EUROPEAN COMMISSION Brussels, 27.2.2019 SWD(2019) 1011 final COMMISSION STAFF WORKING DOCUMENT Country Report Italy 2019









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 EUROPEAN COUNCIL, THE COUNCIL, THE EUROPEAN CENTRAL BANK AND THE EUROGROUP 2019 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(2019) 150 final}



Contents Executive summary 1.Economic situation and outlook 2.Progress with country-specific recommendations 3.Overall findings regarding imbalances, risks and adjustment issues 4.Reform priorities 4.1.Public finances and taxation 4.2.Financial sector 4.3.Labour market, education and social policies 4.4. Competitiveness and investment Annex A: Overview Table Annex B: Commission Debt Sustainability Analysis and fiscal risks Annex C: Standard Tables Annex D: Investment Guidance on Cohesion Policy Funding 2021-2027 for Italy References LIST OF Tables Table 1.1:Key economic and financial indicators - Italy Table 2.1:Assessment of 2018 CSR implementation

Table 3.1:Outward spill-over heat map for Italy Table 3.2:MIP assessment matrix 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: Productivity and potential growth Graph 1.3: Composition of employment growth Graph 1.4: Unemployment and potential labour force Graph 1.5: Compensation of employees, productivity and nominal unit labour costs Graph 1.6: Regional dispersion of real GDP and disposable income per-capita Graph 1.7: Ratings, sovereign spread, policy and lending rates Graph 1.8: Change in net international investment position (NIIP), 2014Q1-2018Q3 Graph 1.9: Public finances indicators Graph 2.1: Overall multiannual implementation of 2011-2018 CSRs to date

Graph 4.1.1: Drivers of "snowball" effect on public debt Graph 4.1.2: Government securities by holding sector Graph 4.1.3: Sovereign yields on the secondary market Graph 4.3.1: Composition of the change of employment Graph 4.3.2: Transition rates of temporary employees Graph 4.3.3: Motivating Teachers - salary and career progression indicators, 2017 Graph 4.3.4: Percentage at risk of poverty or social exclusion by NUTS 2 Region (2017) Graph 4.4.1: Heterogeneity in firm-level productivity in Italy (2001=100) Graph 4.4.2: Estimated contributions to (business and intangibles) investment Graph 4.4.3: Restrictiveness in the retail sector, 2018 Graph 4.4.4: Regional dispersion in Italy in selected macroeconomic variables Graph 4.4.5: EQI index and labour productivity, Italy 2016-2017 Graph 4.4.6: eGovernment Indicator, 2019 LIST OF Boxes Box 2.1: EU funds and programmes contribute to addressing structural challenges and to fostering growth and competitiveness in Italy Box 3.1: Structural reforms and potential spillovers – the case of Italy Box 4.3.1: Monitoring performance in the light of the European Pillar of Social Rights Box 4.4.1: Investment challenges and reforms in Italy

Executive summary In the face of a weakening macroeconomic outlook, tackling Italy’s macroeconomic imbalances remains crucial. In particular, reducing the country’s high public debt ratio requires stability-oriented macroeconomic and fiscal policies to go together with more and better targeted investments and ambitious structural reforms to lift its sluggish productivity and potential growth. These endeavours are also key to market confidence. As a matter of priority, reviving the momentum for reform is needed to ensure sound public finances, more effective public administration and justice, a more efficient education system and labour market, a friendlier business environment and a more resilient banking sector ( ). After solid real GDP growth of 1.6 % in 2017, economic activity slowed down. Exports growth, a main contributor to previous GDP expansion weakened, while household consumption was subdued. The investment recovery remains uneven but is losing momentum overall. This is also partly due to domestic policy uncertainty, negatively affecting business confidence and the real economy through higher risk premia. Real GDP grew by 1.0 % in 2018 and is expected to decelerate sizeably in 2019 amid high uncertainty about domestic policies and the global outlook before picking up in 2020. The uneven and gradual improvement of the labour market continued in 2018. The number of people in employment reached a record high by mid-2018. However, the employment rate remained well below the EU average, particularly for women and young people. Regional employment gaps also remain substantial. Over the past two years, job growth has been driven by temporary contracts. The unemployment rate has been declining at a slow pace also due to rising participation in the labour market. However, youth and long-term unemployment remain very high. Adequate investments are needed to strengthen administrative capacity, human capital and innovation, as well as to reduce regional disparities. Improved administrative capacity is a precondition for the effective delivery of public investment and better use of EU Funds including for active labour market policies (measures that can foster labour market participation) and infrastructures. Investment in human capital is a pre-requisite for boosting public and private investment. Investment in innovation would improve productivity and growth prospects in the medium and long term. These investments would increase productivity in southern Italy in particular and also allow to address smaller firms' weaknesses. Investment, including in climate change response, environmental sustainability and risk prevention, would also benefit from taking into account regional disparities. Annex D identifies key priorities for support by the European Regional Development Fund and the European Social Fund Plus over 2021-2027, building on the investment needs and challenges outlined in this report. Italy has made limited progress in addressing the 2018 country-specific recommendations ( ). There has been some progress in: ·i) Fighting corruption thanks to a new anti-corruption law; ii) the banking sector where the reduction of the stock of non-performing loans has continued and the insolvency reform is being implemented; iii) implementing the reform of active labour market policies also thanks to additional resources allocated to public employment services. There has been limited progress in: ·i) Tackling tax evasion where no action has been taken to encourage e-payments despite some progress in e-invoicing; ii) improving market-based access to finance where only measures of narrow scope have been adopted and some past provisions reversed; iii) enforcing the framework for publicly-owned enterprises despite local bodies still being faced with operational difficulties; iv) encouraging women to work mainly due to the still inadequate provision of care facilities and the parental leave system; v) fostering research, innovation, digital skills and infrastructure and vocational-oriented tertiary education in particular because the funding for innovative investment has been reduced overall, despite some planned measures to strengthen administrative capacity. There has been no progress in: ·i) Shifting taxation away from productive factors, revising tax expenditures and reforming ‘cadastral values’ used as a basis for calculating property tax; ii) reducing the share of old-age pensions in public spending, where there has even been some backtracking; iii) reducing trial length in civil justice; iv) addressing restrictions to competition. Regarding progress towards its national targets under the Europe 2020 strategy, Italy has already achieved its targets on renewable energy, energy efficiency, early school leaving and higher education, and appears on track to reduce greenhouse gas emissions. Limited progress has been made in meeting the targets on employment rate, R&D investment and poverty and social exclusion. Italy faces several challenges with regards to a number of indicators of the Social Scoreboard supporting the European Pillar of Social Rights. Although slowly on the rise, the employment rate remains lower than the EU average and the gender gap is among the highest in the EU. However, a comprehensive strategy to promote women’s participation in the labour market is missing. Long-term and youth unemployment are serious concerns. The share of young people neither in employment nor in education and training is still the highest in the EU after a further increase in 2017. Income inequality and the risk of poverty are high, with wide regional disparities, and the impact of social transfers on poverty reduction is very low. The number of drop-outs from education and training programmes remains high. To tackle this issue, an anti-poverty scheme was introduced in 2018 and will be strengthened in 2019. Health outcomes are generally good and self-reported unmet needs for medical care are around the EU average, although with large regional disparities. The main findings of the in-depth review and the related policy challenges are as follows: ·Italy’s high public debt remains a major vulnerability. The government projections underlying the 2019 budget expect the debt-to-GDP ratio to have risen to 131.7% in 2018. The debt-to-GDP ratio may further increase in 2019 due to the weak macroeconomic outlook, underachievement of privatisation targets and a worsening primary balance. Overall Italy’s structural deficit is estimated to have been 1.8 % of GDP in 2018. Government bond yields increased markedly in 2018, reflecting a higher risk premium and could increase further, as in the rest of the euro area. In the medium and long term, the high stock of public debt, its sensitivity to macroeconomic shocks and future ageing costs explain marked sustainability risks. Moreover, new measures that have introduced the possibility for early retirement, backtracking on earlier pension reforms, will raise pension expenditure and are expected to worsen debt sustainability going forward, also due to possible negative effects on growth potential. ·Productivity growth has been sluggish over the past two decades. The productivity gap between Italy and the EU continues to widen. In 2018 labour productivity is expected to have remained stable, while growth in total factor productivity (measuring how efficiently labour and capital are used in production) is expected to have grown by some 0.5 %, only half as fast as the EU average. This is largely due to low investment and innovation, barriers to competition, weaknesses in the public sector and a non-supportive business environment. ·The unemployment rate remains high. Slow economic growth, low average educational attainment levels, skill mismatches, and growing but still low activity rates limit employment growth. Participation rates, especially among women, remain low. Youth unemployment remains extremely high. ·The cleaning-up of banks’ balance sheets has continued despite renewed market pressure. While Italian banks have continued to boost capital buffers and reduce legacy non-performing loans, they remain largely exposed to their own sovereign bonds. The raise in sovereign bond yields in 2018 adversely affects banks’ capital positions, pushing up their funding costs and curtailing their access to unsecured wholesale funding. While the largest banks appear resilient, as confirmed by the recent EU-wide stress test, significant vulnerabilities remain, especially amongst medium and small banks. The reform of the insolvency framework still has to be implemented. Access to finance continues to be a challenge for many small Italian firms.

