ITALY'S BUDGET BATTLE BEGINS (CORRECTED VERSION -

C O N F I D E N T I A L ROME 003697

SIPDIS


PARIS FOR USOECD, FRANKFURT FOR WALLAR

E.O. 12958: DECL: 08/14/2008
TAGS: ECON EFIN PGOV IT
SUBJECT: ITALY'S BUDGET BATTLE BEGINS (CORRECTED VERSION -
PARAGRAPH NUMBERING)

REF: ROME 2853

Classified By: Economic Counselor Karen Milliken for reasons 1.5 (b, d)


1. (SBU) Summary. The release of the government's four-year
economic blueprint (DPEF) has started off Italy,s annual
budget process with a bang. The DPEF, which sets budgetary
guidelines for the upcoming year and makes projections about
economic performance, was a carefully crafted compromise
among feuding coalition partners. The result, nonetheless,
triggered controversy and finger pointing. Italy,s Central
Bank Governor and leading industrialists harshly criticized
the Berlusconi government for the DPEF,s failure to address
the need for structural reforms and for making what they say
are unfounded claims about a positive economic performance.


2. (SBU) While not binding, the DPEF is normally a preview of
the final budget package. Players in the political process
are scrutinizing the DPEF for insight into the government,s
economic priorities. With its publication, they have begun
their posturing to ensure that, at the end of the day, the
budget preserves their special interests. The DPEF also was
caught up in political tensions within the ruling coalition.
There's a heated dispute among coalition partners on
spending, reforms and the direction economic policy should
take.


3. (U) Even the Italian government admits in the DPEF that
Italy is unlikely to balance its budget before 2007, while
GDP growth rates are expected to hover between two percent
and 2.6 percent in the four-year period. Noticeably absent
from the DPEF are any government plans to privatize key
state-owned business, or for tax and pension reform. End
Summary.

The Basic Facts: DPEF 2004-1007
--------------


4. (U) On July 17, the Berlusconi Government presented to
Parliament its financial plan ) Documento di programmazione
economica e finanziaria (DPEF) - for 2004-2007, which was
reviewed by Parliament before it adjourned for the August
summer recess. The plan outlines the parameters for the
annual budget for 2004, which will be presented to Parliament
in late September.


5. (U) The key targets of the DPEF are:

-- Real GDP growth of 0.8 percent in 2003 and two percent in
2004, increasing gradually to 2.6 percent in 2005-2007.

-- Steady reduction of Italy's high debt from 105.6 percent
of GDP in 2003 to 104.2 percent in 2004 and to 97.1 percent
in 2007. (Note: Last year,s DPEF predicted a drop in
Italy's debt to 95 percent of GDP in 2007. End Note).

-- Stable inflation under 2 percent per year. Inflation is
expected to decline from 2.5 percent in 2003 to 1.7 percent
in 2004, to 1.5 percent in 2005 and 1.4 percent in 2006 and

2007.

-- Lower unemployment, expected from an economic recovery
combined with measures designed to increase labor market
flexibility, from 8.8 percent in 2003 to 8.2 percent in 2004
and 7.5 percent in 2007. The GOI also plans to increase the
labor participation rate to close to 60 percent in 2007.
(Note: The target has been postponed by one year. Last
year,s DPEF predicted that the 60 percent target for the
labor participation rate would be achieved in 2006. End
note).

-- Investment in physical capital, human capital and
technology, aimed at raising productivity and competitiveness.

-- Implementation of macroeconomic and financial policies
that are in line with the European Stability and Growth Pact
commitments.

-- Increased investment in infrastructure, both through the
Tremonti-proposed Euro-wide project and through domestic
initiatives. The GOI has allotted 32 billion Euro for
infrastructure projects in the period 2003-2006.

The problem with the numbers
--------------


6. (SBU) The government,s GDP growth target for 2003 of 0.8
percent is, according to some analysts, still too optimistic.


The latest consensus forecast assumes 0.6 percent growth this
year and 1.6 percent growth in 2004. Comment: The
government's projected growth rate would be possible only if
there were a global economic recovery in the second half of
the year, which at this moment seems unlikely. End Comment.
In the period 2004-2007, the GOI predicts a GDP growth rate
ranging from two percent to 2.6 percent.


7. (SBU) The GOI expects 2.4 percent inflation for 2003,
which many analysts also believe is unrealistic. This
prediction is 20 basis points below the latest data available
(2.6 percent in June),30 basis points below the average of
the first half of the year (2.7 percent) and 10 basis points
below the latest consensus estimates (2.5 percent).


8. (SBU) The DPEF does not specify what spending cuts and
revenue raising measures will be proposed in the 2004 budget.
The DPEF also does not identify any government plans to sell
off state-owned companies in the short term. In the last ten
years, the GOI raised USD135 billion through privatizations,
which helped reduce the debt/GDP ratio from 125 percent to
106 percent of GDP. End note. As it has argued previously,
the GOI contends in the DPEF that it is delaying selling off
companies because of uncertain market conditions.


