: Tangible results delivered through EU support to structural change in Italy Box 3.1: Euro area spillovers Box 4.1.1: Effects on labour supply from rationalising childcare benefits Box 4.3.1: Monitoring performance in light of the European Pillar of Social Rights

Box 4.4.1: Investment challenges and reforms in Italy Box 4.5.1: Policy highlights: Equitable and Sustainable Well-being indicator system Executive summary Italy’s ongoing recovery offers a window of opportunity to boost the reform momentum. By fully implementing already adopted measures and completing key reforms in the pipeline, Italy could lift its sluggish potential growth, rooted in weak productivity. This would reduce the risk of a slowdown, should the external environment and financial conditions become less supportive. In particular, Italy's resilience could be helped by improving the business environment — notably by reforming the judicial process and the insolvency and taxation frameworks — and strengthening the banking system and the labour market. ( ) Italy's recovery has strengthened. Supported by the accommodative monetary policy stance of the European Central Bank (ECB) and buoyant external demand, Italy’s real GDP growth is projected at 1.5 % in both 2017 and 2018. It is expected to slow to 1.2 % in 2019. Rising demand and favourable financing conditions have started to support investment again after the sharp fall it suffered during the global financial crisis. Labour market conditions continue to improve. Headcount employment (15-74 years) rose by 1.0 % in 2017 to over 23 million people, taking it back to pre-crisis levels. The employment rate (20-64 years) rose to 62.7 % last year, largely driven by temporary employment, after a sharp increase in permanent contracts in 2015-2016. Employment is set to increase further in 2018-2019, albeit at a more moderate pace of 0.8 %. As inactive people join the labour force, higher activity rates will support medium term growth prospects. In the short term, however, this will reduce the unemployment rate only gradually. Given its systemic importance, Italy is a source of potentially significant spillovers to the rest of the euro area. Italy is also an important export market for a number of euro area countries and maintains strong financial linkages to other euro area countries. Long-standing structural weaknesses and regional disparities continue to weigh on Italy’s growth potential. Despite the recent recovery, Italy’s real GDP is still below its pre-crisis peak and growing at a slower pace than in peer euro area economies. Regional differences persist both in economic prospects and employment growth. Long-term and youth unemployment remain very high. While the recovery has slightly reduced the headline deficit, Italy’s public debt has continued to grow and is set to have peaked at 132.1 % of GDP in 2017. Despite historically low financing costs, private sector credit growth is still muted. Italy has made some progress in addressing the 2017 country-specific recommendations. Italy made substantial progress in adopting measures to increase tax compliance and fight corruption. Some progress was made in reforming the public administration, addressing restrictions to competition, repairing the banking system and rationalising social spending. Only limited progress was made in shifting the tax burden, reducing trial length in civil justice and reforming the insolvency framework. Gaps also remain in reforming collective bargaining, active labour market policies, and in enhancing access to work for second earners. Regarding the Europe 2020 Strategy, Italy already achieved its targets on renewable energy, energy efficiency, early school leaving and tertiary education, and appears on track on greenhouse gas emissions reduction. Limited progress has been made in meeting the targets on employment rate, R&D investment and poverty and social exclusion. Italy faces challenges with regard to a number of indicators of the Social Scoreboard supporting the European Pillar of Social Rights. In particular, Italy has a very high gender employment gap, low overall employment rate and high and increasing income inequality. The impact of social transfers is low, but policy action has been taken recently. The share of young people not in employment, education or training is very high, although declining. While health outcomes are overall good, the high proportion of the population with self-reported unmet needs for medical care continues to be a challenge. Italy also has a high and increasing risk of poverty or social exclusion, a high number of early leavers from education and training and a low level of digital skills. The main findings of the in-depth review contained in this report, and the related policy challenges, are as follows. ·Italy’s high public debt remains a major vulnerability. The public debt-to-GDP ratio is forecast to stabilise at around 130 % of GDP over 2017-2019. Still low but rising inflation, limited increase in the primary surplus and below-target privatisation proceeds continue to hinder debt-reduction efforts. Yet, refinancing risks seem limited in the short term mainly thanks to ample liquidity in the market and an improved external position. Medium-term sustainability risks remain high as the structural primary surplus, at 1.6 % of GDP in 2018, is insufficient to bring about a rapid decrease in public debt. The long-term fiscal sustainability secured by past pension and healthcare reforms is weakening too due to recent policy measures and adverse demographic trends. Overall, risks may emerge if the current accommodative monetary policy stance were to be reversed. ·Productivity growth still remains weak. Italy’s productivity growth has been sluggish over the past two decades due to persistently stagnant total factor productivity and low investment including in education and intangibles. Neither has regained its pre-crisis level yet. Certain features of the managerial practices in the numerous small businesses, the misallocation of resources among sectors and firms, and public expenditure that is biased towards old-age pensions constitute a further drag on productivity. In turn, the sluggish productivity growth has also contributed to past losses in competitiveness, although Italy has started regaining export market shares in 2013. ·Efforts to address the high levels of non-performing loans are bearing fruit, and acute banking problems have been tackled. The number of new non-performing loans has declined to pre-crisis levels and the stock has decreased markedly over the recent period. Yet, it remains high compared to EU peers and continues to weigh on banks’ profitability and on their ability to raise capital internally and to efficiently (re)allocate it to the most productive firms. Building on adopted measures — like the guarantee scheme to support NPL securitisations — the pursuit of further efforts could help to address the remaining vulnerabilities. The reform of the insolvency framework, in particular, is yet to be finalised. ·Long-term and youth unemployment pose risks to social cohesion and growth. Although declining, both remain among the highest in the EU, also as a consequence of Italy's protracted recession. The low overall activity rate is constraining potential output growth. At the same time, the high level of youth unemployment can hinder young people's acquisition of skills and future employability. Other key economic issues analysed in this report that point to challenges for Italy are the following: ·A high tax burden and low tax compliance continue to hold back economic growth. Despite extended tax incentives to promote employment and investment, Italy’s tax burden on labour and capital remains among the highest in the EU. Efforts to shift it to property and consumption are still limited. The complexity of the tax code increases the burden on compliant firms and households and reduces tax compliance. Recent measures to tackle these problems, including broader compulsory electronic invoicing, are promising. Yet, the long-awaited revision of tax expenditures and cadastral values has been further postponed. The abolition of job vouchers has not given way to alternative strategic approaches to combat undeclared work. ·Investment is still subdued, in particular in intangible assets. Since the crisis, investment declined sharply and has not yet returned to its 2007 level. Despite the adoption in 2017 of an ambitious investment plan in infrastructure, notably in transport, investment is still held back by structural factors. These include financial constraints related to underdeveloped capital markets, impaired bank-lending and lack of high-skilled people also due to brain drain and limited lifelong learning. The business environment is still unfavourable to investment despite ongoing policies such as the ‘Industria 4.0’ to promote business investment. Investment in ‘intangible’ assets such as R&D, innovation and training of workers remains below the EU average due to the large number of micro-firms, Italy's lack of specialisation in knowledge-intensive sectors, limited digitisation and digital skills. Moreover, public spending in R&D has been reduced.