Other key structural issues analysed in this report, which point to particular challenges facing the Italian economy, are the following: ·Taxation of production factors remains high and tax compliance low. Italy’s tax burden on labour and capital is still among the highest in the EU. While a broader ‘flat-rate regime’ slightly lowered taxation on the self-employed, the 2019 budget will raise the aggregate tax burden on firms. There has been no shift of the tax burden onto property and consumption and no revision of tax expenditures (like the number and scope of reduced VAT rates) or of outdated cadastral values (to bring them closer to market values). Tax evasion, especially due to omitted invoicing, remains high in Italy, which has one of the highest VAT gaps in the EU. Measures were enacted to encourage tax compliance through e-invoicing and the digital transmission of receipts, but also a new set of measures equivalent to a tax amnesty. ·Labour market challenges persist. Labour market rules have been tightened and hiring incentives extended to reduce the recourse to temporary contracts. Despite recent measures, active labour market policies remain weak and are poorly integrated with social policies. A new reform of public employment services is meant to support the integration in the labour market of the beneficiaries of the new citizenship income scheme. Despite the new labour inspectorate agency, operational since 2017, undeclared work remains widespread in Italy, especially in the south. Second-level (decentralised) bargaining continues to play only a limited role, also due to the high share of small firms. ·Social policies remain poorly integrated. The citizenship income scheme will replace the previous income support scheme, keeping an active inclusion approach subject to certain conditions. However, the scheme may prove difficult to implement and may put a considerable burden on the public administration. The actual impact on employment will depend on the effectiveness of activation policies and controls. Labour market conditions are improving but in-work poverty is high and rising, affecting in particular temporary workers and people with a migrant background. Access to affordable and adequate housing is also a challenge. Childcare and long-term care services remain underdeveloped. Measures to promote equal opportunities and a work-life balance are fragmented and limited in scope, negatively affecting women’s participation in the labour market amid unfavourable demographic trends. ·Education is a major challenge especially in southern Italy, hindering the quality of human capital. There is a much higher number of early-school leavers and low achievers in the south. Attracting, selecting and motivating secondary education teachers remains a challenge. Following recent reforms, the apprenticeship system is gaining momentum. The percentage of people having completed higher education remains low, and the higher education system appears underfinanced and understaffed. Despite better employability rates, vocational-oriented higher education remains limited in scope. Measures to boost digital skills and adult learning lack a comprehensive approach. ·Structural factors hold back investment and other key productivity drivers. Weak human capital slows down Italy’s transition to a knowledge-based economy. In the public sector, weak administrative capacity remains a barrier to public investment. Measures to boost private investment and innovation like the ‘Impresa 4.0’ plan generally had a positive effect, but the most efficient measures need to be made permanent following an in-depth assessment. Furthermore, micro and small firms face specific difficulties to adopt productivity-enhancing strategies. Measures to support knowledge (such as technological clusters) and cooperation among firms help smaller firms in particular to tackle these difficulties and increase their low productivity. ·Significant barriers to competition remain. Some sectors are still over-regulated, including business services and the retail sector. The lack of competitive processes to award public service contracts and concessions for public goods negatively affects the quality (and cost) of the service. Timely implementation of the 2015 competition law and the removal of remaining restrictions to competition would support productivity. However, recent announcements seem to go in the opposite direction by, for instance, restricting competition in the retail sector. ·The regional divide remains acute. In the south, productivity is particularly weak due to structural factors such as insufficient and ineffective investment. Territorial imbalances have risen since the crisis. In southern regions, investment and productivity are hampered by weak governance and low capacity to spend and implement policies. Moreover, lower levels of education and innovation limit the positive impact of measures adopted to support private investment. The south lags behind mainly in terms of intangible investment, as well as in transport infrastructure, waste management, water infrastructure and the prevention of risks from natural disasters. In rural areas the broadband network is also less advanced. ·Efforts are needed to improve the public administration, the judicial system and the anti-corruption framework. Despite recent reforms, the public administration and public-sector employment perform worse than in peer countries, not least in the area of digitisation and market surveillance. Challenges persist in managing publicly-owned enterprises and local public services, and uncertainty over the implementation of the public procurement code defers investment. Trial length in civil justice remains worrying, and a reform to streamline the civil procedure and limit the abuse of litigation is still pending. A new anti-corruption law and stronger prevention ensured by the national anti-corruption authority can improve the anti-corruption framework. However, the low efficiency of the criminal justice system is still preventing the prosecution of corruption, and a much-needed reform of the criminal trial and appeal system is at a very preliminary stage. 1. Economic situation and outlook Real GDP growth, prospects and risks Amid a slowdown in the euro area, the Italian economy slipped into a contraction. After solid real GDP growth in 2017 at 1.6 %, economic activity slowed down over 2018 (Graph 1.1). Exports and industrial production started weakening at the beginning of the year, amid concerns about global trade. Specific problems of the automotive industry added to the subdued picture. ( ) In the second half of 2018, real GDP recorded a slight contraction, as the positive impact from re-strengthening exports was more than offset by faltering domestic demand. Helped by a relatively strong carryover from the previous year, real GDP grew by 1.0% in 2018 (European Commission, 2019a). Graph 1.1:Real GDP and components Source: Eurostat. Household consumption downshifted sizeably in 2018. Despite rising disposable income and relatively high consumer confidence, consumer spending only grew moderately, as higher oil prices dented private consumption. Purchases of passenger cars and other durable consumption goods declined in the first nine months of 2018. ( ) Moreover, financial market tensions and negative wealth effects associated with falls in asset prices appear to have curbed consumer spending and led households to increase savings. The investment recovery is vulnerable to worsening financing conditions. Gross fixed capital formation, at 18.1 % of GDP in Q3-2018, is still markedly below both the latest peak of 2007 (22 %) and the EU average (20.6 %). While spending on equipment is almost back to 2007 levels, investment in construction has only recently bottomed out. The share of intangible assets, albeit still low by EU standards, increased to 2.9% of GDP by 2015 but has been stagnating since then. The recovery of private investment is forecast to slow down sizeably on the back of a more unsecure economic outlook. Furthermore, tailwinds such as an accommodative monetary policy stance and tax incentives wane, while some firms already face tighter financing conditions, also due to the worsening of sovereign funding conditions. The adopted budget emphasises short-term demand stimulus over supply-side reforms. With the budget law adopted in December 2018, the government primarily intends to increase current expenditure (social transfers) and allocates only a relatively small amount of extra spending to public investment in 2019, even though the latter is assumed to be more effective in stimulating economic growth and supporting private investment (Ramey and Zubairy, 2018). The government revised its fiscal plans in December 2018 and reduced the deficit target for 2019, which eased uncertainty and helped stabilise financial markets. However, sovereign yields remain high compared to early 2018 and are expected to eventually translate into higher borrowing costs for firms and households. Hence, tighter financing conditions risk diluting or even offsetting the growth impact of budgetary measures (Blanchard and Zettelmeyer, 2018). Significant supply-side reforms that would be likely to have a sizeable impact on longer-term growth are mostly absent. Growth prospects are subdued and subject to uncertainty and intensified downside risks. Real GDP growth is projected at 0.2 % in 2019 and at 0.8 % in 2020. Private consumption is expected to support growth, also helped by the introduction of the citizenship income scheme, while business investment is forecast to slow down sharply. High uncertainty about the economic outlook, the possible materialisation of external policy risks and a further rise in Italian sovereign yields could curtail both external and domestic demand. In particular, the planned rollback of structural reforms might have ramifications for medium-term growth prospects. Graph 1.2:Productivity and potential growth Source: European Commission.