9. (SBU) Comment: Even when market conditions improve, we do
not expect the government to sell off its most valuable
assets. Reluctant to sell shares of firms in sectors
considered to be critical to national security, such as
aerospace and defense, the GOI is likely to hold on to its
32.3 percent stake in Finmeccanica (the large aerospace and
defense holding company),67 percent stake in Enel (Italy,s
main electrical producer) and 30 percent stake in ENI
(Italy,s largest hydrocarbon company). The GOI also is not
considering sale of RAI (radio and TV broadcasting) or
Alitalia (national airlines.) Both entities are
over-staffed, money losers. End Comment.

Controversy Erupts
--------------


10. (SBU) With the DPEF,s release, a long-brewing squabble
between Finance Minister Tremonti and Central Bank Governor
Fazio bubbled over. The DPEF was the ostensible reason for
the spat, with Fazio harshly and publicly criticizing the
DPEF for ignoring the need for major structural reforms.
However, the dispute,s roots went much deeper.


11. (SBU) Although initially enthusiastic about the
Berlusconi government's economic program, Fazio has become
increasingly disenchanted with the government writ large,
but, most pointedly, with Tremonti. Fazio has criticized the
government for not tackling more seriously the need for
structural reforms, including pension and tax reforms, and
for consistently projecting a positive economic performance,
which he argues, is unfounded. Fazio,s criticism is shared
by many, including Antonio D,Amato, president of Italy,s
largest business confederation, who argued that the Italian
government has not done enough to improve Italy,s
competitiveness and to address major structural problems.


12. (C) Comment: The position of the Central Bank Governor is
traditionally a "neutral8 voice in economic policy making.
Fazio, many believe, has personal political aspirations to
become Finance Minister and so is distancing himself from the
Government's policies. Tremonti has argued that Fazio's
inaction to protect Italian investors and consumers requires
systemic change to take away some of the Central Bank's
banking supervisory authority, a challenge to one of the few
independent functions still exercised by the Bank of Italy.


13. (C) Comment continued: There has been a lot of jockeying
in the ruling coalition over who has the upper hand in
economic policy making. Tremonti, a technocrat firmly linked
to coalition partner Northern League, still has the lead, but
National Alliance (AN) and the Union of Christian Democrats
of the Center (UDC) recently pushed hard for a greater role
in economic policy making, complaining of being presented
with faits accomplis in meetings of the Council of Ministers.
Some ministers also are complaining that they have no extra
funds for "politically necessary" expenditures. A proposal by
Berlusconi to create a mini-cabinet under the direction of
Deputy Prime Minister Fini to coordinate economic policy
making was overturned. But AN and UDC laid down markers that
they expect to be given decision-making power in the run-up
to the final budget package. The DPEF was a compromise
document carefully crafted to keep the coalition in line in
the face of these tensions.


Other voices of criticism
--------------


14. (SBU) Labor unions reacted coolly to the plan, despite
the GOI offer to discuss the labor issues contained in the
DPEF. The opposition, as expected, criticized it. Banking
lobbies, forced the GOI to delete provisions regarding home
mortgages.

The last time?
--------------


15. (U) Given this year,s controversy over the DPEF and the
questionable utility of this annual exercise, Finance
Ministry Tremonti has called for a much different DPEF next
year. Pointing out that only Italy goes through this annual
exercise, Tremonti has said the 2004 DPEF will be reduced to
just one page. Budget details will only be revealed in the
presentation of the budget each September before Parliament.

Final Comment
--------------


16. (SBU) The DPEF, while just a planning document,
demonstrates how difficult it will be to enact major
structural changes. Even mention of the need for such
reforms was struck out at the last minute based on some
coalition partners' objections. Already various political
parties, industrial associations and labor unions have put
the government on notice that they expect more from the final
budget package in terms of growth initiatives. Recent
indications that Italy is now officially in recession for the
first time since 1992 (the economy has shrunk over two
quarters) will fuel this clamor. Yet many of these groups
have fought hard against needed tax, labor and pension
reforms.


17. (C) The August vacation season has stilled the
controversy over the DPEF. The battle will begin again with
the September presentation of the budget to Parliament, with
attention focusing on Finance Minister Tremonti. Embattled
for several months, Tremonti seems to have held his ground,
although resentment of what is perceived as his high-handed
style lingers, as do real differences among coalition
partners toward the way ahead for Italy's economy. The
question remains whether the intra-coalition struggle will
challenge Tremonti's staying power and his pro-reform
policies. His coalition opponents see the clocking ticking
toward spring elections, are hungry for more budgetary
flexibility to permit "political expenditures." Once again,
in Italy, it is politics as usual. End Comment.
Skodon


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2003ROME03697 - Classification: CONFIDENTIAL