RPT-Fitch: New Italian Government Faces Economic, Reform Challenges

Wed May 1, 2013 6:21am EDT

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May 1 (Reuters) - (The following statement was released by the rating agency)

The formation of a new government is positive for Italy, but the sovereign has very limited fiscal headroom and the coalition government may not be strong enough, or last long enough, to deliver the structural economic reforms needed to increase trend growth, Fitch Ratings says.

The coalition's broad base and large majorities in confidence votes in both parliamentary chambers should enable a resumption of proactive policy making after a two-month hiatus. It draws support from the centre-left Democratic Party, the centre-right People of Freedom Party, and members of former Prime Minister Mario Monti's Civic Choice party.

But the fragility of the new left-right coalition limits the scope for meaningful reform that could raise Italy's low potential GDP growth. Prime Minister Enrico Letta has committed the new government to electoral reform and measures to tackle youth unemployment, but major structural economic reforms may prove elusive.

The recession in Italy is one of the deepest in the eurozone and so far there are hardly any signs of a recovery. Furthermore, the medium-term potential growth rate of the Italian economy is low even by European standards; Fitch estimates it to be around 1%.

Letta's first outline of his government's programme, in a speech to Parliament on Monday, lacked important detail on how major tax reductions will be funded. A planned suspension of June payments under the country's recently introduced housing tax ahead of a broader review of property taxes, combined with the abolition of a 1pp VAT increase in July, would reduce revenue by around EUR6bn this year.

Letta did not specify what, if any, measures would offset the lost revenue, but he did say the new government was committed to meeting its budget commitments and controlling the public finances. It will also be fiscally bound by the Fiscal Compact and last year's constitutional amendment requiring the government to achieve a balanced structural budget by 2013.

We would anticipate more detail in the coming weeks. Meanwhile, in its 2013 Stability Programme the previous government forecast a budget deficit of 2.9% of GDP in early April 2013, including around 0.5pp contributed by government arrears payments to boost domestic demand, while reiterating the commitment to keep the deficit below 3%. This illustrates that despite substantial progress on consolidation, Italy has very limited fiscal headroom. As we said when we downgraded Italy to 'BBB+' with a Negative Outlook on 8 March, economic and fiscal outturns that reduced confidence that public debt would be placed on a firm downward path from 2014 after peaking this year would increase pressure on the sovereign rating.

Letta's speech also outlined some initial reform proposals to boost employment and growth, such as reducing hiring tax for young employees. This emphasis on reform is encouraging, but making the Italian economy sufficiently flexible to boost trend growth remains challenging. On labour law, for example, it is not yet clear whether the previous administration's reforms have been effective, and Letta's speech did not refer to liberalising closed professions.

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