Potential growth is projected to rise moderately but continues to lag behind peer countries. On the back of low investment and weak productivity growth, potential output has been declining since the onset of the global financial crisis. Supported by structural reforms and the recovery of investment, growth in potential output is estimated to have turned positive in 2017 and to increase moderately in 2018-2020. Potential output is mainly driven by rising labour input, followed by capital accumulation. Trend TFP growth is estimated to have resumed in 2018 and to make a positive contribution to potential growth in 2019-2020 (Graph 1.2). Weak productivity growth is a major constraint on economic expansion. The productivity gap between Italy and the rest of the EU remains substantial (Graph 1.2). Labour productivity (measured as real gross value added divided by hours worked) increased on average by 0.5 % per year between 2010 and 2017, compared with an EU average of 1.3 %. Labour productivity is projected to have remained unchanged in 2018. Growth in total factor productivity (TFP) is lagging behind the EU average. In 2010-17, annual TFP growth rates averaged a mere 0.3 %, which is 0.5 pp. less than the EU average. In 2018, TFP is expected to have grown by 0.4 %, also. Despite the recent albeit moderate pick-up in TFP growth, helped by the cyclical recovery of business investment, structural obstacles remain. They hamper an efficient allocation of production factors across the economy and the diffusion of innovation and technological change (to use labour and capital more efficiently) has been insufficient. Labour market After hitting new records, job growth slowed amid weak economic activity. Headcount employment reached a historical record by mid-2018 but dropped slightly in Q3 2018, the first quarterly decline since 2013. Job growth has been driven by temporary contracts (Graph 1.3). The share of temporary employees has risen to 17.5 % in Q3 2018 and is above the EU average. The median duration of temporary contracts is less than 12 months. Gender and regional employment gaps remain substantial (section 4.3.1). The unemployment rate fell to 10.3 % in the third quarter of 2018. As more people are joining the labour force, the unemployment rate is only slowly declining. As it is more difficult to find employment after an extended stint of unemployment, long-term unemployment is dropping more slowly than total unemployment. Youth unemployment (15-24) remains extremely high at 32.0 %. Moreover, the share of young people (15-24) neither in employment nor in education or training increased to 20.1 % in 2017 and remained the highest in the EU. Graph 1.3:Composition of employment growth Source: ISTAT. Labour market conditions improved but the slack remains substantial. More people have started actively looking for a job, whereas the share of underemployed part-time workers has broadly stayed constant (Graph 1.4). Involuntary part time is widespread in Italy. In 2017, about 17 % of part-time workers declared their willingness to work more hours, with the highest incidence in Trentino, Veneto and Lazio. ( ) The recent increase in hours worked was driven by the growth in positions filled rather than by hours worked per employee, which increased markedly only in the manufacturing sector. ( ) Graph 1.4:Unemployment and potential labour force Source: Eurostat. Prices, wages and costs Weak wage growth reflects the labour market slack. In 2017, compensation per employee grew by 0.3 % in nominal terms, but dropped by 0.8 % when adjusted for inflation. Real compensation per employee remains well below the level in 2000, as people on average work fewer hours, while real hourly wages are stagnating. In addition to the labour market slack, the structural shift of jobs from sectors with relatively high productivity growth (industrial sector) to sectors with relatively low productivity growth (services) and the shift within the services sector from higher-paid jobs (e.g. in financial services) to lower-paid ones (e.g. in hotel and catering) is softening wage growth. ( ) Due to subdued wage growth, the increase in unit labour costs remains contained. Nominal wage growth accelerated in 2018 on the back of wage increases in the public sector (which had been frozen since 2010) ( ) but wage growth in the broader economy is expected to remain moderate. ( ) The expected slow growth in productivity implies that wage moderation is likely to continue as it limits the scope for wage increases that do not impair price stability and competitiveness. Nominal unit labour costs fell in 2017 largely because of subdued wage growth (Graph 1.5). Graph 1.5:Compensation of employees, productivity and nominal unit labour costs Source: European Commission. Consumer prices are set to rise moderately. The headline harmonised index of consumer prices increased by 1.2 % in 2018, but is expected to rise by only 1.0% in 2019, before picking up again to 1.3% in 2020. Core inflation is set to rise gradually, in line with wage growth. Income inequality, inter–regional disparity and social situation Disposable incomes are lower than in 2008 and income inequality remains high. In 2017, real gross disposable income per capita was almost 9 % lower than in 2008 and income growth continues to lag behind the EU average. In 2017, the income of the 20 % of households with the highest income was almost six times the income of lowest income households (income quintile ratio (S80/S20 indicator). ( ) Per-capita GDP in the South is only two thirds of the national average, while the northern regions exceeded the national average by more than 20 %. The ability of the tax-and-transfer system to mitigate interregional inequality via interregional income transfers appears limited (Graph 1.6). Graph 1.6:Regional dispersion of real GDP and disposable income per-capita Source: ISTAT The risk of poverty remains high. As highlighted by the Social Scoreboard, 28.9 % of the population were at risk of poverty or social exclusion in 2017. This rate, albeit lower than in the previous year, still exceeds both the pre-crisis level (25.5 % in 2008) and the 2017 EU average (22.4 %). The improving labour market situation provided some relief, but wage growth has so far remained subdued. Inter-regional income inequality remains persistent and social disparities loom large. Italy has a progressive personal income tax system, but social benefits for people at working age are generally low and are thus not effective in reducing poverty and inequality (section 4.3.3) By contrast, wealth is more evenly distributed, due to high home ownership rates. Financial developments

Sovereign bond yields came under severe pressure between May and December 2018. Market tensions owing to uncertainties about the economic and fiscal policy stance affected equity and sovereign debt markets. The ten-year sovereign bond yield rose from 1.8% at the beginning of May to 3.4 % by the end of October, and the spread vis-à-vis German bonds widened by 180 basis points over the same period. In December, financial tensions eased and market conditions progressively improved, although they remain worse than at the beginning of the year. Following the agreement on the budget, the ten-year sovereign bond yield declined to 3.0 % by early February 2019, with the spread vis-à-vis German bonds decreasing by 42 basis points. Rating agencies downgraded Italy's credit rating or worsened the outlook. On 19 October 2018, Moody’s downgraded Italy’s rating to Baa3 (BBB-), one notch above investment grade, while Standard&Poor’s left its rating unchanged at BBB but changed its outlook from ‘stable’ to ‘negative’ on 26 October 2018. Rating agencies stressed the increase in borrowing needs, the high debt-to-GDP ratio and the worsening economic outlook as main factors behind the negative rating action. Following the downgrade of sovereign debt, rating agencies also started downgrading the ratings of resident banks and firms (Bank of Italy, 2018). Amid a global stock market slide and domestic policy uncertainty, equity prices fell sharply. The Milan benchmark stock exchange index lost almost 20 % of its value since early May, with the bank sub-index falling by more than 37%, as domestic banks are broadly exposed to Italian sovereign debt. Since mid-November 2018, bank credit default swap premia improved, but bank stocks hardly recovered and price-to-book ratios, a common metric for the valuation of banks, have dropped by over 25 % since the beginning of 2018 (BIS 2018). Non-domestic investors reduced their exposure to Italian assets. Between May and November 2018, non-resident investors reduced their holdings of government securities and bank bonds by EUR 77.3 billion and EUR 16 billion respectively. By contrast, deposits placed with Italian banks remained stable and private sector deposits rose by 3.3% in November, compared to the same month of the previous year. Since May 2018, deposits from domestic households and non-financial corporations have remained broadly stable, while foreign banks increased their deposits, as they appear to keep part of the proceeds from recent asset sales as deposits in Italy. Lending conditions to the private sector face first signs of tightening. Interest rates on corporate loans and mortgages appear so far only marginally affected by recent market turbulences and rising sovereign yields (Graph 1.7). Bank lending surveys indicate a tightening of credit conditions, while the cost of new bond issuances has been increasing since May 2018. Moreover, the worsening of sovereign funding conditions tends to impact on banks' credit conditions with a time lag. Lending to firms is still growing at a moderate pace. Loans to households are driven by consumer credit, which is albeit weakening in line with the economy. However, increasing sovereign yields risk affecting banks' funding costs ( ) and the deteriorating macroeconomic environment might worsen credit quality and undermine ongoing initiatives to reduce non-performing loan ratios. Consequently, a persistent fall in sovereign bond and other asset prices would entail higher borrowing costs for the private sector and weigh on household wealth. ( ) Graph 1.7:Ratings, sovereign spread, policy and lending rates Source: Bank of Italy, ECB, Bloomberg. Financial risks have increased but some factors mitigate the impact of financial stress in the short term. Relatively low private sector debt, ample trade surpluses and an almost balanced net international debt position are able to absorb a large part of the financial shock in the short term. Moreover, the high average residual maturity of the public debt slows down the transmission of an increase in government securities yields to the average cost of debt. However, a marked economic slowdown and higher interest rates in light of high public debt could expose financial vulnerabilities. External position Italy’s current account surplus remained broadly stable in 2018. Amid a worsening external environment, the current account balance registered a surplus of 2.7 % in the 12-month period up to November 2018. The export performance deteriorated and Italian exports lost market shares, due to an appreciation of the euro in nominally effective terms, the slowdown in particular export markets and political uncertainty about global trade policy. By contrast, import growth remained relatively strong owing to the cyclical investment recovery and higher oil import prices. Consequently, the trade surplus declined by 0.2 pps. to 2.8 % of GDP over the same period. The 12-month primary income balance recorded a surplus of 0.8 % of GDP largely driven by improvements in the balance of investment income (which turned positive in September 2016). The current account surplus reflects saving and investment decisions by the different sectors of the economy. The corporate sector has assumed a net lending position since 2009, amounting to 1.1 % of GDP in 2017. Households increased net lending until 2014 and reduced residential investment in line with the slowing housing market but net lending fell to 0.9 % of GDP in 2017. In addition, the reduction of the government deficit supported the shift to a net lending position of the Italian economy. The cyclically adjusted current account surplus is estimated at 2.3 % of GDP in 2018. The current account surplus remains somewhat above the level suggested by fundamentals, i.e. about 1.5 % of GDP. This surplus is estimated to be sufficient to keep Italy's net international investment position stable and bring it closer in line with fundamentals (in the absence of valuation effects). ( ) The net international investment position (NIIP) has moved close to balance. Since the beginning of 2014 when net foreign liabilities peaked at almost EUR 400 billion (or 25 % of GDP), Italy's NIIP has improved by 342.5 billion (corresponding to 20 % of 2017 GDP). Net liabilities have fallen to 54.7 billion (or 3.1 % of GDP) by Q3 2018 (Graph 1.8) thanks to persistent current account surpluses and supported by valuation effects. The latter have been driven by the rate-of-return differential between Italian assets (mostly government bonds) held by non-residents and foreign assets (mostly equity and shares in investment funds) held by residents. ( ) The sharp increase in government yields since May 2018 and the reciprocal fall in government bond prices imply a fall in the value of foreign liabilities and an improvement of the NIIP. Graph 1.8:Change in net international investment position (NIIP), 2014Q1-2018Q3 Source: Bank of Italy, Commission calculations. The TARGET2 balance worsened in the second half of 2018. Since May 2018, the Bank of Italy’s net debtor position in the TARGET2 European payment system deteriorated and net liabilities reached a new peak at EUR 492.5 billion in August 2018. By the end of the year, the balance had fallen to EUR 482 billion, largely thanks to inflows in December. Public finance: public deficit and debt Italy's headline and primary balance have broadly stabilised in recent years. After the sizable fiscal effort carried out over the period 2010-2013, which raised the primary surplus to above 2% of GDP, Italy's primary balance fell to 1.5% of GDP in 2014 and progressively deteriorated to 1.4% of GDP in 2017. The headline deficit fell from 3% of GDP in 2014 to 2.6% in 2015, and gradually narrowed to 2.4% of GDP in 2017, thanks to declining interest spending. The latter was also the result of historically low nominal interest rates on newly issued government securities, allowed by the ECB's accommodative policy stance. Graph 1.9:Public finances indicators Source: European Commission Relatively weak economic growth and current fiscal plans are expected to put pressure on the government deficit in the coming years. Based on the government projections underlying the Budget Law approved in December 2018, the government headline deficit is expected to have declined to 1.9% of GDP in 2018, supported by economic growth and declining interest spending. For 2019, the government projects that the headline deficit will increase to 2.0% of GDP. However, the macroeconomic scenario underlying the 2019 deficit target is subject to downside risks, considering that the Commission 2019 winter forecast expects lower economic growth as compared to the government, both in real and nominal terms. In 2020, the government headline deficit is expected to decline to 1.8% of GDP based on the government projections, which assume additional revenues worth 1.2% of GDP from the automatic increase of VAT rates legislated as a safeguard clause. However, considering that in recent years such clauses were systematically repealed without implementing adequate alternative financing measures, there are high risks that the headline deficit will significantly increase in 2020 based on the government plans.