·‘Second-level’ wage bargaining is not widespread and the implementation of the active labour market policies (ALMPs) reform is delayed. Despite recent labour market reforms, limited use of ‘second-level’ wage bargaining — at regional, sectoral or company level — may weaken the link between wage levels and local economic conditions, thereby reducing competitiveness. Moreover, while a dedicated agency to reform ALMPs was set up in 2017, the governance of the system remains weak and no strategic plan has been adopted yet. The annual reports on the implementation of the Jobs Act provisions on ALMPs, envisaged by the law, have not been published yet. ·New social policies are being implemented to tackle rising poverty, while demographic challenges remain. The rate of people at risk of poverty or social exclusion in Italy is high, especially for children, temporary workers and migrants. In response, the design of a new permanent scheme to tackle poverty represents a major breakthrough, which could also help reinforce so far understaffed social services. Moreover, Italy’s low fertility rate, ageing population and worsened migration balance raise medium-term challenges. These require the development of long term strategies such as better targeted family-support policies. The proportion of women participating in the labour market remains in fact one of the lowest in the EU. The main reasons include the difficulty of reconciling work with family care due to the limited availability of affordable childcare and long-term care services, low take-up of parental leave by men and the weak incentives offered by certain aspects of the tax and benefits system. The currently fragmented system of bonuses to support families appears to be ineffective in addressing these challenges. ·The education system is underfunded. Italy’s early school leaving rate remains above the EU average and wide regional disparities persist in educational attainment despite an overall improvement in the quality of schooling. High dropout rates and a comparatively long duration of studies contribute to low tertiary education attainment rates. Despite these challenges, the share of public expenditure in education continued its downward trend. ·Efforts were made in 2017 to reform the public administration, judicial system and anti-corruption framework. Yet, the functioning of the public administration and the management of public employment are still less efficient than in peer countries. Challenges persist in the management and rationalisation of publicly-owned enterprises. The length of civil justice proceedings remains worrying especially at higher instances, where the effectiveness of past reforms to prevent abuses of the trial remains uncertain and case management can still be improved. Moreover, while Italy strengthened its regulatory framework to fight corruption, challenges still remain in terms of its implementation. ·The business environment continues to hinder entrepreneurship, and significant barriers to competition remain. Some sectors are still over-regulated, including professional services, local public services and transport. The lack of competitive processes to award public service contracts and concessions for access to public goods negatively impact service quality, especially in the transport sector. Timely implementation of the 2015 competition law and the removal of the remaining restrictions to competition could help a more efficient allocation of resources and improve productivity. The low quality of public administrations and the great regional variation in their responsiveness to business needs have a negative impact on the business environment and limit firms' ability to exploit innovation opportunities. The benefits of the public procurement reform will depend on its timely completion and consistent application. 1. Economic situation and outlook Real GDP growth, risks and challenges The recovery strengthened in 2017, supported by the global cyclical upswing. After emerging in mid-2014 from a protracted double-dip recession, Italy saw its real GDP grow by a cumulative 4.2 % up to the fourth quarter of 2017. However, the recovery set in later and is proceeding more slowly than in other euro area countries, and real GDP is still considerably below its pre-crisis peak in 2007. Supported by the ECB’s accommodative monetary policy and buoyant external demand, real GDP is expected to have grown by 1.5 % in 2017 (European Commission, 2018f). Exports of goods and services picked up markedly. However, since imports grew equally strongly, partly due to the relatively high import content of exports and equipment investment, net trade made a slightly negative contribution to GDP growth. Despite subdued real wage growth consumer spending increased, as stable growth in employment underpinned private consumption (Graph 1.1). Graph 1.1:Real GDP and components Source: Eurostat Favourable financing conditions and rising demand are supporting investment. Aggregate investment started recovering in 2014, supported by increasingly favourable financing conditions and fiscal incentives but also by the need to renew an ageing and declining capital stock. Equipment investment has been the major driver of the recent investment recovery (Graph 1.2). By contrast, construction, accounting for roughly half of total investment, has barely recovered from its deep slump. This applies particularly to non-residential investment, largely due to falling public investment (see Section 4.4.2). Lending to non-financial corporations is still subdued and the pace of the recovery in capital spending is still too moderate to quickly recoup the large drop in investment during the crisis. The total net capital stock further declined in 2016. Graph 1.2:Real investment and components Source: Eurostat Economic prospects are also gradually improving in the southern regions. In 2016, real GDP in the Mezzogiorno (southern regions) increased by 0.8 %, after 1.5 % a year before when it recorded its first GDP rise since 2007. Southern Italy accounts for 22.6 % of the country's total output and grew on average slightly faster than the north in 2015-16 (Graph 1.3, left-hand side). Private consumption grew by an average 1.4 % in line with rising disposable income, while investment rebounded in 2015 after dropping by a cumulative 62 % in 2007-2014. However, the lower industrial base in the southern regions is limiting the positive impact of the rebound in manufacturing. In the economy of the southern regions the public sector and services have a more prominent role — and these sectors normally register lower average productivity growth than manufacturing industry. Maintaining the current momentum of growth remains challenging. Looking ahead, the recovery is set to become more self-sustained, but growth prospects remain moderate. Real output is forecast to expand at a modest and declining pace, reaching 1.2 % in 2019. The expected slowdown reflects an external environment which is projected to become less supportive, an expected gradual tightening of the monetary and fiscal policy stance and the Italian economy's low growth potential. The latter is related to weak growth in total factor productivity, rooted in long-standing deficiencies in the functioning of Italy's labour, capital and product markets (see Section 3). Potential growth is projected to rise moderately, driven largely by rising labour input. Potential output has been declining since the onset of the global financial crisis. The reasons for this have been low investment and weak productivity growth. However, helped by structural reforms and the recovery of investment, growth in potential output is forecast to turn slightly positive in 2017 and to increase moderately in 2018-2019 (based on the commonly agreed methodology).( ) Potential output is being mainly driven by rising labour input, in particular higher employment due to increasing activity rates (Graph 1.3, right-hand side). However, rising labour input offsetting falling or low productivity does not bode well for medium-term growth prospects, given Italy’s shrinking working-age population. In line with investment growth, capital accumulation is expected to become a complementary driver of potential growth. By contrast, growth in total factor productivity contributed negatively to potential growth until 2017 and is estimated to make only a very small positive contribution in 2019. Graph 1.3:Regional contributions to national GDP growth (left-hand side) and potential growth and contributions (right-hand side) Source: ISTAT, European Commission Labour market performance Employment is rising broadly in line with output growth. In Q3 2017 the number of workers (15-74 years) increased by 1.0% y-o-y and hit a record of over 23 million. As such, the employment rate (20-64 years) rose to 62.7 %. Since 2013 employment growth has been mainly driven by pension reforms that gradually lifted the statutory retirement age. By contrast, employment on temporary contracts increased sharply in 2017( ), becoming the main driver of jobs growth (See Section 4.3.1). Gender and regional differences remain persistent. The activity rate remains well below the EU average, especially for women. The employment rate of women, though increasing, is far below that of men. The gender gap is one of the highest in the EU (52.6 % employment rate for women vs 73.0 % for men in Q3 2017). Regional divergences in overall employment rates, albeit narrowing since 2013, remain considerable. They currently range between 71.9 % in Trentino-Alto Adige and 40.6 % in Calabria. The number of employed persons has returned to pre-crisis levels but hours worked still lag behind. The number of employed people continued to increase and is now around pre-crisis levels. By contrast, total hours worked, which started to recover in 2015, are still considerably lower than before the recession (Graph 1.4). This is also reflected in the lower level of employment expressed in full-time equivalents. The still relatively subdued level of hours worked is mostly due to the two sharp drops during the double-dip recession. ( ) Since 2013, headcount employment, employment in full-time equivalents and hours worked have grown at roughly the same rate, albeit from different levels. Graph 1.4:Labour market indicators: Employment (left-hand side) and unemployment (right-hand side) Source: Eurostat

Despite strong job creation, unemployment is declining gradually, as labour force participation is rising. The unemployment rate, at 10.8 % in December 2017, has been declining gradually from its 13.0 % peak in November 2014. The pace of decline is slowed by the return to the labour force of previously ‘discouraged’ workers (those available to work but not formally seeking jobs). Long-term unemployment has also been slowly declining from its 7.7 % peak in 2014 to 6.2 % in the third quarter of 2017 (Graph 1.4). In the first quarter of 2017, the average length of unemployment was 15 months, 2 months less than before the crisis. The number of ‘discouraged’ workers remains high but is receding (from 3.6 million in 2015 to 3.3 million in 2016). In 2016, unemployment among the low-skilled was 19.2 % but less than 7 % among the highly educated. Youth unemployment is still among the highest in Europe despite decreasing from its peak of 43.6 % in 2014 to 32.2 % in December 2017. The number of young people not in employment, education or training (NEET) fell from 22.2 % in 2012 to below 20 % in 2016, but is still the highest in the EU and subject to wide and persistent regional differences. Price and wage developments Wage growth remains moderate, as slack in the labour market persists. Contractual wages grew by 0.7 % in the year to December 2017, which is broadly consistent with current inflation and productivity developments as well as the still high level of unemployment. Since 2009, constrained nominal wage growth has helped stem the loss in cost competitiveness. Recent contract renewals have been characterised by modest wage increases and some of them adopted wage-setting mechanisms based on past, instead of expected, inflation. Public wages, effectively frozen since 2010, are set to increase modestly following the renewal of labour contracts in the public sector which will affect about 3.4 million employees. Compensation per hour worked and per employee increased in 2017 on the back of rising social contributions after the end of hiring incentives. Graph 1.5:Price and wage dynamics Source: ISTAT, Eurostat Due to subdued wage growth, the rise in unit labour costs remains limited despite weak productivity growth. In contrast to the years before 2009, unit labour costs have been growing broadly in line with those of the euro area, on the back of moderate wage increases and declining labour productivity. Real compensation per employee grew by only 0.3 % in 2016 and was still below the level of 1999. By contrast, labour productivity declined by 0.6 %. The sharp reduction in social contributions for new hires on permanent contracts and the reduction in the regional tax on productive activities helped contain gross wage growth. Strengthening domestic demand and moderate wage growth suggest a gradual rise in core inflation and the GDP deflator. The headline annual harmonised index of consumer prices (HICP) inflation averaged 1.3 % in 2017, after 3 years near zero (Graph 1.5). It is expected to increase to 1.5 % by 2019. Annual HICP core inflation (i.e. excluding unprocessed food and energy) stood at 0.8 % in 2017 and is set to pick up gradually — in line with moderate wage growth and the recovery of profit margins — to 1.6 % in 2019. 