A welcome economic rebound is underway in Italy. After having recorded real GDP growth of 1.9% last year – below the average for the euro area, but above the potential rate – growth is set to maintain that pace in 2007. While this partially reflects ebullient foreign demand, there are also early signs of more fundamental improvements. Some Italian exporters have regained export market shares in the segment of high-quality consumer items and machinery to produce them, in which they have traditionally specialised. The rapid increase of export prices may signal that these firms have recouped some of their pricing power and moved upscale towards highly-priced products. However, there are also firms that failed to restructure, innovate or outsource and must still downscale, as suggested by the overall decline of profitability and continuing loss of export market shares in the aggregate. The fact that Italy’s export structure remains heavily biased towards low-skill production, hence exposing it to competition from emerging market economies, continues to handicap growth.

The Italian economy rebounded significantly in 2006. Growth has remained well above its potential rate, also entailing a sharply lower public deficit. The main motor has been strong foreign demand and an evident adjustment process among Italian exporters that has allowed them to benefit from the better external conditions. Even so, Italy’s export structure remains heavily biased toward low skill production, hence highly exposed to cost competition by emerging market economies in the present era of globalisation. The process of deindustrialisation has also not triggered a take off in services sectors, as in some of the more successful OECD countries. This macro-structural weakness can be traced to a lack of total factor productivity growth, reflecting the shortcomings in efficiency, process and product innovation. A main policy challenge is to raise human capital and market competition to spur both the supply and demand for innovation and skills, imparting needed dynamism to the economy. Employment creation has been a main bright spot in the economy, but needs to go further by rebalancing employment protections to reduce labour market duality. A large regional gap and still low formal labour market participation may be part of the current problem but are the source of significant unrealised growth potential. Reducing the drag of fiscal policy on the economy will involve sustaining a rapid pace of consolidation beyond the current upswing, while also raising spending quality to allow lower spending and tax-to-GDP ratios.

Italy has experienced a marked slowdown in productivity growth since the mid- 1990s. While it is not entirely clear what caused this slowdown, it is likely that insufficient product market competition played a key role. Hence, the two recent waves of liberalisation are welcome. These reforms are not only likely to reduce entry barriers and rents in a number of services sectors, but could also positively impact on other industries. Yet there is still scope to strengthen market forces. For instance, implementing new competition bodies at local levels, driven primarily to protect consumers’ interest, could be a key factor to stimulate the retail and wholesale trade sector and improve transparency in local public utilities. As well, Italy needs more competition in the financial sector so as to spur innovation and productivity; in this respect, recent reforms in the banking industry appear promising.

Italy’s budget deficit contracted last year and further improvement is expected to occur with the implementation of the 2007 budget. This is a welcome development that results from both unexpected revenue buoyancy and a greater degree of spending control. Nonetheless, the state of public finances remains difficult. The public debt ratio is the second highest in the OECD, with no sign of significant decline, making the budget vulnerable to sudden increases in interest rates and changes in market sentiment. Alleviating somewhat the risk to fiscal sustainability is the moderate cost pressure from population ageing, but this still requires the full implementation of measures to adjust pension benefits, which have been approved but not yet fully put into place. Tax rates are high compared to other countries, so that consolidation must come not from new tax increases but from better spending control. Hence, there is no other choice than decisive budgetary consolidation: the authorities’ goal of bringing back the primary surplus to the level prevailing at the time of entry into EMU, namely 5% of GDP, is welcome; while it is planned to reach this target by 2011, this should be possible ahead of time considering recent strong fiscal outcomes. The first signs of improvement recorded last year and expected this year are encouraging. But the way ahead remains challenging.

Fiscal federalism can be an important complement to structural reforms and budget consolidation. Empowering subnational governments while at the same time making them accountable to local citizens in the uses of tax money could improve the allocation of public resources and promote catch up of the lagging regions. Italy has launched itself in the federalist direction by decentralising spending, regulatory and tax powers in the late 1990s and reinforcing growing lower level responsibilities with a constitutional reform in 2001. The constitution has yet to be fully implemented, though, and the government has signaled its intention to do so. A stronger focus should now be put on the financing side, i.e. getting a better match between spending responsibilities and taxing powers so as to boost local autonomy and responsibility in line with the goals of federalist reforms. As the lower levels are fully in charge of health and long term care, they will face intense pressures due to population ageing which is especially rapid in Italy, so that more tax bases should be devolved to them, especially as pension reform has reduced such pressures on central government. Redistributive mechanisms should be redesigned to improve fiscal effort, and Italy must decide in that context to what extent it can really afford to guarantee uniform national service levels – and conversely, how much regional differentiation of services it will tolerate in pursuit of higher efficiency. Framework conditions need to be strengthened, notably accounting standards which need to be upgraded and standardised. Fiscal discipline under the Internal Stability Pact should be strengthened via better ex ante co–ordination and tougher sanctions ex post.