No reduction in government debt is expected over the coming years. The gross debt-to-GDP ratio increased steeply during the double-dip recession, from 102.4% in 2008 to 131.8% in 2014, before slightly declining to 131.2% in 2017. In 2018, the government projections underlying the 2019 budget assume the debt-to-GDP ratio to have increased to 131.7% of GDP in 2018, mainly due to a large stock-flow adjustment partly related to fluctuations in the Treasury accounts. In 2019, the national authorities expect the government debt-to-GDP ratio to decline by 1 percentage point to 130.7%, by assuming privatisation proceeds amounting to 1% of GDP. However, this assumption appears unrealistic, considering that almost no privatisation proceeds were recorded over 2016-2018 despite the original targets of 0.5% of GDP per year (2016 Draft Budgetary Plan). Without considering the assumed privatisation proceeds, the government debt-to-GDP ratio is set to remain stable at close to 132% based on the government projections. Considering the downside risks to the government macroeconomic and deficit projections for 2019, it is likely that the government debt-to-GDP ratio will increase up to above 132% this year. In 2020, the government projections expect the debt-to-GDP ratio to decline by 1.5 percentage points to 129.2%, by assuming additional VAT revenues from the activation of the safeguard clauses amounting to 1.2% of GDP, as well as privatisation proceeds amounting to 0.3% of GDP. However, these projections are subject to significant risks, given that in recent years VAT safeguard clauses were systematically repealed and privatisation targets underachieved. Table 1.1:Key economic and financial indicators - Italy Source: Eurostat and ECB as of 31-1-2019, where available; European Commission for forecast figures (Winter forecast 2019 for real GDP and HICP, Autumn forecast 2018 otherwise) 2. Progress with country-specific recommendations Since the start of the European Semester in 2011, 57 % of all country-specific recommendations addressed to Italy have recorded at least ‘some progress”. ( ) 43 % of these CSRs recorded 'limited' or 'no progress' ( Graph 2.1). The areas that registered the best performance in terms of progress are the measures to fight corruption and to reform the public administration and the labour market. Good performances have been registered also in the banking sector and in reducing restrictions to product and services markets. Graph 2.1:Overall multiannual implementation of 2011-2018 CSRs to date Source: European Commission Concerning public finances and taxation, limited progress was made to address the related CSRs. Efforts focused on 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 trend is being reversed: the share of old-age pension in total expenditure is expected to rise, mostly as a result of the implementation of the new early retirement scheme in 2019, backtracking on elements of past pension reforms. No privatisations have been undertaken to reduce public debt, so that recent targets have been systematically underachieved. Tax expenditures have been reviewed but not yet streamlined, Italy has not reviewed the outdated cadastral values, and taxation on labour has not been shifted to other tax bases. The first residence tax was repealed in 2015. The e-invoicing and e-transmission of receipts for commercial transactions, which are compulsory since January 2019, are expected to have a positive impact on tax compliance. However, the repeated tax amnesties may negatively impact tax compliance, while limited efforts were made to tackle tax evasion with consent, for instance by encouraging e-payments. 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, some civil justice reforms have been passed, increasing the specialisation and digitalisation of courts, reinforcing alternative dispute resolution and aiming to limit abuses of the trial through stricter admissibility rules for appeals. However, an all-encompassing reform of the civil trial is still pending. Overall, the length of civil trials has not been visibly reduced compared to past years. 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 new anti-corruption law was adopted in December 2018, introducing better investigation techniques, stricter penalties and longer prescription terms for corruption offences. It also cancels prescription terms after a first instance conviction as of 2020. However, the effective sanctioning of corruption is hindered by the length of criminal proceedings, broadly unchanged since 2014 in the absence of a comprehensive reform of the criminal trial, including the appeal system. A comprehensive reform of public administration was adopted in 2015 and new draft bill was put forward in 2018. The measures simplify and clarify the decision-making process, encourage transparency and efficiency, and improve the management of public employment. 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. However, newly announced or adopted measures seem to go in the opposite direction, namely in the retail sector and in the collaborative transport sector. In the financial sector, some progress was made. Banks’ balance sheet repair including NPL disposals through outright sales and securitisations supported by the government guarantee scheme has substantially progressed. The corporate governance reform of the large cooperative banks has stalled and that of the small mutual banks was somewhat watered down and delayed, while the insolvency framework reform still has to be finalised. Some progress was achieved regarding market-based access to finance, with. policy measures adopted in recent years slowly bearing fruits, though bank credit remains the dominant source of financing for corporates. However, in the last year the reform efforts have lost momentum. The recent abrogation of the allowance for corporate equity appears at odds with the objective of strengthening firms' capital. On the labour market, reform progress was limited. More than four years after its introduction, the jobs act reform remains incomplete, since important complements have not been fully implemented. Despite some recent efforts to make active labour market policies more effective, the placement capacity and overall efficiency of Public Employment Services remain weak, performance varies widely between regions and employment services are barely integrated and coordinated with other social and educational policies. The employment rate of women remains sizeably below the EU average. A comprehensive strategy combining a more efficient tax system with measures helping to reconcile career and family life, and subject to evaluation and monitoring, is still missing. Overall, Italy made limited progress in addressing the 2018 country-specific recommendations. ( ) No progress has been recorded in shifting the tax burden away from labour, despite a minor reduction of the tax burden for the self-employed, and in reducing the share of old pensions in public spending, which should actually increase. Limited progress has been made in tackling the shadow economy and strengthening the use of e-payments. While the progress was also limited concerning publicly-owned enterprises and local public services, some progress was achieved in improving the legal framework for fighting corruption, mainly thanks to a new anti-corruption law. However, no progress was recorded in reducing the length trial in civil justice and in addressing restrictions to competition. Some progress was also made in addressing non-performing loans in the banking sector and in implementing the insolvency reform while progress was limited in improving market based finance. Progress was also limited concerning women labour market participation and innovation, research, digital skills and infrastructure, and vocational oriented tertiary education. Some progress was recorded in implementing the reform of active labour market policies. Table 2.1:Assessment of 2018 CSR implementation Source: European Commission Box 2.1: EU funds and programmes contribute to addressing structural challenges and to fostering growth and competitiveness in Italy Italy is one of the highest beneficiaries of ESI Funds. Financial allocation from programmes under the European Structural and Investment Funds (ESI Funds) aimed to support Italy in facing development challenges, amount to EUR 44.6 billion in the current multiannual financial framework (to which should be added EUR 30.5 billion from national contribution). The overall allocation is distributed between the ESI funds: 48.5% under the European Regional Development Fund (ERDF), 22.8% under the European Social Fund (ESF), 23.4% under the European Agricultural Fund for Rural Development (EARDF), 4.1% under the Youth Employment Initiative (YEI), and 1.2% under the European Maritime and Fisheries Fund (EMFF). As of the end of 2018, Italy is lagging behind in the implementation of ESI funds if compared to the EU average. In terms of selection rate (% of the total allocation selected for the implementation of specific projects), the level recorded for Italy is 56% against 63% for the EU. Likewise, the payments rate for Italy (20%), remains below the EU average (27%), though it has allowed attaining the 2018's end-of-year targets. EU funds are being used to address policy challenges identified in the 2018 CSRs. As regards labour market participation, the ESF supports the reform of active labour market policies, in particular by strengthening the public employment services, as well as the implementation of the youth Guarantee scheme. By November 2018, more than 1.4 million young people had registered in the programme and 1.1 million had been taken in charge; about 56% of them have benefited from an active policy measure. In the field of social inclusion, the ESF is contributing to support the national anti-poverty strategy (i.e. REI – Reddito di Inclusione), while actions financed under the Education programme contributes to implement the "Good School" reform. In the field of infrastructure, EUR 2.45 billion of ESI funds are allocated to investments in transport networks, EUR 1.4 billion to sustainable urban transport infrastructures and EUR 889 million to fast internet networks, of which EUR 577 million for 100 Mbps and beyond. In these domains, projects should be finalised by the end of the programming period 2014-20. In particular, broadband infrastructure is expected to benefit 1 717 646 households, and railway projects are expected to modernise 270 km, located prevalently in the TEN-T core-network section of Southern Italy, such as along the Napoli-Bari and Messina-Catania-Palermo railways. The EU spending for infrastructure in Italy is reinforced by the Connecting Europe Facility (CEF). Under the 2014-2017 calls, Italian applicants submitted 164 eligible proposals. 