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 2017 but is forecast to rise to 1.4 % by 2019. Social situation Labour market situation is improving. However, the proportion of the population at risk of poverty or social exclusion was 29.9 % in 2016, an increase of 1.2 percentage points from 2015. It remains above the EU average (23.5 %) which by contrast is decreasing. Similarly, per-capita GDP, which fell in both real and nominal terms until 2013, remains below the EU average. These figures mask relatively wide variations between age groups, with older people, especially pensioners, less affected by poverty than the young. The impact of social transfers on reducing poverty was low and decreased in 2016 (20.3 %). ( ) The share of the working-age population with a low level of education, a significant risk factor for poverty, was 39.9 %, well above the EU average (23 %). Income inequality is high and rising in Italy, while marginally falling in the EU. According to data for 2016, the income of the top 20 % of households was 6.3 times higher than that of the poorest 20 % (S80/S20 indicator). This ratio has increased compared to the previous 3 years and is even higher for people of working-age, as the redistributive impact of pensions is excluded. Unemployment remains a key driver of inequality, as shown by the significant difference between the median income of people who are employed (EUR 19 028 per year in 2015) and the unemployed (EUR 9 926 per year). By contrast, net wealth is more equally distributed than income (also compared to the euro area average). Likewise, inequality of opportunities appears to be less of a concern. For example, social status tends to be only a weak predictor of educational achievements. However, rising child poverty among disadvantaged families and unequal access to healthcare, together with regional disparities, are reasons for concern (see Section 4.3.3). Financing conditions Despite financing costs being at historically low levels, private sector credit growth is still muted. Interest rates on new mortgage loans have halved since early 2012 and stood at 1.9 % in December 2017. Rates for new company loans dropped from about 4 % to 1.5 %. Although the ECB’s supportive monetary policy has reduced nominal interest rates sharply, lending activity remains subdued. Lending to the non-financial private sector is supported by loans to households (adjusted for securitisations and other loan disposals) which show average monthly growth of around 2.5 % year-on-year since the beginning of 2017 (Graph 1.6). Growth in mortgage loans and consumer credit is benefiting from the recovering housing market, low interest rates and improved consumer confidence.. Corporate loans have stabilised since 2016. With the debt-reduction process still under way, overall lending to non-financial corporations remains weak. Credit supply standards are easing but are still tighter than before the crisis. However, lending to non-financial firms varies widely by sector and firm size. Credit to the industrial and service sectors increased but was mostly targeted to larger and more productive firms. In line with the pick-up in fixed investment, non-financial corporations are gradually increasing capital spending financed by new loans. By contrast, lending to the building sector contracted sizeably over the 12-month period due to low activity and higher risks. ( ) Graph 1.6:Credit growth and lending rates Source: Bank of Italy Growth in credit supply is helped by structural improvements. The legacy stock of non-performing loans (NPLs) on banks’ balance sheets is declining. Moreover, the NPL inflow rate, i.e. the ratio of new non-performing loans to outstanding loans, has fallen to a level last seen before the global financial crisis (see Section 4.2). Despite some improvements in the first half of 2017, the profitability of Italian banks is still among the lowest in the EU, due to both cyclical factors and structural problems. Overall, credit growth, especially to small and risky firms remains subdued. External position Italy’s current account surplus is approaching 3 % of GDP. An improved export performance and compressed domestic demand during the double-dip recession have gradually shifted the current account balance from a deficit of 3.5 % of GDP in 2010 to a surplus of 2.9 % in 2017. The trade balance recorded a surplus of 3.2 % of GDP, benefiting from favourable terms of trade partly linked to a lower oil import bill and healthy external demand. In September 2016 the 12-month primary income balance turned positive, largely driven by improvements in the balance of investment income that turned into a surplus in 2017( ) (Graph 1.7). Estimates indicate a cyclically-adjusted current account surplus of 1.8 % of GDP in 2017. The current account surplus remains above the level suggested by fundamentals (+0.5% of GDP). This contrasts with a 0.2 % of GDP deficit which would be sufficient to keep Italy's international investment position stable (in the absence of valuation effects). ( ) Graph 1.7:Current account balance Source: Bank of Italy The current account surplus results from saving and investment decisions at the sectoral level. The corporate sector, traditionally a net borrower, has increasingly assumed a net lending position since 2009. Households increased net lending until 2014 and reduced residential investment in line with the slowing housing market. The government reduced the deficit, among other things by cutting nominal investment by 35 % over 2009-2016. The net international investment position (NIIP) is still slightly negative. ( ) The position recorded a negative balance of 7.8 % of GDP at the end of the third quarter of 2017. This level is close to the NIIP suggested by fundamentals (about 0% of GDP), and considerably above the prudential threshold that indicates external crisis risk (-63% of GDP for 2016) (see European Commission, 2016). This improvement is largely due to the trade surplus, but is also linked to valuation effects. The latter is reflected in the sizeable improvement in the investment income balance which shifted into surplus in early 2017. The net liabilities of the Bank of Italy towards the Eurosystem, reflected by the negative TARGET2 balances, are at least partly linked to the ECB’s decentralised asset purchasing programme. The programme gives rise to substantial cross-border flows of reserves. ( )

Public finance: public deficit and debt Italy’s fiscal stance has eased in recent years. Italy carried out a sizeable fiscal effort over 2010-2013, raising its primary surplus to over 2 % of GDP and reducing its headline deficit from the peak of 5.3 % in 2009 to a level no higher than 3 % of GDP from 2012 (Graph 1.8). However, the fiscal stance has eased in recent years, partly to cut the tax burden and support private investment and structural reforms (e.g. the Jobs Act with fiscal incentives). This was allowed also by the ECB’s accommodative monetary policy stance, whereby newly issued government securities benefitted from historically low nominal interest rates (0.55 % on average in 2016, down from more than 3 % in 2012). As such, interest expenditure fell from the peak of 5.2 % of GDP in 2012 to 4 % in 2016. In turn, Italy's primary surplus fell to 1.5 % and the headline deficit stabilised at around 2.5 % of GDP in 2016. Overall, over 2013-2016 Italy’s structural balance is estimated to have markedly worsened from 0.8 % to 1.7 % of potential GDP. This was accompanied by an even larger deterioration in the structural primary balance (from 4.0 % to 2.3 %) in the context of falling interest expenditure. Graph 1.8:Italy's public finance indicators Source: European Commission The headline deficit is set to decrease further also thanks to a positive outlook. The headline deficit is forecast to have decreased to 2.1 % of GDP in 2017. This was due to higher-than-expected economic growth, a better-than-anticipated primary surplus of 1.7 % of GDP and interest expenditure further shrinking to 3.8 % of GDP. Looking ahead, the headline deficit is set to further decrease to 1.8 % of GDP in 2018, thanks to a stronger forecast for nominal GDP growth (2.6 %) and a slightly larger primary surplus (1.8 % of GDP) than in 2017. However, Italy’s fiscal stance, after a deterioration in 2017, is expected to be broadly neutral in 2018. Given the further reduction in interest expenditure to 3.6 % of GDP, this also corresponds to a slight worsening in the structural primary balance. Italy’s gross public debt is expected to stabilise at around 130 % of GDP. The gross public debt ratio increased by 5 pps per year on average during the double-dip recession of 2008-2013, It continued to increase in 2014-2016, though at a slower average pace of 1 pp. per year to 132.0 % of GDP. Very low interest rates are currently limiting debt growth (see Section 3). However, public debt is forecast to remain stable at 132.1 % in 2017, partly due to the resources earmarked for public support to the banking sector and retail investors. Thereafter, higher nominal GDP growth is set to allow a slight decline in the debt ratio to 130.8 % in 2018 and 130.0 % in 2019. Risks to the debt forecast remain high. Risks to the European Commission’s debt projections are related to a larger-than-anticipated impact of the bank resolutions in 2017. Beyond 2017, the risks come from worse-than-anticipated nominal growth, the public administration’s large stock of trade debt arrears (see Section 4.1.1) and below-target revenues from privatisations. On this last, after missing its 2016 and 2017 targets, ( ) the government projects privatisation proceeds of 0.3 % of GDP for 2018. Italy’s public debt maturity is increasing and bond spreads are narrowing. Since spring 2017, spreads vis-à-vis German sovereign bond yields have gradually shrunk, to below 140 basis points for 10-year bonds at the end of 2017. In spite of the risks still weighing on Italy’s public finances, this trend possibly reflects reduced uncertainty about economic policy prospects following some large Member States’ electoral cycles and the ECB’s decision not to discontinue the Public Sector Purchase Programme (Bank of Italy, 2017a). In addition, Italy’s debt management office continued to take advantage of low interest rates to raise the share of long-term fixed-rate bonds issuances (to 71 % in September 2017, up from 70 % in December 2016). Consequently, average life-to-maturity rose further to 6.9 years. Banks' exposure to Italian sovereign debt has decreased. The share of public debt held by the Bank of Italy continued to increase under the Public Sector Purchasing Programme. It reached EUR 319 billion (19 % of GDP) in November 2017, up from EUR 200 billion a year before. Meanwhile, the share held by Italian banks decreased to EUR 344 billion (20 % of GDP) in November 2017, down by 12.7 % a year earlier (Bank of Italy, 2018). The proportion of foreign private investors, while increasing from 28.4 % in 2016 to 32 % in 2017, remained low. This reflects persistent reluctance to invest in Italy, especially by non-euro area investors (European Commission, 2017i). Moreover, still low interest rates induced Italian households to further cut their direct holding of public debt and to diversify their investment portfolios into foreign assets. Table 1.1:Key economic, financial and social indicators - Italy Source: Eurostat and ECB as of 30 Jan 2018, where available; European Commission for forecast figures (Winter forecast 2018 for real GDP and HICP, Autumn forecast 2017 otherwise) 2. Progress with country-specific recommendations Progress with the implementation of the recommendations addressed to Italy in 2017 ( ) has to be seen in a longer term perspective, since the introduction of the European Semester in 2011. Looking at the multi-annual assessment of the implementation of the CSRs since these were first adopted, 60 % of all the CSRs addressed to Italy have recorded at least 'some progress', while 40% of these CSRs recorded 'limited' or 'no progress' (see Graph 2.1). The areas that registered the best performance in terms of progress are the adoption of measures to fight corruption and to reform the public administration. Good performances are registered also in the banking sector, in the labour market and in reducing restrictions to product and services markets. Graph 2.1:Overall multiannual implementation of 2011-2017 CSRs to date Source: European Commission Concerning public finances and taxation, some progress was made to address the related CSRs. Efforts focused in containing public expenditure. Public wage bill growth has been moderate, with public wages rising in 2017 for the first time since 2011. Past pension reforms contributed to curb liabilities arising from ageing population and improve the long-term sustainability of public finances. However, this effort has partly been reversed in the latest budgets, and pension expenditure is expected to start rising again as of 2017 (see Section 4.1). Some privatisations have been implemented to reduce public debt, but recent targets have been systematically underachieved. Several taxation reforms have been implemented, especially to reduce the tax burden on labour and capital, which still remains comparatively high. Tax expenditures have been reviewed but not yet streamlined. The tax on immovable property was increased in 2011 but partly repealed in 2015, and a reform of cadastral values is still pending. To step up the fight against tax evasion, the 'split payment' system for VAT and the use of e-invoicing in transactions with the public administration were introduced in 2015. The latter will be progressively extended to private sector transactions over 2018-2019. Some progress was registered in addressing CSRs concerning civil justice, the fight against corruption, public administration and the reduction of barriers to competition. Following the major reorganisation of civil courts in 2013, several measures were implemented to accelerate civil procedures, including by increasing the specialisation and digitalisation of courts and trying to avoid abuses of the trial through stricter admissibility rules for appeals. Yet, still very long trial length puts into question the effectiveness of some of those reforms. The fight against corruption was stepped up in 2012 through a comprehensive anti-corruption law, which also established the national anticorruption authority. In 2017, the statute of limitations was reformed and whistle-blowers’ protection extended. A comprehensive reform of public administration was adopted in 2015, simplifying and clarifying the decision-making process, encouraging transparency and increasing efficiency. Nevertheless, the operationalisation in specific areas, namely public employment and publicly-owned enterprises, may prove difficult while local public services will need a new legislative initiative to be reformed. In-depth market opening measures for product and services market were introduced in 2012 and 2017. Since 2011, several packages have been introduced to reduce the administrative burden for companies and citizens. In 2016, Italy has reformed the public procurement code. In the banking sector some efforts were made. The authorities' clean-up of some of the weakest banks in mid-2017 has reduced acute financial stability risks. The high legacy stock of NPLs is declining on the back of NPL disposals including via the State guarantee scheme to support NPL securitisations (GACS). The supervisor has enhanced oversight of less significant institutions including by announcing a guidance on NPL provisioning. The various corporate governance reforms are broadly on track. Consolidation and restructuring in the banking sector have continued. Regarding the overhaul of the insolvency framework, the enabling law has been adopted, and relevant implementing decrees have to be passed within a year. The Patto Marciano, an adopted measure to shorten the period of collateral enforcement, is not yet used by banks for firms. Reforms such as the Jobs Act have helped increase labour market flexibility. But important complements to the jobs act reforms aiming at greater wage differentiation through a more efficient collective wage bargaining system and at enhancing job match through effective active labour market policies are lagging behind. The reform of collective bargaining is proceeding only very slowly. Social partners have signed a new agreement on rules and criteria on trade union representativeness, a prerequisite for fostering second-level bargaining. But this agreement is not expected to become operational before mid-2019. Hardly any progress can be witnessed in the field of active labour market policies. The placement capacity and overall efficiency of Public Employment Services (PES) remain weak and performance varies widely between regions. Even though female employment increased recently, it is still sizeably below the EU average and a comprehensive strategy, coupled with adequate evaluation and monitoring, to increase female labour market participation is still missing. On the positive side, the anti-poverty scheme has been adopted. This scheme is funded through the 2018 Budget Law and subject to sound means-testing. Overall, Italy made some progress in addressing the 2017 country-specific recommendations ( ). Limited progress was made with regards to the privatisation programme and shifting the tax burden away from the production factors, while substantial progress has been made concerning mandatory e-invoicing. While the progress was limited also concerning reducing the trial length in civil justice by improving case management and ensuring procedural discipline, substantial progress was achieved in improving the legal framework for fighting corruption, although challenges remain in terms of implementation. Some progress was recorded on competition with the adoption of the 2015 annual competition law and in reforming public employment and improving the efficiency of publicly-owned enterprises. Some progress was also made with regard to the banking sector and the insolvency framework. With the exception of the anti-poverty scheme, progress on labour market and social policies was limited. Table 2.1:Summary table on 2017 CSR assessment Source: European Commission. The overall assessment of CSR 1 does not include an assessment of compliance with the Stability and Growth Pact. Member States can request from the Commission technical support to prepare, design, and implement growth-enhancing structural reforms. The Structural Reform Support Service (SRSS) provides, in cooperation with the relevant Commission services, tailor-made technical support, which does not require co-financing and is provided at a Member State's request. The support addresses priorities identified in the context of the EU economic governance process (i.e., implementation of country-specific recommendations), but the scope of the SRSS support is wider as it can also cover reforms linked to other Commission priorities, or reforms undertaken at the initiative of Member States.

Italy has requested technical support from the SRSS to help implement reforms in various areas such as: growth and business environment, public financial management, taxation, and the financial sector. In particular, the SRSS provides support to fight tax evasion, enhance transparency and growth. It is also providing support to design a comprehensive accrual accounting system across Italy's public administration (according to International and European Public Sector Accounting Standards – IPSAS/EPSAS). Box 2.1: Tangible results delivered through EU support to structural change in Italy Italy is a beneficiary of significant European Structural and Investment Funds (ESI Funds) support and can receive up to EUR 44.4 billion until 2020. This represents around 11% of public investment ( I ) annually over the period 2014-2018. By 31 December 2017, an estimated EUR 18.7 billion (42% of the total) was allocated to projects on the ground. This has resulted in 5 000 enterprises receiving support, around 600 of new researchers financed in supported entities, around EUR 92 million private investments matching public support to enterprises and 900 000 people had taken part in training or other active labour market measures until 2016. In addition, 6 026 farm holdings received support for investments through the EARDF. An additional 5 500 households have broadband access of at least 30 Mbps. Out of the EU financing, EUR 1.8 billion is to be delivered via financial instruments. ESI Funds help address structural policy challenges and implement country-specific recommendations. Actions financed cover, among others, improving the business environment, particularly by contributing to the acceleration of the implementation of the Small Business Act and the facilitation of SME access to finance; supporting the reform of the public administration by enhancing the institutional capacity of public authorities and stakeholders and implementing the National Digital Agenda, improving the effectiveness of the justice system, supporting the national anti-poverty strategy and the "Good School" reform and improving labour market access. Italy has also received support from the Youth Employment Initiative to combat youth unemployment. In June 2017, almost 1.4 million young people were registered and around 400 000 young people completed training or apprenticeships; about 46% of them were in employment after the YEI support had ended. The ESF contributes to supporting the current reform of Active Labour Market Policies by strengthening the public employment services and by supporting the "Piano per le Politiche attive" to better coordinate ESF interventions at national and regional level. Various reforms were undertaken already as precondition for ESI Funds support ( II ). These include the adoption of the first national broadband and Digital Agenda strategies, the setting up of a national system of ports and logistics and a national strategic policy framework for poverty reduction. An important contribution was also made on State aid and public procurement by addressing the deficiencies in cross-regional application of the EU State aid rules and by overcoming the shortcomings in the transposition of the public procurement acquis. These reforms have prepared the ground for better implementation of public investment projects in general, including those financed from national sources and from the other EU instruments mentioned above. Efforts are made to complete the only remaining outstanding ex-ante conditionality as soon as possible. Italy is advancing the take up of the European Fund for Strategic Investments (EFSI). As of December 2017, overall financing volume of operations approved under the EFSI amounted to EUR 6.5 billion, which is expected to trigger total private and public investment of EUR 36.7 billion. More specifically, 54 projects involving Italy have been approved so far under the Infrastructure and Innovation Window (including 13 multi-country projects), amounting to EUR 4.6 billion in EIB financing under the EFSI. This is expected to trigger about EUR 14 billion in investments. Under the SME Window, 59 agreements with financial intermediaries have been approved so far. European Investment Fund financing enabled by the EFSI amounts to EUR 1.9 billion, which is expected to mobilise approximatively EUR 22.4 billion in total investment. Over 206 200 smaller companies or start-ups will benefit from this support. SMEs rank first in terms of operations and volume approved, followed by RDI, energy and transport. Funding under Horizon 2020, the Connecting Europe Facility and other directly managed EU funds is additional to the ESI Funds. By the end of 2017, Italy has signed agreements for EUR 1.4 billion for projects under the Connecting Europe Facility. https://cohesiondata.ec.europa.eu/countries/IT 3. Summary of the main findings from the Macroeconomic Imbalance Procedure in-depth review The in-depth review for the Italian economy is presented in this report. In spring 2017, Italy was identified as having excessive macroeconomic imbalances, in particular relating to its high public debt and protracted weak productivity growth in a context of high, though decreasing, non-performing loans (NPLs) and unemployment. The 2018 Alert Mechanism Report (European Commission, 2017b) concluded that a new in-depth review should be undertaken for Italy to assess developments relating to identified imbalances. Analyses relevant for the in-depth review can be found in this section, Section 1 and in Sections 4.1 to 4.5. ( ) Imbalances and their gravity Italy's high public debt remains a major drag on growth. The public debt-to-GDP ratio is expected to broadly stabilise at around 130 % over 2017-2019. In particular, still low but rising inflation, a limited increase in the primary surplus and privatisations falling short of the government's plans keep hindering debt-reduction efforts. The high level of public debt remains a major source of vulnerability for Italy's economy. Despite the current downward trend in interest expenditure, considerable public resources, around 4 % of GDP, are still earmarked to cover debt servicing costs. This, coupled with a long-standing bias in the composition of public spending towards old-age pensions, could crowd out more productivity-enhancing spending like education, infrastructure and innovation and limit the possibility to lower the tax burden on the factors of production. The high level of public debt makes the country more vulnerable to shocks. The combination of high public debt and low growth prospects, also related to sluggish productivity growth, may prevent fiscal automatic stabilisers from being used effectively in case of negative economic shocks. A country with high public debt is also more exposed to financial market volatility in periods of increased risk aversion, when higher interest rates on government securities issuances could tighten financing conditions for the real economy. This was seen in the collapse in private investment witnessed in 2011-2012. Low productivity growth lies at the heart of Italy's lacklustre growth performance. Over the past two decades productivity growth has been generally weak, with labour productivity growth hovering around zero since 2011. Long-standing shortcomings in the functioning of labour and capital markets have hampered the acquisition of necessary in-work skills and innovation. Remaining restrictions to product market leading to inefficiencies and distortionary elements of the tax system have also weighed on the business environment. This negatively affects competitiveness and GDP growth, which in turn will make it more difficult to reduce Italy's still high public debt ratio. Medium-term growth prospects are closely related to productivity growth given the shrinking working age population. Still high levels of non-performing loans (NPLs) hamper efficient capital allocation. While the protracted recession had drastically worsened Italian banks' asset quality, the situation has stabilised on the back of the economic recovery. The stock of gross NPLs declined to EUR 324 billion in Q2 2017, though the NPL ratio at 16.4% was still higher than in EU peer countries. The NPL problem is weighing on banks’ profitability and their ability to internally raise capital. Banks have tightened credit standards since the financial crisis, extending credit mainly to larger, well-established firms. Therefore, banks' intermediary function of facilitating the (re)allocation of capital to firms has been constrained. Credit to non-financial firms, especially smaller ones, is still subdued and is limiting investment growth. The labour market is still marked by the legacy of the recession. Despite recent labour market reforms, unemployment is receding only slowly in Italy. This is due to both hitherto rather moderate recovery and increasing labour force participation. Unemployment has dropped, from 13.0 % at its peak in November 2014 to 10.8 % in December 2017, while participation rates have been rising, albeit from low levels. Youth unemployment is declining but the rate remains one of the highest in the EU. Low activity rates are constraining potential growth whereas entrenched joblessness among young people is likely to impede their acquisition of skills and their future employability. As the third largest economy in the euro area, Italy is a major source of trade and financial spillovers. Italy accounts for 16 % of euro area GDP and has strong trade linkages. Exports of goods and services to the rest of the euro area correspond to 12 % of its GDP. Italy is also an important export market for a number of euro area countries. Moreover, Italy's economy maintains strong financial linkages to other euro area countries. In particular, French banks remain in the lead with an exposure to the Italian economy of 12.3 % (of French GDP) in Q3 2017. Meanwhile, Italian banks remain strongly exposed to Germany and Austria, respectively by 10.9 % and 4.7 % of Italy’s GDP in Q3 2017. Box 3.1 illustrates how structural reforms in Italy can have both a positive domestic and cross border effect, in line with the euro area recommendation on increasing growth potential and access to the labour market. Evolution, prospects and policy responses Large interest rate-growth rate differentials contributed to past increases in public debt. The debt ratio reached 132.0 % in 2016, i.e. 0.5 pps higher than in 2015. The increase was partly due to a 'snowball' effect, as the real implicit cost of debt, ( ) while gradually decreasing (to below 2.3 %, from 2.7 % in 2013), remained above real GDP growth (0.9 %). This was mainly due to still low inflation (GDP deflator growth of 0.8 %). Slightly negative real spot interest rates on new government securities issuances only gradually passed through into the real servicing cost of the outstanding stock of debt, given its duration and roll-over period (Graph 3.1). As such, a still positive interest-rate-growth-rate differential (1.3 %, vs. 2.5 % in 2014) implied a large debt-increasing impact. On the other hand, a broadly stable primary surplus (1.5 % of GDP) helped to curb debt dynamics in 2016, while the stock-flow adjustment (0.2 %) was debt-increasing. The projected reduction in public debt is below the improvement in the interest-rate-growth-rate differential. The 'snowball' effect is expected to shrink from 2017 due to a gradual decrease in the real implicit cost of debt (Graph 3.1, dashed blue line) and the recovery in real GDP growth (Graph 3.1, solid blue line). However, it is set to remain slightly debt-increasing (Graph 3.1, yellow shade) due to the still positive interest-rate-growth-rate differential (0.9 % in 2017 and 0.3 % in 2018, below the pre-crisis average of 1.2 % over 1999-2007). The debt ratio is thus forecast to marginally increase to 132.1 % of GDP in 2017. This is also due to a large debt-increasing stock-flow adjustment (0.7 % of GDP) driven by the impact of two recent bank resolution and liquidation cases (around EUR 15.6 billion or 0.9 % of GDP), in the absence of privatisation proceeds. The debt ratio is forecast to slightly decrease to 130.8 % in 2018. This is thanks to a marginal improvement in the primary surplus (1.8 % of GDP) and small debt-increasing impacts from the 'snowball' effect (0.4 %) and stock-flow adjustment (0.1 %). Graph 3.1:Drivers of 'snowball effect' on public debt Source: European Commission The improving macroeconomic environment helps short-term fiscal sustainability. Italy is exposed to sudden increases in financial market risk aversion due to improving but still large roll-over needs (around 20 % of GDP in 2017) related to its public debt. At the moment, however, Italy does not seem to face sustainability challenges in the short-term, mainly thanks to limited risks from the macro-financial context. This is partly related to the ECB's accommodative monetary policy. The European Commission's short-term fiscal sustainability risk indicator S0 is thus set to be below the 'high-risk' threshold in 2017. However, at 0.36, it remains among the highest in the EU, mainly due to high public debt. In the medium term, Italy faces marked sustainability challenges. The structural primary surplus is projected to deteriorate to 1.6 % of GDP in 2018, down from 3.3 % in 2015. This could heighten sustainability risks in the medium term, as a weak fiscal position might raise risk premia. This is captured by the European Commission's medium-term fiscal sustainability risk indicator S1, which points to 'high risk'. It reflects the fact that achieving a debt ratio of 60 % of GDP by 2032 would require Italy to make a large cumulative fiscal effort of 8.1 pps of GDP over 2020-2024. Graph 3.2:Evolution of Italy's public debt-to-GDP ratio under different debt sustainability analyses Source: Commission Services A debt sustainability analysis (DSA) confirms high sustainability risks if the accommodative monetary policy were phased out. The European Commission's DSA points to 'high risk' in the medium-term (European Commission, 2018a). A deterministic DSA exercise run over 10 years also shows that Italy's debt-to-GDP ratio would remain above 130 % by 2029 if: the interest rate-growth rate differential converged by 2024 to its pre-crisis (1999-2007) average of 1.2 pps (up from the 0.3 trough in 2018) in line with the gradual phasing out of the ECB's accommodative monetary policy; and Italy kept constant its structural primary surplus of 1.1 % of GDP expected for 2019 (Graph 3.2, left-hand side, blue line).

Long-term projections confirm the importance of growth-friendly fiscal consolidation to reduce public debt. Under the hypothesis of increasing interest-rate-growth-rate differentials, the DSA suggests that a structural primary surplus gradually returning to a level of 4 % of GDP by 2024 would make the debt-to-GDP ratio decline in line with the debt rule over 10 years and approach 107 % by 2029 (Graph 3.2, left-hand side, green line). Instead, if the structural primary balance were worsened by further pension expenditure due non-adjustment of the retirement age under past pension reforms, the debt-to-GDP ratio would increase to more than 136 % by 2029 (Graph 3.2, left-hand side, red line). In a reinforced sensitivity analysis based on a stochastic DSA, the Commission applied random shocks to the primary balance over 2018-2022, whereas interest rates and GDP growth follow their historical path (European Commission, 2018a). This analysis also confirms that Italy's public debt ratio could further increase in the medium term if the fiscal position is not adequately strengthened (Graph 3.2, right-hand panel). As such, further fiscal effort and full implementation of reforms to foster productivity and potential growth in the medium to long term remain key to creating a satisfactory debt reduction path. This is especially the case in the event of the accommodative monetary policy being reversed. The long-term sustainability ensured by past pension reforms is slowly deteriorating. Pension expenditure as a share of GDP rose by around 2 pps as a result of the crisis and the related fall in nominal GDP (European Commission, 2017a). It is now the second highest in the EU/OECD after Greece. Implicit liabilities arising from population ageing were curbed by past pension and healthcare reforms, improving Italy's long-term sustainability. However, the 2017 and 2018 budgets contained measures that partially reversed past pension reforms and slightly increased pension expenditure over the medium term (Section 4.1). As such, the long-term fiscal sustainability risk indicator S2 points now to 'medium risk'. In fact, a permanent increase in the structural primary surplus of around 2.2 pps of GDP would be needed to keep the