59 projects were selected, with Italian beneficiaries receiving €1.5 billion of CEF Transport funding, and investing a total of €3.8 billion in these projects. This sum covers key cross-border rail projects such as the Brenner base tunnel or the new Lyon-Turin Rail link. ESI funds are used also to improve the quality of areas, plants and equipment, mainly in Southern Italy, for the provision of local public services in the fields of risk prevention (EUR 2.3 billion), circular economy and water management (EUR 1.4 billion). ESI funds are expected to generate benefits related to water supply (1 373 786 persons should benefit from improved service by the end of the 2014/20 programming period), waste water treatment (4 014 540 population equivalent), waste recycling (877 800 Tonnes/year), flood protection (196 070 persons), forest fire protection (1 693 859 persons), habitats conserved (273 915 hectares). EU programmes are also widely used in Italy to foster research and innovation. ESI funds allocate EUR 4.2 billion to research and development in the current multiannual financial framework. By the end of the programming period, programmes co-financed under ESI Funds should support 6 945 enterprises in building cooperation with research institutions and 4 528 enterprises in introducing new products in their markets. Programmes co-financed under ESI funds are also expected to support 3 750 full time equivalents new researchers and 4 962 full time equivalents researchers working in improved research infrastructure facilities. Furthermore, private investment matching public support in innovation or R&D projects is expected to reach EUR 2.18 billion by the end of 2014/20. An additional boost to research and innovation comes from Horizon 2020, as participants from Italy received EUR 3.01 billion so far, with a projection to reach EUR 5.42 billion by the end of 2014/20, which would be 49.2% increase compared to 3.63 billion received in FP7. Applicants from Italy were awarded with 1812 Seals of Excellence, ranking Italy 2nd in the EU. EU funding contributes to mobilisation of private investment. In particular, ESI Funds alone mobilise additional private capital by allocating about EUR 2.6 billion in the form of loans, guarantees and equity. This includes EUR 320 million for the SMEs Initiative, which provides securitisation of existing loans allowing enterprises to receive loans, with an expected leverage of 9.7. Altogether, 8.3% of the ESI Funds is allocated in a form of financial instruments. The Commission can provide tailor-made technical support upon a Member State's request via the Structural Reform Support Programme to help Member States implement growth-sustaining reforms to address challenges identified in the European Semester process or other national reforms. Italy, for example, is receiving support to design a comprehensive accrual accounting system across Italy's public administration (according to International and European Public Sector Accounting Standards – IPSAS/EPSAS). The Commission is also continuing to assist the authorities in their efforts to fight tax evasion, notably by developing a methodology for estimating the excise tax gap. In addition, in 2018, work has started on enhancing the efficiency and effectiveness of the whistleblowing mechanism to fight corruption and on support for the implementation of the Italian National Digital Strategy. In Italy, the overall volume of approved operations by the European Investment Bank (EIB) with the European Fund for Strategic Investments (EFSI) backing amounts to EUR 9.6 billion, which is set to trigger a total of EUR 57 billion in additional private and public investments (February 2019). Italy ranks 6th as to the overall volume of approved operations as a share of GDP. 81 projects involving Italy have so far been approved under the infrastructure and innovation window of EFSI. They amount to EUR 7 billion in total financing, which should, in turn, generate EUR 30.6 billion in investments. Under the SME component, 76 agreements with intermediary banks have been approved for a total of EUR 2.6 billion, which should mobilise around EUR 26.9 billion of total financing. 215 614 SMEs and mid-cap companies are expected to benefit from this support. "Acquedotto pugliese water services" is a notable example of such project in Italy. Acquedotto pugliese is the largest integrated water services operator in Southern Italy. The EIB is providing EUR 200 million in financing to upgrade the water network, and invest in water treatment facilities to increase the availability and quality of the drinking water distributed to the local population. EU actions strengthen national, regional and local authorities and the civil society. Italy has allocated EUR 1.2 billion, the highest amount in the EU, for reinforcing the capacity of public administrations at different levels and prompting close cooperation with stakeholders. These resources focus on the improvement, simplification and modernisation of public administration’s processes and organisation, with specific actions also aiming at strengthening the efficiency of anti-corruption measures and enhancing the justice system. 3. Overall findings regarding imbalances, risks and adjustment issues The 2019 Alert Mechanism Report concluded that a new in-depth review should be undertaken for Italy to assess the persistence or unwinding of its imbalances. In spring 2018, Italy was identified as having excessive macroeconomic imbalances (European Commission, 2019d). The imbalances identified related, in particular, to high public debt, low productivity growth, high unemployment rate and the stock of non-performing loans. This section summarises the findings of the analyses in the context of the MIP in-depth review that is contained in various sections in this report.( ) Imbalances and their gravity Italy's high public debt is a major vulnerability for the economy. At 131.2 % of GDP in 2017, Italy's public debt translates into high servicing costs (3.8 % of GDP in 2017). The latter reduce the resources available for productivity-enhancing spending – already limited by the longstanding bias in public expenditure towards old-age pensions – and for implementing countercyclical policies in case of negative economic shocks. Furthermore, the sizeable rollover needs related to the high public debt expose Italy's public finances to sudden increases in financial market risk aversion. As observed since May 2018, fluctuations in market perceptions and preferences can result in high volatility and marked increases of sovereign yields, with potential negative spillovers to the banking sector and ultimately to financing conditions for firms and households. The slow growth in productivity hampers the unwinding of macroeconomic imbalances. Stronger productivity dynamics would be a key driver to lift Italy's growth potential and strengthen its economic resilience. Despite the recent pick-up in labour productivity, overall productivity levels remain low, and the gap between Italy and the EU has continued to widen. Labour market conditions are only slowly improving. In 2018 headcount employment exceeded pre-crisis levels. However, since hiring incentives expired at the end of 2016, jobs growth has almost exclusively been driven by temporary employment. Women’s activity rates remain low and have dropped below 2016 levels in Q3 2018.

Despite the recent large reduction in NPLs, their legacy levels are still high. The gross NPL ratio declined from 11.5% at end-2017 to 10.2% in Q2-2018. Despite the progress made, the legacy stock of bad loans and unlikely-to-pay exposures remains still high in absolute terms and compared to EU peers. Due to the banks' high exposure to their own sovereign, higher sovereign yields have adversely affected banks' capital positions, pushing up their funding costs and curtailing their access to unsecured wholesale funding. Italian banks have recently tightened credit standards due to market uncertainty. As a consequence, bank credit to non-financial firms, especially smaller ones, is still subdued and is limiting overall investment growth in Italy. Italy has strong trade and financial links to the Euro area and it accounts for 16 % of euro area GDP. Therefore, it remains a major source of trade and financial spillovers (tables 3.1 and 3.2). Exports of goods and services to the rest of the euro area correspond to 13 % of Italy’s 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. Evolution, prospects and policy responses Italy's public debt is not expected to decrease substantially in the coming years. After a slow decline observed in recent years, the government debt-to-GDP ratio is set to have increased in 2018 to 131.7% based on the government projections. In 2019 and 2020, the public debt reduction projected by the government is subject to significant downward risks, as it assumes high privatisation proceeds in 2019 (1 % of GDP) and sizable revenues from the activation of VAT safeguard clauses in 2020 (1.2 % of GDP). Sovereign yields, which increased significantly in 2018 and declined only partially towards the end of the year, are expected to increase further from 2020 as in the rest of the euro area. In 2018, foreign investors decreased their holdings of Italian sovereign bonds, while Italian banks raised their exposure. However, despite episodes of scarce market liquidity observed at the end of May, which temporarily affected sovereign yields of other Member States, negative spillovers to the rest of the EU have been limited. In the medium and long term, Italy is expected to face marked fiscal sustainability challenges based on standard fiscal sustainability risks indicators and on the Commission debt sustainability analysis. Its high stock of debt, its sensitivity to macroeconomic-fiscal shocks and the future ageing costs contribute to that assessment. The new measures on pensions backtrack on pervious reforms and are expected to worsen fiscal sustainability, by increasing pension expenditure in the coming years and possibly hampering potential growth. Table 3.1:Outward spill-over heat map for Italy Source: UN, OECD, WIOD, BIS and Commission services Productivity has recently risen, but reforms to strengthen productivity are still pending, insufficiently implemented or limited in scope. Over 2018-2020 a moderate increase in labour productivity is projected. Yet, the impact of recent reforms on productivity is only gradually building up and is sometimes hindered by inadequate implementation. The reform of active labour market policies aims to overcome labour market frictions and, in particular, to mitigate skill mismatches through adequate training and education. Yet, three years after its adoption, those measures are not yet fully implemented. Moreover, effective reforms to boost competition on product markets and thereby increase innovation and productivity suffer from a piecemeal approach. Weakening economic activity in combination with lingering structural challenges puts employment growth at risk. The unemployment rate declined to 10.2% in Q3 2018, while youth unemployment remained high at about 32%. The economic slowdown, in combination with low levels of average educational attainment and persistent skill mismatches, is likely to weigh on employment growth. On the other hand, policy measures with the potential to boost employment dynamic once the economic activity recovers, such as increasing the degree of competition in product markets, remain ineffectual. Banks have adopted several measures to reduce their NPLs and address sovereign risk. Besides having improved their internal work-out capacity, banks have also benefitted from public support for NPL disposal, such as aid-free State-guaranteed securitisations, and from a buoyant secondary market for impaired assets. Although so far market uncertainty has not significantly impaired NPL sales, including disposal price, downside risks for NPL disposals prevail in the current fragile market environment. In order to mitigate the impact of high sovereign yields on their capital base, several banks