debt-to-GDP ratio stable over the long term, including the cost of ageing (European Commission, 2018b; 2017c). Together with the worsening demographic trends projected by Eurostat, and the related risk of an increase in healthcare spending, a substantial backtracking on the implementation of past pension reforms, in particular the adjustment of the retirement age, could further worsen Italy's long-term sustainability risks and the S2 indicator. Italy suffers from a long-term productivity slump. Total factor productivity (TFP), a measure of how efficiently capital and labour are being used in production, remained broadly flat 0.1 % over 1999-2007. After a sharp fall in 2008-2009 during the protracted crisis, labour and TFP growth returned to a moderately positive trend, briefly interrupted in 2012 (Graph 3.3). TFP grew by 0.8 % in 2017 and is set to rise by 0.6 % on average over 2018-2019. Labour productivity grew moderately in 2017 (0.4 %) and is set to remain broadly on this path in 2018-2019. Despite the recent rebound, productivity growth is set to be below the EU average. Graph 3.3:Productivity growth and gross value added Source: European Commission. Aggregate productivity developments vary markedly across firms, sectors and regions. On average, small firms fare worse than larger ones on productivity growth. As such, the high share of small firms in Italy has a bearing on the economy's aggregate productivity. The productivity gap with peer countries concerns almost all sectors but is most pronounced in services. Labour productivity in the manufacturing sector is increasing since 2003, thus gradually closing the gap with peer countries. By contrast, productivity in the service sector has been stagnating or slightly falling since the 1990s without any sign of recovery. Wide regional disparities in productivity dynamics persist. These contributed significantly to the past loss in competitiveness as wage increases did not reflect the regional differences in productivity. Productivity trends also hint at inefficiencies in managerial practices and investment spending. While total factor productivity has returned to a moderately positive trend since the start of the recovery in 2014, the capital stock has not fully overcome the legacy of the crisis. Italian firms tend to employ relatively little productivity-enhancing information technology compared to companies in EU peer countries, largely because of less efficient management practices. This is partly linked to the close family orientation of many family-owned firms, especially SMEs, which drastically constrains the pool from which they recruit future managers. In addition, weaknesses in innovation and R&D as well as the misallocation of resources across firms and sectors have hampered aggregate productivity growth. In this respect, the low share of intangible investment does not bode well. In addition, companies facing financial stress are generally smaller and less productive. Hence, the large share of financially-constrained companies is hampering an improvement in overall productivity. Weak productivity growth prevents a speedy recovery of cost competitiveness. The erosion of price competitiveness has stopped, mainly thanks to limited wage growth and nominal depreciation of the euro. Italy has indeed recorded small gains in export market share since 2013. Given subdued wage growth, unit labour costs grew only moderately despite declining productivity. Yet, a sizeable rebound in productivity remains the most effective way to restore competitiveness. Subdued productivity growth also reflects the relatively slow pace of technological change, which is also weighing on non-cost competitiveness. The impact of recent reforms on productivity is only gradually building up. Following the adoption of the Jobs Act reform labour productivity declined by 0.4 % in 2016 as the rise in employment outpaced the expansion of gross value added. Until 2016, the sizable rise in employment was to a large extent supported by hiring incentives which might have induced firms to substitute capital with labour. In addition, the rise in temporary contracts could reduce incentives for human capital formation. For the period 2017-2019 a moderate rise in labour productivity is projected. However, reforms can only achieve their full potential in addressing the bottlenecks that hold back productivity growth, if they are properly and fully implemented. The strengthening of the framework for collective bargaining which would allow wages to be set more in line with local economic conditions made only limited progress. Employment has returned to pre-crisis levels thanks to a modest recovery and labour market reforms. Employment grew by 1.0 % in 2017, after 1.4 % in 2016, largely helped by generous hiring incentives. Yet, total hours worked remain below pre-crisis levels. Employment growth is set to continue, but the unemployment rate is forecast to drop only to 10.5 % by 2019, with long-term unemployed and young out of work still numerous. Some progress has been made in reducing NPLs. Italian banks have continued the restructuring process by further increasing provisioning and accelerating NPL disposal, also through State-guaranteed securitisations. This is in line with euro area recommendation to lower NPL levels. In addition, the authorities have taken a number of measures to foster the development of a secondary market for NPL sales (Section 4.2). Helped by the ongoing recovery and the structural reforms in the banking sector, the inflow of new NPLs has returned to pre-crisis levels. However, several factors are still preventing a faster NPL resolution. They include in particular weaknesses in the insolvency framework, the slow judicial system and challenges related to NPL servicing. Overall assessment Despite encouraging recent developments, macroeconomic imbalances remain significant. Italy's public debt-to-GDP ratio is expected to have risen further to 132.1 % in 2017 and to remain above 130 % in the coming years. The high debt ratio thus remains a major source of vulnerability for the economy, a drag on growth and a source of negative spillovers for the euro area, despite recent positive developments in debt management such as increasing maturity (Section 1). Moreover, long-term and youth unemployment remain high and weigh on growth prospects. Investment, innovation and a rapid upgrade of Italy's production structure are also still hampered by structural shortcomings. Overall, the resulting sluggish productivity growth suggests that more progress is needed to improve Italy's growth prospects and to facilitate public sector debt reduction. However, the erosion of price competitiveness has stopped mainly thanks to contained wage growth and the depreciation of the euro. The adjustment in the labour market is continuing, resulting in a gradual decline in the unemployment rate. Efforts to tackle the high stock of NPLs are starting to bear fruit but challenges remain. Several reforms were implemented to address the 2017 country-specific recommendations (Section 2), which in Italy’s case are all related to its macroeconomic imbalances. Consistent implementation of those reforms is crucial to address large stock imbalances (e.g. the high public debt) in the medium term. Table 3: Macroeconomic Imbalance Procedure Assessment Matrix (*) - Italy (Continued on the next page) Table (continued) Source: European Commission Box 3.1: Euro area spillovers Spillovers can affect partner economies either positively or negatively, depending on the nature of the shock. Italy’s high public debt remains a source of risk and potential adverse spillovers to the rest of the euro area. For example, negative spillovers may arise from an abrupt change in the currently favourable risk perception, including a faster-than-expected rise in long-term interest rates. On a more positive note, the continuation of economic reforms, which are partly linked to previous reform efforts, can be expected to stimulate economic activity in Italy. Spillover effects of supply-side reforms tend to be small or ambiguous due to the combination of income (more net imports) and competitiveness (more net exports) effects. At the same time, reforms may be associated with stronger private-sector demand reflecting an improvement in economic confidence. The European Commission's QUEST ( III ) model has been used to simulate a stylized scenario that combines a labour market reform and improving economic confidence. In particular, the scenario includes an increase in labour market participation (especially via higher female labour market participation) in which the 8-percentage-point gap between Italy and the EU-average is halved, i.e. an increase in labour force participation in Italy by 4 pps. The simulation assumes the increase in the activity rate to be spread over 16 years, in line with the observation of slow movement in labour participation trends. It is assumed that the average entrant is as productive as the average current worker (no skill bias). Improving confidence is captured by an improvement in financial market conditions for Italy. In particular, the spread between Italian and German sovereign bonds (currently around 150 bps.) is eliminated. In line with analysis by Zoli (2013), it is assumed that half of the decline in sovereign spreads is transmitted to firm lending rates, amounting to a decline in corporate financing costs by more than 70 bps in annualized terms (see Zoli, 2013). GDP spillover to the rest of the euro area mainly occurs via the trade channel. The scenario does not include a rise in economic confidence in other EA countries and monetary policy rates in the EA are assumed to remain unchanged during the first two years. The simulation highlights the significant potential domestic benefits from higher labour market participation and improving confidence. A rising activity rate translates into higher employment and private consumption demand, whereas lower financing costs imply a strengthening of capital spending, in particular corporate investment. This reform scenario points to a rise in real GDP in Italy by 1.8 % after 5 years and 3.2 % after 10 years. In reality, participation gaps may actually differ across skill groups with new entrants to the labour market having a lower skill level. Hence, results on the positive GDP effect in Italy should be interpreted with caution and rather be regarded as an upper bound. The assumed scenario suggests non-negligible spillovers. The spillovers from growing labour force participation is small as the (income-induced) increase in Italian demand for imported goods is counterbalanced by a boost to exports in response to improving price competitiveness. The spillovers from improving confidence are unambiguously positive as higher investment demand in Italy translates into higher imports from other EA Member States. The later effect drives the rise in real GDP in the rest of the Euro area (REA) by 0.4 % after 10 years (Graph 1). 4. Reform priorities

4.1. Public finances and taxation 4.1.1.fiscal framework* Italy’s public spending remains biased towards old-age pensions. In 2016 Italy’s real public primary expenditure continued to increase above potential growth, confirming a long-term trend prevailing since the end of the 1990s (Graph 4.1.1, left-hand side). This reflects not only the country’s sluggish growth potential, hovering around zero since 2011, but also the dynamics of spending items like pensions, which are expected to have resumed their upward trend from 2017. In fact, both the 2017 and the 2018 budgets contained provisions that partially reverse past pension reforms aimed to curb implicit liabilities arising from population ageing, not least by gradually adjusting retirement age to life expectancy. Moreover, not only does Italy have a larger share of population above 65 years old than the EU average (see Section 4.3) but the share is projected to reach 24.9 % by 2025, above the EU average of 22.2 %. As such, Italy’s old-age dependency ratio is expected at 39.6 % by 2025, compared to an EU average of 35.5 %. Pension expenditure is thus set to increase over the medium term, compounding Italy’s long-term fiscal sustainability challenges (see Section 3) and long-standing bias in the composition of public spending (Lorenzani and Reitano, 2015). Looking at the shares of primary expenditure by functions between 2013 and 2016 (Graph 4.1.1, right-hand side), pensions are still the largest item, at around 15 % of potential GDP. They are followed by health (stable at around 7 %) and slightly rising ‘other social spending’ (5.8 %). Education, at 8.6 % of primary spending in 2016 (3.8 % of potential GDP), continued its decreasing path started in the early 2000s when it was 11.2 %. Graph 4.1.1:Evolution of real general government primary expenditure (left-hand side) and composition of primary expenditure by COFOG functions (right-hand side) Source: Commission Services, ISTAT, and European Commission 2018b for pension expenditure Systematic spending reviews and broader use of centralised procurement may help to contain public expenditure growth. The 2018 budget implemented the reformed budgetary process for the first time. In particular, line ministers were directly involved in selecting areas within their own budgets where targeted savings could be realised. These will be monitored under specific agreements with the Ministry of Finance to be made public by March each year. Overall, the spending review is set to yield additional gross savings of around EUR 3.2 billion (0.18 % of GDP) in 2018, also by rationalising ministries’ expenditure and planning lower transfers to local public bodies, which might however lead to lower public investment as in the recent past. Centralised procurement is also being used more broadly, and the new Code of Public Procurement has the potential to increase it further. Around EUR 50 billion of public expenditure is already covered by the national central purchasing body Consip (out of EUR 89 billion for public procurement overall) and estimated average savings amount to 14 % on observed unit prices (Consip, 2016). A permanent ‘technical working table’ completed the list of goods and services that all administrations, including local authorities, must purchase through the 32 procurement aggregator centres. However, the decrees needed to make this provision operational and to complete Consip’s benchmark for goods and services are still pending. Medium-term budgetary planning remains weak, hampering predictability. The 2018 budget confirmed the chronic practice of including large VAT rate increases (now worth 0.7 % of GDP in 2019 and 1 % in 2020) as ‘safeguard clauses’. These ensure the attainment of the fiscal targets in the outer years but are systematically deferred at the time of budget preparation. The budgetary process has also been recently characterised by frequent changes in budget composition and in the fiscal targets, mostly in the direction of less ambitious deficit reduction objectives. For instance, the fiscal effort targeted for 2018 by the 2017 Stability Programme was revised downward; the simplified tax regime (IRI) originally planned for 2017 by the 2017 budget was postponed to 2018; and the spending cuts to be attained by the regions under past provisions were systematically revised (UPB, 2017). Late payments by the public administration remain a problem but monitoring is improving. The extension of mandatory electronic invoicing to all commercial transactions with public administrations in 2015 has provided them with an incentive to improve their payable accounts and better monitor and reduce the average payment period. The latter has continued to decrease but it still amounted to 100 days at the beginning of 2017 ( ) (Bank of Italy, 2017b). The European Commission referred Italy to the Court of Justice of the EU under an infringement procedure initiated in 2014 for lack of compliance with the limits prescribed by the Late Payment Directive. Overall, the stock of public administrations’ trade debt at the end of 2016 was around EUR 64 billion or 3.8 % of GDP. Of this, a significant 2 % of GDP consisted in arrears beyond normal payment deadlines (Bank of Italy, 2017b). A considerable share of public bodies still fails to communicate data on actual payments despite e-invoicing being mandatory. The new ‘SIOPE Plus’ platform has been in a pilot phase since July 2017 and is set to gradually involve all regions, local governments and health service bodies from 2018. It aims to improve monitoring of payments and acquire all information on trade debt in real time. 4.1.2.TAXATION* The tax burden on factors of production is still among the highest in the EU, and efforts to shift it to property and consumption remain limited. The tax wedge on labour ( ) was one of the highest in the EU in 2016 (47.8 % at the average wage, compared to the EU average of 40.6 %). In 2016, the implicit tax rate on labour stood at 42.6 %, among the highest in the EU, and in 2015 the tax burden on capital reached one of the highest level in the EU (10.9 % of GDP, compared to the EU average of 8.4 %). Yet, measures to shift the tax burden to other tax bases have been limited. Namely, there have been delays in reforming the outdated cadastral system, reintroducing first property taxation on high-income households, setting up a digital platform for immovable properties, and reducing the number and scope of tax expenditures. While the latter are now reviewed annually, the government has recently increased the number of tax credits rather than rationalising them. Tax incentives to support employment and investment have been extended. Past provisions to reduce the tax wedge on labour through fiscal incentives were, with a few exceptions, temporary and due to expire in 2018. Yet, the 2018 budget extended some of them permanently (see Section 4.3). The budget also extended the possibility for firms to deduct from the tax base more than 100 % of the amount spent in certain types of new investment in 2018 and 2019 (‘super-’ and ‘hyper- amortisation’ for software, instrumental and digital equipment). This was accompanied by a reduction in the level of tax relief on instrumental equipment (from 140 % to 130 %). Instead, the government postponed to 2018 the entry into force of the new tax on corporate income (at 24 %, in line with the statutory corporate tax rate enacted in 2017), originally meant to harmonise the tax treatment of small firms and corporations from 2017. The debt bias in corporate taxation has also been widened by reducing the notional return on new equity capital or reinvested earnings exempted from the corporate income tax under the ‘allowance for corporate equity’ (ACE) (from 2.3 % to 1.6 % in 2017 and from 2.7 % to 1.5 % in 2018). Rationalising aspects of the tax-benefit system to encourage more women to work would boost growth. The take-up of work by second earners is still limited in Italy and support measures to tackle this issue remain fragmented (see Section 4.3). Namely, the major four existing childcare-related bonuses are characterised by temporary nature, overlapping eligibility conditions and unclear link to the working mothers’ needs. Simulations carried out with EUROMOD (Box 4.1.1) suggest that mothers would increase labour supply substantially if those four existing bonuses were replaced by a single permanent in-work benefit targeting only lower-income working mothers with children aged under three. This budget-neutral reform is estimated to increase aggregate labour supply by around 2.3 %, corresponding to an impact of 0.4 % of GDP over five years relative to the baseline. The VAT gap remains high but measures have been taken to fight tax fraud, notably for indirect taxes. In 2015, Italy’s VAT gap ( ), at 25.8 % of the total tax liability, was among the highest in the EU (CASE et al., 2017) despite a decrease compared to 2014. Measures to combat tax fraud were a pillar of Italy’s budgetary strategy for 2017 and 2018. Namely, in 2017 the ‘split payment’ ( ) was extended to all transactions by public administrations, by companies under direct or indirect public control, by professionals dealing with the public administration, and by listed companies included in the main stock market index. Moreover, the existing mandatory electronic invoicing for transactions with the public administration has been extended to all private sector transactions from 2019, except for taxpayers subject to a simplified tax regime. The extension applies from 2018 in the fuels sectors and for subcontractors in public procurement. If properly implemented, this could ensure better control over commercial transactions, encourage e-payment of invoices and, in turn, increase tax compliance without imposing a large additional burden on firms already equipped to e-invoice the administrations. Other provisions to fight tax fraud included further limits on the automatic compensation of tax credits with tax dues; lower thresholds for enhanced tax checks by the public administration before proceeding to a payment; and a new system of preventive fulfilment of tax obligations in the case of intra-EU transactions in mineral oils. However, especially in the absence of strict limits on cash payments, the ability of those provisions to reduce ‘tax evasion with consent’ remains to be seen. Moreover, the repeatedly extended possibility for taxpayers to avoid sanctions by spontaneously regularising their tax position could discourage future compliance by becoming an implicit reward to non-compliance. A reform of the tax system and tax trial could improve tax collection and reduce litigation. Some features of the tax administration remain burdensome for businesses. For instance, it takes longer in Italy for a small firm to file tax returns than in the rest of the EU (World Bank, 2017). Moreover, among all sections of the Court of Cassation, the tax section continued having in 2017 the longest disposition time (5.3 years), the lowest clearance rate (68 %) and the highest share in overall civil cases incoming (38.1 %) and pending (48.4 %) at the Supreme Court (Corte di Cassazione, 2017). Yet, a slight reduction in tax litigation in regional and provincial tax committees was possibly due to the broader use of alternative dispute resolution tools. A few measures were taken to improve tax collection and reduce tax litigation, although a comprehensive reform of the tax administration and tax trial is still pending. For instance, digitalisation of tax trials was extended to the whole country in July 2017, helping to reduce formalities and delays. The 2018 budget implemented mutual agreement procedures for international tax disputes and provided for hiring for three years up to 50 additional auxiliary judges currently retired to help the Court of Cassation manage its pending tax trials. Box 4.1.1: Effects on labour supply from rationalising childcare benefits Simulations of the effects on labour supply and growth of a rationalisation of existing family support policies in Italy have been conducted by the Joint Research Centre of the European Commission using EUROMOD. ( IV ) The introduction of a more targeted in-work benefit to raise low female participation in the labour market has been part of a long-standing policy debate in Italy and was also proposed by the president of the National Social Security Institute (INPS). Numerous measures, mostly of a temporary nature, were enacted in past years, coupling the objectives of supporting fertility rates and addressing the childcare-related needs of working mothers often in an unclear way and with overlapping beneficiaries. As a first step, EU-SILC data for Italy and EUROMOD (policy year 2017) were used to simulate the fiscal impact of repealing the four largest family bonuses currently in place (INPS, 2016): (a) "Voucher baby-sitting" (in 2017-2018 working mothers can request, within 11 months of the end of parental leave, a voucher to cover baby-sitting or crèche costs for a maximum period of 6 months); (b) "Bonus bebè" (a 3-year monthly bonus of EUR 80 to families with a child born or adopted over 2015-2017 and an Equivalent Financial Position Indicator –ISEE– of at most EUR 25 000); (c) "Bonus mamma" (a one-off premium of EUR 800 in case of a child born or adopted as of 2017); and (d) "Assegno di maternità" (support provided by Municipalities to mothers below a specific income threshold for children born or adopted). Following the repeal of the four bonuses, the available fiscal resources are estimated at EUR 2.3 billion. As a second step, the effect of using the freed resources to introduce a single permanent in-work benefit for working women with children was simulated. In order to ensure