have adopted strategies to rebalance part of their sovereign bond portfolios to the held-to-collect category (not marked-to-market). However, especially smaller banks' capital buffers are likely to be further affected by wider sovereign spreads. Overall assessment Italy’s remaining imbalances are not expected to unwind in the near term or could even deteriorate. Importantly, the public debt-to-GDP ratio remains very high, and its reduction going forward is hampered by current fiscal plans, weakening economic recovery as well as still higher borrowing costs. The high debt level is a potential source of negative spillovers for the euro area, though contagion from the higher market volatility has been limited so far. Labour market conditions are gradually improving, but the unemployment rate remains high and is still far above pre-crisis levels, in particular for young people and the long-term unemployed. The economic outlook is subject to amplified downside risks, in the context of a policy-induced rise in sovereign yields and a very high public debt. This adds to Italy's structural weaknesses such as sluggish productivity growth, a still low investment ratio and a shrinking working age population, which are weighing on Italy's potential growth. Banks' balance sheet repair has progressed substantially, but significant vulnerabilities remain, in particular those related to banks' exposure to their own sovereign and to the weaknesses of small and medium banks. On the positive side, Italy’s external position is relatively strong, with current account surpluses and a net international investment position moving closer to balance. Still, non-cost factors continue to weigh on export performance. Some structural reforms have been implemented to address the 2018 country-specific recommendations (Section 2), which in Italy’s case are all related to its macroeconomic imbalances. However, the reform momentum has sizeably slowed down since 2018 and elements of backtracking are evident in some reform areas. Consistent implementation of those reforms, as well as a sufficient degree of ambition in the forthcoming reform effort are crucial to decisively tackle Italy’s macroeconomic imbalances. Box 3.1: Structural reforms and potential spillovers – the case of Italy There is some debate about the size and direction of the cross-border spillovers of structural reforms. While the demand effect (higher demand for foreign products) leads unequivocally to positive spillovers, reforms typically also improve a country’s competitiveness and this can go at the (relative) expense of other countries. Whether the net effect is positive or negative depends on the relative strength of these two opposing channels and is likely to be reform-specific. In a model simulation exercise ( I ) the impact of a comprehensive set of reforms is quantified for all EU Member States in a harmonised way (Varga and in ’t Veld, 2014). For a large set of structural indicators the benchmark is defined as the average of the three best performing counties, and then in the simulation these gaps are closed by half for all indicators, for each country separately. An update of this exercise for Italy is shown in the table below, based on more recent indicators (but not capturing the most recently introduced reform measures). As the magnitude of the reform ‘shocks’ simulated here are based on a harmonized benchmarking exercise, they do not necessary correspond to past European Semester Country Specific recommendations, but they illustrate the potential impact structural reforms can theoretically have on Member States’ economies. The simulated reforms cover the following areas: product market regulation and entry, labour market participation, tax structure and R&D subsidies. For Italy the largest ‘reform gaps’ identified are in product market regulation (service sector markups and entry costs), the tax structure (as captured by the relative share of labour tax revenues compared to consumption tax revenues) and low labour force participation, in particular of low skilled and early retired. According to this theoretical exercise, this ambitious reform package, if adopted altogether and contemporaneously, could boost GDP by 7% after 10 years, and 14 ¾ % after 20 years. The reforms would raise competitiveness, boosting both exports and imports. As the terms of trade fall by about 3.5% after 10 years, the trade balance to GDP ratio actually falls slightly by 0.8 pps. The net spillover to the rest of the EA is very small but positive. Table 3.2:MIP assessment matrix (Continued on the next page) Table (continued) Source: European Commission 4. Reform priorities 4.1.Public finances and taxation 4.1.1.Public DEBT* A worsening primary surplus is expected to hinder the reduction of Italy's public debt over the coming years. In recent years, the difference between the real implicit cost of debt and real GDP growth, although remaining positive, progressively narrowed also thanks to the economic recovery and declining interest spending (Graph 4.1.1). As such, the snowball effect has shrunk, supporting the reduction of the debt-to-GDP ratio. However, the deterioration in the primary surplus and slightly debt-increasing stock-flow adjustments partly offset those developments. Overall, the debt-to-GDP ratio declined only slowly from 131.8% in 2014 to 131.2% in 2017. In 2019, the primary surplus is expected to slightly deteriorate based on the government projections underlying the 2019 budget. In 2020, the planned fiscal measures are set to entail a more marked deterioration, without considering the additional revenues expected from the activation of the VAT safeguard clauses. Graph 4.1.1:Drivers of "snowball" effect on public debt Source: European Commission

Sovereign yields increased in 2018, leading to higher debt servicing costs. Yields on 10-year sovereign bonds increased by 1.6 pps between the beginning of May and the end of October 2018 (reaching 3.4%), before slightly declining to 2.6 at the end of January 2019 also as a result of Italy’s revised fiscal targets in the 2019 budget. Yields on 2year bonds increased by 1.4 pps. over the same period in 2018 (from -0.3% to 1.1%), before declining at the beginning of this year (to 0.3%). From 2020, sovereign yields are expected to further increase in line with the projected developments for the euro area. Even considering the relatively long average maturity of the stock of government securities (around 7 years at end of 2017), the implicit interest rate on government debt is set to progressively increase from 2020. Overall, the level shift observed in Italian sovereign yields contributes to reverse the declining trend in interest spending observed in recent years. Based on the government projections underlying the 2019 budget, interest spending is set to increase from 3.6 % of GDP in 2019 to 3.8 % in 2020. Graph 4.1.2:Government securities by holding sector Source: Bank of Italy Italian banks increased their holdings of Italy's sovereign bonds in 2018. After progressively decreasing in recent years, the amount of government securities held by Italian banks increased in the central months of 2018, by around EUR 55 billion between April and October (of which EUR 28 billion in May according to Bank of Italy data). The holdings of the central bank, which were already growing in recent years reflecting the quantitative easing programme, continued increasing in the course of 2018 at a moderate pace. Overall, the share of government securities held by private Italian banks, after progressively declining from 23.2% in 2013 to 17.6% in April 2018, increased to 18.9% in May and reached 20.2% in October (Graph 4.1.2). Foreign investors decreased their exposure to Italy's public debt. The share of government securities held by foreign investors declined from 36.9% in April to 35.4% in May and 32.8% in October. Those developments suggest a change in foreign investors’ preferences, which might have led Italian banks to act as a buffer and limit losses on their portfolio of sovereign bonds. Italian households do not appear ready to compensate for the withdrawal of foreign investors as shown by the weak result of the November 2018 auction of the “BTP Italia” (EUR 2.1 billion raised against an average of around 7 billion per auction in recent years), which is a government security specifically designed for retail investors. However, the subscription for syndicated sovereign bonds in early 2019 suggests that foreign interest might have increased again following the revision of the government’s fiscal plans in December 2018. Graph 4.1.3:Sovereign yields on the secondary market Source: Bloomberg Despite episodes of scarce market liquidity, negative spillovers to other Member States have been limited. Overall, risks from the macroeconomic-financial context appear to be low, ensuring the possibility to refinance debt rollover needs at ease. However, the high level of debt increases investors' sensitivity to potential risks, possibly causing rapid changes in market sentiment and strong volatility on secondary markets. In particular, the peak in sovereign yields recorded at the end of May was marked by a substantial flattening of the yield curve (on the 29 May, yields increased by 0.5 basis points on 10-year bonds and 1.9 basis points on 2-year bonds, reaching 3.2% and 2.8% respectively), pointing to a large increase in perceived risk. Those developments temporarily affected other Member States’ sovereign yields (for instance, Spanish and Portuguese 2-year yields rose, respectively, by 0.4 and 0.2 basis points between the 24th and the 30th of May). However, the yields on Italy's short-term bonds soon normalised while remaining at a relatively high level, and other Member States’ sovereign yields quickly decoupled from Italy’s ones, showing little correlation with the Italian sovereign bond market since then (Graph 4.1.3). 4.1.2.Debt sustainability analysis and fiscal risks* Italy is expected to face marked sustainability challenges in both the medium and the long term. Both the Commission's debt sustainability analysis and the fiscal sustainability risk indicator S1( ) point to high risk in the medium-term. The high and increasing stock of debt projected in 2029 in the baseline scenario and its sensitivity to macroeconomic-fiscal shocks contribute to that assessment (Annex B). In the long term, the assessment of fiscal sustainability takes into account the sizeable fiscal adjustment required to stabilise the debt-to-GDP ratio, especially in light of future ageing costs and the vulnerabilities linked to the high debt burden ( ). The long-term fiscal sustainability risk indicator S2( ) points to medium risks, also due to the projected increase in ageing costs. However, an overall analysis points to high risk in the long term, given the vulnerabilities linked to the high debt burden captured by the debt sustainability analysis risk assessment. The new provisions on pensions are expected to worsen fiscal sustainability. As regards long-term fiscal sustainability, implicit liabilities arising from population ageing have been curbed by various pension reforms enacted in past years. However, a decree law of January 2019 reverses elements of those reforms by broadening the possibility of early retirement. In particular, the decree introduces the possibility to retire with 62 years of age and 38 years of contributions over the period 2019-2021. While no specific reduction in pension benefits is envisaged, shorter contribution periods for the beneficiaries of the scheme (either partially or totally covered by the Notional Defined Contribution system) will automatically imply lower pension benefits. Moreover, the indexation to life expectancy of the minimum contribution requirement needed to retire under the existing early retirement scheme (“pensione anticipata”) has been removed up to 2026. In addition, the temporary early retirement scheme for women (“opzione donna”) has been extended. Although the parliament may still amend details of that reform and the precise cost will also depend on the actual take-up, the new provisions will markedly increase pension expenditure over the coming years. The 2019 budget allocated a fund of 0.2 % of GDP in 2019, 0.4 % of GDP in 2020 and 0.5 % of GDP in 2021. However, the reform will pose a burden on public finances also after 2021. In fact, even if the new early retirement scheme is not prolonged, the number of pensioners will have increased during the three-year window, lifting pension expenditure for several years after 2021 compared to the pre-reform scenario. Moreover, the lack of indexation to life expectancy of the contribution period needed to retire under the existing early retirement scheme is set to increase pension expenditure in the medium term. Finally, those provisions, by broadening the possibility for early retirement, might negatively affect labour supply, thereby hampering potential growth. 4.1.3.COMPOSITION OF PUBLIC SPENDING* While supporting public investment, the 2019 budget worsens the bias of Italy’s public spending towards old-age pensions. After rising during the last double-dip recession, in recent years total public spending has progressively decreased as a share of GDP, reaching 54.2 % in 2017, also thanks to lower interest rates, the freeze of public wages and turnover limits for public employees. Public investments also dropped markedly as a share of GDP from 3.0 % in 2008 to 2.0 % in 2017 and are expected to have further declined in 2018 based on the government projections. Social transfers in cash, after rising significantly over 2013-2014, declined only marginally over the last years as a share of GDP, thereby increasing their share over total public spending. In particular, spending for old-age pensions, which already in 2008 represented a comparatively large share of public expenditure, has further increased in recent years and stood at around 15 % of GDP in 2016, among the highest in the EU. The 2019 budget is expected to increase total public spending as from 2019. In particular, it may support the recovery of public investment by allocating additional funds and strengthening administrative capacity (Section 4.4). However, such recovery is subject to downward risks, as the 2019 budget has also temporary reduced other investment funds and subsidies to investment. In addition,,administrative bottlenecks and implementation delays might further hamper the recovery. Social transfers, including spending for old-age pensions, are set to rise more markedly due to the introduction of a minimum income and an early retirement schemes, which have been allocated two funds worth in total 0.5 % of GDP in 2019 and 0.8 % of GDP in 2020-2021. The assessment of the first spending review undertaken under the reformed budgetary process is still ongoing. With the 2018 budget, the government applied for the first time the reformed budgetary process that includes a systematic spending review across all levels of government. The assessment of that spending review is ongoing under specific agreements between the Ministry of Finance and each line Ministry. A similar spending review is planned for 2019, with expected savings of around 0.2 % of GDP. At the same time, the budgetary autonomy at the subnational level will be slightly increased as of January 2019, ( ) by allowing local governments to spend their budgetary surpluses without prior authorisation. 4.1.4.TAXATION* Italy's tax system weighs heavily on labour and capital, while other sources of revenues are underused. Although decreasing for the fourth year in a row, the tax-to-GDP ratio, at 42.1 % in 2017, is still significantly above the EU average (39.0 %). Revenues from labour taxes are around the EU average as a share of total tax revenues but remain comparatively high as a share of GDP (20.7 % against an EU average of 19.4 %). In fact, the tax wedge on labour ( ) is one of the highest in the EU, at 47.7 % in 2017 for a single at the average wage against an EU average of 42.8 %, and the implicit tax rate on labour stood at 42.4 % in 2017, against an EU average of 36.3 %. Similarly, the tax burden on capital was well above the EU average in 2017, as indicated by high revenues from capital taxes (24.1 % of total tax revenues compared to 21.9 %). At the same time, revenues from value-added tax (VAT) are relatively low, at 14.9 % of total tax revenues in 2017 compared to 18.1 % for the EU. In fact, although on a declining trend, Italy's VAT gap ( ) remains among the highest in the EU, at 25.9 % in 2016 (EU average at 12.0 %). This is due, on the one hand, to relatively low tax compliance, especially related to omitted billing and invoicing (so-called tax evasion "with consent"); on the other hand, to the broad use of reduced VAT rates, while the standard one (22 %) is slightly above the EU average (21.5 %). The wide use of reduced rates resulted in a very high VAT rate gap of 14.9 % in 2016, well above the EU average of 10.3 % (CASE, 2018). Efforts to shift the burden to tax bases less detrimental to growth and to reduce the complexity of the tax system remain limited. Despite the annual review of tax expenditures, there are still no plans to reduce their number and scope. The VAT hike legislated as a budgetary "safeguard clause", which included an increase of the 10 % reduced VAT rate, has been systematically postponed so far. Moreover, despite the ongoing efforts to set up and improve a digital platform for immovable properties, no concrete steps are planned to reform the outdated cadastral system or to reintroduce a recurrent property tax on first residences for high-income households. At the same time, the 2019 budget sligthly reduced the employers' contributions to the national insurance institute for accidents on the workplace (INAIL). Based on the latest Eurobarometer (Eurobarometer 2018), half of the companies surveyed consider the lack of stability and the complexity of the tax legislation as a major obstacle to investment (50 % and 54 %, respectively, against 28 % and 32 % in the EU). The extension of flat-rate regimes will lower taxes on the self-employed and individual entrepreneurs. Two provisions included in the 2019 budget will lower taxes on self-employed workers and individual entrepreneurs. First, the scope of the existing simplified tax regime will be extended. The current regime consists in an optional forfeit 15 % tax rate for self-employed workers and individual entrepreneurs with yearly turnover below sector-specific thresholds up to a maximum of EUR 55 000. With the new provisions, among other changes to the eligibility conditions, the income threshold is raised to EUR 65 000 irrespective of the sector of activity. Second, a new 20 % forfeit tax rate will be available as of 2020 for the same category of taxpayers with yearly turnover between EUR 65 000 and EUR 100 000. Based on the government estimates, the two provisions will correspond, respectively, to a net revenue loss of around EUR 1.4 and 1.1 billion as of 2021. While the two measures are relatively small in scope and affect a limited number of taxpayers, the use of flat-rate regimes reduces the redistributive power of the tax system. Based on a simulation by the European Commission Joint Research Centre using EUROMOD ( ), the first reform would potentially benefit mostly the new eligible self-employed in the upper half of the household income distribution . Measures on corporate taxation have temporarily increased the tax burden on firms at an aggregate level. After being postponed by the 2018 budget, the previously legislated tax regime for personal income from entrepreneurial activities (“Imposta sul Reddito Imprenditoriale”), aimed at harmonising the tax treatment of small firms and corporations, has been abrogated. Only a few of the tax expenditures to support private investment and innovation, expiring in 2018, have been extended, while also being reduced in scope (Section 4.4). At the same time, the tax deductibility of specific costs for some categories of firms, especially banks, will be limited, with a temporary positive effect on revenues in 2019. The 2019 budget also introduced a tax on digital services and on money transfers. Furthermore, the "allowance for corporate equity" (ACE), introduced in 2011 to reduce the corporate debt bias, has been replaced by a new tax rebate on firms' profits used to increase investment or hire new employees, with an overall positive impact on tax revenues in the short run. The tax rebate consists in a reduction of the standard corporate income tax (IRES) rate from 24 % to 15 %. As the main beneficiaries of ACE have been de facto financial institutions, this reform shifts the tax burden from non-financial to financial corporations. Although the new tax rebate directly targets productive investments, its implementation may prove complex. Furthermore, the abolition of ACE will reduce firms' incentives to use equity financing, worsening the debt bias in corporate taxation (Section 4.4). The compulsory e-transmission of receipts is expected to encourage tax compliance and improve revenue collection. In recent years, Italy's budgetary strategy strongly relied on measures to combat tax fraud, especially for indirect taxes ( ), which contributed to raise VAT revenues. Electronic invoicing has become mandatory for all companies as of January 2019, which might help reducing tax evasion “without consent”, i.e. omitted declaration (MEF, 2018). However, its implementation should ensure simplification and a low administrative burden on taxpayers in order not to encourage tax evasion “with consent” in the form of omitted invoicing. The decree law 119/2018 ("fiscal decree"), converted into law in December 2018, has complemented the electronic invoicing by making the electronic transmission of receipts compulsory for all commercial transactions with final consumers.( ) This provision is expected to provide the tax agency with more timely and accurate information, allowing targeted inspections. The related deterrent effect might help reducing tax evasion "with consent", particularly in the form of omitted billing and invoicing. The new possibility to settle past tax liabilities without fines and at advantageous interest rates could have a negative impact on tax compliance. This provision represents the third initiative of this kind in recent years, and is more advantageous for taxpayers compared to past editions, to the extent that payments can be made in instalments over several years. The "fiscal decree" also includes several smaller provisions curtailing old pending tax liabilities of limited size and reducing incentives for taxpayers to prolong the duration of tax litigations. Overall, the new provisions equivalent to a tax amnesty are expected to discourage tax compliance in the future, by implicitly rewarding non-compliant behaviour (Luitel et al. 2007, Jensen and Woehlbier, 2012).