budgetary neutrality, the new bonus has the following features: (a) it is only given to wage-employed women with an ISEE lower than EUR 50 000 not receiving any disability benefits and living with partners working full-time (the last condition in order to allow the assessment of their labour supply behaviour); (b) their children are younger than 3 years old and attend childcare services; (c) the benefit corresponds to actually incurred childcare costs up to a cap of EUR 600 per month; and (d) the benefit has a default duration of 12 months, unless the eligible child reaches the age of 3 by September 2015 (year of EUSILC data), in which case the entitlement is only for 8 months, or is younger than 12 months by September 2015, in which case the entitlement corresponds to the duration of childcare after the maternity leave. The results (Graph 1) indicate that the average benefit amounts to around 265 EUR per month and involves approximately 700 000 working women in Italy. The estimated impact on the labour supply of the eligible women is significant and consists in an increase in labour market participation by around 17 % (i.e. around 113 000 working women) and of average weekly working hours by around 20 % (namely, full-time work would increase by around 24 %, long part-time by around 13 % and short part-time by around 7 % compared to the baseline). This corresponds to an overall impact on aggregate labour supply of around 0.8 %. While the working mothers' disposable income slightly increases, the impact of the reform on income distribution, as measured by the Gini index of inequality, is very marginal. Including the mentioned labour supply shock in QUEST III (the European Commission's dynamic general stochastic equilibrium model), the overall estimated impact amounts to around 0.4 % of GDP over five years relative to the baseline, mainly through the channel of an increase in employment by 0.5 %. 4.2. Financial sector Table 4.2.1:Italian banking system key indicators Source: Bank of Italy Market confidence in Italian banks has increased as a result of long-awaited actions to deal with some of the weakest banks. The Italian authorities have adopted several measures including the Salva Risparmio decree law, which enabled the precautionary recapitalisation of Banca Monte dei Paschi di Siena (BMPS). Furthermore, Banca Popolare di Vicenza (BPVi) and Veneto Banca (VB) were put into liquidation under national insolvency proceedings in mid-2017. This alleviated the most acute risks in the banking sector. On the back of the economic recovery, Italian banks have continued the restructuring process by further increasing provisioning and accelerating the disposal of their high stock of NPLs, including through State-guaranteed securitisation transactions. Consolidation has further progressed due to bank restructuring, while some banks plan to significantly reduce branches and staff. However, the banking system remains vulnerable. The current economic recovery offers a narrow window of opportunity to comprehensively address the remaining structural weaknesses. High NPLs continue to constrain banks’ weak profitability and their ability to internally generate capital, also in light of tighter regulatory requirements. Although the level of NPLs is expected to significantly decline in the near future thanks to the planned NPL disposals, continued efforts are necessary to tackle the large stock of legacy NPL. This includes completing reforms on the insolvency framework and collateral enforcement as well as improving NPL servicing and data quality that could contribute to a deeper secondary market for distressed debt. With the economic tailwinds, banks are able to seize the opportunity to address their structurally weak profitability through comprehensive cost-cutting, restructuring and by adapting business models. Swift and full implementation of the corporate governance reforms, in particular the consolidation of the small cooperative banks, is key to increasing the resilience of the banking system. Overall, fixing structural weaknesses would help the banking system enhance its intermediary role for an efficient allocation of capital and would strengthen the economic recovery. Progress is being made with reducing NPLs, but the legacy NPL stock remains high. The total stock of gross NPLs continues to decline, amounting to around EUR 324 billion in Q2 2017 (implying a 16.4 % NPL ratio), down from the crisis peak of EUR 360 billion. In this regard, bad debts (sofferenze), i.e. debt with the worst recovery prospects, have also dropped on the back of banks’ NPL disposals. The bad debt coverage ratio has further improved (Table 4.2.1). Importantly, the inflow of new NPLs relative to the loan stock has returned to pre-crisis levels. Meanwhile, banks’ capitalization levels have remained stable. Low profitability continues to be a major challenge, while liquidity remains comfortable. Several factors are straining banks' profitability: the low interest rate environment; the still subdued credit recovery amid the ongoing deleveraging process (see Section 1); the elevated loan-loss provisioning; and the high cost-to-income ratios for several banks. In contrast, system-wide liquidity has remained comfortable amid overall low bank funding costs. The largest banks have boosted their deposit funding as a result of the recent restructuring and consolidation of the Italian banking system. Meanwhile, the issuance of debt instruments by banks has declined, mainly due to the decrease in issuances of retail bonds. In addition, banks’ reliance on ECB financing including through the targeted long-term refinancing operations (TLTROs) has remained substantial at EUR 252 billion (6.5 % of banks’ liabilities) in November 2017. Banks continue to be important holders of domestic sovereign debt with 17.2 % of outstanding public debt in Q3 2017, which shows the persistence of the bank-sovereign nexus. Subordinated bank debt held by retail investors continues to decline (in line with the maturing outstanding stock).

Italian banks underperform their European peers on several indicators. Despite the progress made, a simple benchmarking exercise (Graph 4.2.1) for the banking system as a whole illustrates that Italian banks continue to lag behind their EU peers (with arguably some differences between individual Italian banks). Below-average profitability and capitalisation make the Italian banking system more vulnerable to downside shocks. In spite of the progress, Italy still exhibits very high NPL ratios relative to EU peers. In addition, their low operational efficiency (as proxied by cost-to-income) has hindered a more rapid increase in NPL provisioning coverage, which could have accelerated NPL disposals. Despite the positive developments, Italian banks still lag behind some of their peers in rationalising branches and staff since the beginning of the crisis. This highlights that Italian banks still have a long way to go in improving their operational efficiency towards the best performers in the EU. Recent bank cases* In the first half of 2017, government actions were taken to address some of the weakest Italian banks. The process that led to the liquidation of Banco Popolare di Vicenza (BPVi) and Veneto Banca (VB) was protracted: The Atlante I fund acquired both banks following two unsuccessful IPOs in May and June 2016. It then injected further capital in January 2017 (bringing Atlante I's total capital injection to EUR 3.5 billion). However, as a result of both banks' significant losses in recent years and the continued deterioration of their financial situation, the conditions for a precautionary recapitalisation, ( ) which the banks requested in March 2017- were not met, and the ECB declared them failing or likely to fail on 23 June 2017. Following this, the Single Resolution Board (SRB) — the competent resolution authority — decided that a resolution action was not in the public interest in either case. This meant that both banks had to be liquidated under national insolvency proceedings. On 25 June 2017, following the ECB and SRB decisions, the European Commission approved, under EU State aid rules, the measures proposed by Italy to facilitate the liquidation of BPVi and VB. These measures included inter alia the partial sale of their good assets and liabilities to Intesa Sanpaolo, while the NPLs remained in the entities for liquidation. The sale of the good assets of both banks was supported by the Italian government through cash injections (EUR 4.8 billion) and a maximum of about EUR 12 billion in State guarantees. In line with EU State aid rules, to reduce the cost for taxpayers, burden-sharing was applied to the shareholders and subordinated bondholders of the two Venetian banks.( ) The precautionary recapitalisation of Banca Monte dei Paschi di Siena (BMPS) alleviated the bank’s acute vulnerabilities. BMPS applied for a precautionary recapitalisation by the Italian State in December 2016. ( ) It had failed to raise capital from private investors that month and had been in trouble since 2009, benefiting from previous recapitalisations (which had been repaid in 2015). On 4 July 2017, the Commission authorised the Italian authorities to conduct the precautionary recapitalisation of BMPS under EU rules, on the basis of a thorough restructuring plan including disposal of a significant portfolio of impaired assets. The precautionary recapitalisation entails State aid of EUR 5.4 billion, whereas the shareholders and subordinated debtholders of BMPS contributed EUR 4.3 billion, thus limiting the cost for taxpayers. The bank will dispose of EUR 26.1 billion of gross NPLs through a NPL securitisation transaction, which is expected to benefit from State guarantees (Garanzia Cartolarizzazione Sofferenze -GACS) and funding from the Atlante II fund (recently renamed the Italian Recovery Fund). The Italian Recovery Fund will invest in the mezzanine and junior tranches issued by the special purpose vehicle (SPV) at a disposal price of 21 % of the gross book value. Asset quality* NPL securitisation has developed into an important strategy for banks to clean up their balance sheets. Banks' take-up of the GACS was initially rather subdued, as the first State guarantees on the senior tranche of an NPL securitisation vehicle were granted only in early 2017. However since then, especially large and medium-sized banks have expressed interest in or taken first steps towards using GACS. Several securitisation transactions have been completed or launched, including the BMPS securitisation, the biggest NPL securitisation ever on the Italian market. The securitisation rules were amended in 2017 to facilitate the securitisation of some categories of NPLs (in particular unlikely-to-pay loans), increase the room for manoeuvre of special purpose vehicles (SPVs) and encourage participation in foreclosure auctions.( ) However, the GACS has not been the one-size-fits-all solution to address the legacy NPL problem for a number of reasons: (i) the absence of detailed loan portfolio data, especially for smaller banks, has slowed down GACS transactions, including the rating process by credit rating agencies; (ii) some banks hesitate to take on the upfront costs of improving NPL data quality and NPL servicing arrangements in order to participate in the GACS; (iii) some loan portfolios that are of poor quality or older NPL vintages are often not securitised with a view of applying for GACS. Graph 4.2.1:Benchmarking the Italian Banking System Source: ECB, European Commission calculations The Italian Recovery Fund has become the main NPL investor in Italy. With an NPL securitisation investment of EUR 2.5 billion so far (involving roughly EUR 31 billion of gross NPLs), the Italian Recovery Fund has supported the NPL disposal by four vulnerable banks. Disposal prices in the NPL securitisation transactions ranged between 19 % and 32 % of the gross book value, which reflects the different composition, data quality and impairment degree of securitised assets. The Fund has also contributed to the further development of the asset servicing market, as it entered into several agreements with CERVED on the servicing of securitised portfolios. NPL disposal gained momentum in 2017. Banks have continued to upgrade their capacity to manage arrears. While some of them are still considering the NPL internal work-out as their