4.2. Financial sector Italian banks have made significant progress on balance sheet restructuring despite renewed market pressure. However due to the high bank exposure to the sovereign, higher sovereign yields (though recently come down) have adversely affected banks' capital positions, pushing up their funding costs and curtailing access to unsecured wholesale funding. Nevertheless, banks have continued to boost capital buffers and reduce legacy non-performing loans (NPLs) to 10.2 % in Q2-2018 amid positive profitability since 2017. The recent European Banking Authority stress test has shown the resilience of the involved Italian banks in the assumed adverse scenario. Smaller banks though are often perceived as more vulnerable. Further balance sheet restructuring and consolidation, as well as improving banks' capital and earnings capacity should be fostered. While access to finance has improved, it continues to be a challenge for many small Italian firms. Recent developments* Since the market uncertainty in late spring 2018, Italian banks had increased their exposure to their sovereign. According to Bank of Italy data, Italian banks' holdings of Italian sovereign bonds have increased from EUR 298 billion in April 2018 to EUR 328 billion in November, partly compensating for the withdrawal of foreign investors since spring. Sovereign debt as a share of total banking sector assets remains elevated at 10.5 % in November 2018 (higher than many EU peers), reflecting the close sovereign-bank feedback loop in Italy, with smaller banks often being more exposed than larger ones. The common equity Tier 1 capital for the largest Italian banks has declined by up to 80bp in Q2-2018 (less so in Q3) due to the sovereign yield widening. According to Bank of Italy (2018), a 100bps upward shift in the government yield curve (as of end-June level) would reduce the common equity Tier 1 ratio of banks by 50bps (40bps for significant banks and 90bps for less significant banks). Assuming no substantial changes in the cost of funding, most banks can withstand in the short term a further increase in sovereign spreads. Several banks adopted strategies to rebalance part of their sovereign bond portfolios to the held-to-collect category (valued at amortised cost) to avoid a negative impact on the capital base from the rising sovereign yields. ( ) Any persistently high sovereign yields are likely to negatively impact banks' cost of funding, their market access, and hence credit provision. Banks could be adversely impacted by the higher sovereign risk through a number of reinforcing channels, such as capital losses from their sovereign exposures, higher funding costs, limited market access, lower collateral valuation and credit ratings or reduced funding benefits from government guarantees. However, the liquidity position of Italian banks has remained adequate, mainly supported by the increase in domestic deposits and the reliance on ECB refinancing operations. Since May, many banks were precluded from issuing unsecured senior or subordinated debt securities. A worsening of the market situation risks increasing banks' funding costs (whilst impairing credit supply) and making it more difficult for banks to meet the subordinated part of the minimum requirements for own funds and eligible liabilities (so-called MREL) targets as well as to adjust from the phase out from the ECB targeted longer-term refinancing operations starting in 2020. Notwithstanding recent improvements, the subdued profitability continues to be a major challenge for the banking sector. Despite the market volatility, banks continued to increase their capital buffers in 2018 with the common equity Tier 1 increasing to 13.2 % in June 2018, compared to 12.5 % in June 2017. Despite some narrowing, a gap remains between the capital buffers of Italian banks and the average of EU peers. On the back of cost reductions and lower loan-loss provisions, profitability improved further in the first half of 2018 for both large groups and smaller banks, but remains very low, partly due to the low interest rate environment. In spite of efforts to further increase efficiency, some Italian banks are still struggling with high cost-to-income ratios. Furthermore, Italian banks have continued to also lag behind in terms of rationalising staff and branches since the beginning of the crisis. The below-average profitability, with some heterogeneity against EU peers, jeopardises the capital strengthening process of Italian banks, making their generation of capital more difficult. Italian banks have made significant progress in reducing legacy NPLs via disposals and continuing balance sheet repair. In 2017 and in the first half of 2018, banks disposed of a significant amount of bad loans (roughly EUR 40 billion), nearly two thirds of which came through securitisations. ( ) Italian significant institutions are expected to dispose some EUR 40 billion in NPL transactions from their balance sheets by end-2020. The secondary NPL market has further developed with NPL pricing improving, supported by better NPL data quality, and more NPL servicing firms have entered the market. Banks have also improved their internal work-out capacity. Looking ahead, due to the significant volume of unlikely-to-pay loans in bank balance sheets, the secondary market offers the potential for further development. Banks will have to decide whether to invest in the active management of these loans or to de-recognise them through outright sales to specialised operators and securitisation. Market operators focusing on unlikely-to-pay loans, which are currently few on the Italian market, require specific skills, strategies and logistics (i.e. proactive management of borrowers, early warning indicators, advanced IT platforms), and appropriate financial resources to support borrowers. However, many banks still exhibit high NPL levels, especially when compared with EU peers. While market uncertainty has so far not significantly negatively impacted NPL sales including prices, downside risks for NPL disposals prevail in the current market environment, as the State sponsored securitisation scheme is also becoming more costly due to higher fees on State guarantees. Commission estimates show that NPL ratios would be sizeably impacted by any sudden economic downturn, while banks' credit growth is adversely affected by NPLs (especially for smaller banks). ( ) Some progress has been made on State-aided banks, though significant vulnerabilities remain. Banca Monte dei Paschi di Siena has continued to implement its restructuring plan, inter alia, on NPL disposals, mainly through a large securitisation transaction, and cost-cutting measures. ( ) However, recent efforts to further increase its subordinated debt (after an issuance in early 2018) have been curtailed by the unfavourable market conditions, while the bank's NPL ratio is still above domestic peers. Regarding the 2015 resolution of four small banks and the 2017 liquidation of two Venetian banks, no significant public contingent liabilities related to these cases have so far materialised. Adding to previous schemes, which have led to substantial compensation payment to retail investors for misselling, the government has set up a compensation scheme for retail shareholders and subordinated bondholders of gone-concern banks. As part of the 2019 budget law, the government has set up a savers compensation fund (Fondo indennizzo risparimiatori) with an initial envelope of EUR 1.6 billion for the period 2019-2021. Beneficiaries should be bank shareholders and holders of subordinated bonds with a retail client profile, individual entrepreneurs and some micro-enterprises, which suffered losses during the compulsory administrative liquidation of banks liquidated between 16 November 2015 and end-2017. However, to what extent the existence of the conditions of mis-selling will be assessed by an independent body are still to be seen. The compensation would equal 30 % of the acquisition cost, up to a maximum of EUR 100 000 per shareholder and 95 % of the recognised amount, up to a maximum of 100 000 per bondholder. Compensations under this scheme will be granted net of any previously received compensation, reimbursement or refund. Previous mis-selling compensation schemes covered only holders of subordinated debt subject to burden-sharing and compensation were granted only after a court or an independent panel confirmed an instance of misselling in the specific case, in line with EU legislation. Second-tier banks* Second tier banks have also progressed on their balance sheet de-risking and strengthening. Notwithstanding this progress, some mid-cap banks are still perceived as more vulnerable by the market. In early January 2019, the ECB put Banca Carige under temporary administration, following the rejection by a shareholders' meeting of a capital increase of EUR 400 million and the subsequent resignation of the majority of the board members. ( ) Subsequently, the government notified aid in the form of a State guarantee on newly-issued liabilities and emergency liquidity assistance, which the Commission authorised. Second-tier banks have been very active on the secondary market for distressed assets and have improved their arrears management capacities, also due to supervisory pressure. The ongoing balance sheet repair will prepare the second-tier banks for the new NPL calendar provisioning rules. Despite progress with balance sheet de-risking, these banks still have above-system average NPL ratios and need further efforts to strengthen their capital buffers and resilience to shocks, including from higher sovereign spreads. In addition, whereas their liquidity position has remained adequate, ECB funding constitutes a significant contribution to the total funding of these banks, as it exceeds 10% of their total assets. Most of these banks though have only a limited track-record of accessing wholesale markets, which could make funding after the phasing out of the targeted longer-term refinancing operations more expensive and difficult. Corporate governance and insolvency reforms* The final part of the 2015 reform of the large cooperative banks has been recently suspended. All large cooperative banks (banche popolari) with assets above EUR 8 billion have already transformed themselves into joint-stock companies by the end-2016 deadline, with the exception of Banca Popolare di Bari and Banca Popolare di Sondrio. Some provisions of the 2015 reform were subject to a Constitutional Court challenge with the implementation of the reform being suspended in the meantime. The March 2018 ruling of the Constitutional Court confirmed that the reform did not infringe any constitutional provisions. However, the full implementation of the reform was postponed again in July 2018 until end-year (Mille-Proroghe decree law). Importantly, a recent decision of the Italian State Council referred several questions related to this reform to the Court of Justice of the European Union while suspending in the meantime the transformation of Banca Popolare di Bari and Banco Popolare di Sondrio into joint stock companies, with the government intending to delay the completion of the reform until end-2019. The almost completed reform of small mutual banks was recently further amended. The 2016 reform of small mutual banks (banche di credito cooperativo) was not completed by July 2018 (as originally planned), but was subject to a 3 months delay. In December 2018, the Parliament approved an amendment to the Decree 119/2018 (Fiscal Decree), which allows the small mutual banks operating in the Bolzano and Trento provinces to participate in institutional protection schemes, as an alternative to setting up a cooperative banking group. In the view of the authorities, this would reinforce the cooperative features of the small mutual banks and maintain regional links. Following these amendments, the reform will lead to the emergence of only two groups with national coverage, ICCREA and Cassa Centrale Banca, which will be subject to a comprehensive assessment by the Single Supervisory Mechanism in 2019. The Government plans to complete the reform of the insolvency framework in the near future. In October 2017, the parliament passed an enabling law of the insolvency framework, authorising the government to overhaul its bankruptcy legislation which dates back to 1942. The reform, inter alia, promotes out-of-court agreements between debtors and creditors, simplifies bankruptcy procedures and introduces a pre-emptive mechanism for corporate insolvencies. A legislative decree to adopt the insolvency code has been recently approved by the Council of Ministers. A timely implementation of the decrees is important to accelerate the slow judiciary system for foreclosure procedures and collateral enforcement and to further boost the resilience of the banking sector. Measures to accelerate out-of-court collateral enforcement have not progressed so far. The Patto Marciano, which is a private enforcement clause in credit agreements (adopted in 2016), has not been de facto used so far by banks neither in loan contracts with firms nor with households. The application of the Patto Marciano with firms has been further facilitated and promoted in a Memorandum of Understanding between the Italian Banking Association and Confindustria in February 2018. It will be important to monitor the impact of this memorandum in practice and remove any remaining legal uncertainty and take appropriate corrective action, where needed. Access to finance*

Access to finance remains a barrier to investment in Italy. Firms’ financing in Italy remains predominantly bank-based, while the capital market is still underdeveloped if compared to EU peers. The large share of NPLs (although significantly decreasing) and the traditional over-reliance of Italian firms on bank credit represented a drag on investment during the crisis. Though access to bank credit has improved in recent years on the back of declining interest rates and improved credit conditions, it remains subdued amid downside risks (see Section 1). At the same time, since the financial crisis, firms have reduced leverage, boosted equity and self-financing capacity, lowering overall credit demand. Having a more diversified financial system with deep and developed capital markets, an objective of the capital markets union, would complement