SNAPSHOT OF ITALY'S ECONOMY BEFORE UPCOMING

UNCLAS ROME 001955

SIPDIS


DEPT FOR EUR/WE, EUR/ERA, EB/IFB/OMA
PARIS ALSO FOR USOECD
TREAS FOR OASIA STUART
FRANKFURT FOR WALLAR
USDOC 6800/ITA/TD/OTEA/TISD/HSCHULTZ
STATE PASS USTR

E.O. 12958: N/A
TAGS: ECON EFIN ETRD IT EUN NATO
SUBJECT: SNAPSHOT OF ITALY'S ECONOMY BEFORE UPCOMING
ELECTIONS

SUMMARY
--------------


1. Because of a marked decline in domestic demand and
exports, the GOI has just decreased 2004 GDP growth
estimates from 1.4 to 0.9-1.0 percent. A key economic ratio
- budget deficit/GDP -- continues to climb upward, because
the deficit is growing faster than the economy (as measured
by GDP growth). The European Union, worried Italy's
performance will deteriorate further to violate Stability
and Growth Pact commitments, will delay an "early warning"
to Italy regarding its budget deficit until after local and
EU parliamentary elections in June. In return, Italy has
agreed to five billion euros in spending cuts. We think
there is enough fat in the budget to make these cuts without
widespread reductions in public services. We also do not
expect voter backlash over the spending cuts. However,
combining these cuts with the recently announced plan to
reduce taxes and implement pension reform will require
skillful management by the Government. End Summary.

GDP Growth Forecasts Cut
--------------


2. The consensus forecast for 2004 GDP growth is 0.9-1.0
percent, down from previous predictions of 1.4 percent
growth. This is a half percentage point below the expected
GDP growth rate in the Euro area this year. The downward
revision is due to a marked decline of domestic demand and
exports during the fourth quarter of 2003, which translated
into no growth for fourth quarter 2003 GDP from the previous
quarter.


3. Italy's Central Institute of Statistics (Istat) released
May 13 preliminary GDP growth data for first quarter 2004
that showed Italian GDP growth at 0.4 percent, compared to
the first quarter of 2003 - a rate lower than that of the
United States, France, or the UK. Istat also released
industrial production data indicating a 0.5 percent decline
in industrial production in the first quarter 2004, over the
fourth quarter in 2003.

Domestic Demand and Exports: Lackluster Performance
-------------- --------------


4. The disappointing fourth quarter 2003 results reflect the
lackluster performances of domestic demand and exports.
Only rising inventories prevented a more pronounced fall in
GDP growth. The decline in domestic demand (i.e., a 0.4
percent quarter-on-quarter decline in household consumption,
the first decline since 2002) is indicative of the current
fragile state of consumer confidence. This deterioration of
consumer confidence reflects concern over the employment
outlook; perception of high inflation; the psychological
fall-out from earlier financial scandals (Argentine bonds,
Cirio, and Parmalat); and the sharp increase in oil prices.


5. Nor did the export sector perform well. Largely because
of the Euro's appreciation, exports dropped by 3.8 percent
from the previous quarter.

GOI Revises GDP Growth Forecasts
--------------


6. As a result of the less promising macroeconomic outlook
for 2004, Treasury analysts are revising downward the
official GOI assumptions for the 2004 budget that they used
in late 2003. The GOI revised its GDP growth target
estimate downward from 1.9 percent (a September 2003
estimate) to a more realistic, although still optimistic,
1.2 percent. (Note: GOI GDP growth estimates are not really
forecasts, but rather assumptions and targets set during the
budget preparation process to identify budget decisions
necessary to reach certain Budget Deficit/GDP ratio and
Debt/GDP ratio targets. End Note.)


7. The GOI will also revise upward the official estimated
target for the Budget Deficit/GDP ratio from 2.2 percent to
2.7-2.8 percent.

EU Commission Watching Italy's Deficit
--------------


8. Earlier this year, contrary to GOI estimates, the EU
Commission estimated that Italy's deficit would, in fact,
rise to 3.2 percent of GDP in 2004 and to four percent of
GDP in 2005. For this reason, the European Commission had
discussed issuing an early warning to Italy for possibly
violating the three percent deficit/GDP ceiling, but then
decided to postpone discussion and a decision until early
July, after the mid-June European parliamentary elections.


9. In return, Italy agreed to a spending cut package of
some Euro five billion, equal to about 0.4 percent of GDP.
The spending cut package will be implemented through a
decree law, approved by the Cabinet. Reportedly, consensus
already exists within the Cabinet to approve the package.
(Note: Decree laws go immediately into force, but the
Parliament must approve them within sixty days. The
Government's majority in Parliament means the measure, once
introduced, is almost certain to be approved. End Note.)
Finance Minister Tremonti called the Commission's
postponement "a logical and natural solution."

At Least One Stimulus Proposal Remains: Tax Reform
-------------- --------------


10. This is the year of local and EU parliamentary
elections; and, while Finance Minister Tremonti will
continue to have a dominant say in all spending decisions,
we can expect Parliament and many Government ministers,
especially Defense Minister Martino, to continue to urge
additional spending. In addition, the GOI has just
announced it will implement in 2005 the last, and most
significant piece of its proposed tax reforms - to cut the
current five personal income tax brackets to two: 33 percent
for income over Euro 100,000 per year, and 23 percent for
lower incomes. We expect the Cabinet decree law to leave
this tax reform relatively untouched, since the Prime
Minister promised this reform during his 2001 election
campaign "Contract with Italy." Tax reform also will be
sold to the public and Parliament as boosting consumption
and domestic demand.

The Impact of Parmalat and Alitalia on the Budget
-------------- --------------


11. Italy is now contending with crises in two major firms
- the USD 18 billion Parmalat fraud, and the possibility of
a failure of its flagship air carrier, Alitalia. Due to EU
constraints on government subsidies, we do not expect a GOI
bailout of either of the two corporate giants, and, thus, no
impact on government spending.


12. In the case of Parmalat, there is no government
guarantee of Parmalat bonds; most of the burden of
restructuring Parmalat's debt falls on creditors' shoulders.
According to the Bank of Italy, even the impact on the
Italian banking sector will be limited. (Small Italian
investors are the big losers in this scandal, with almost
all Parmalat bonds sold by banks to individuals before the
scandal was made public.) Italian bank exposure to Parmalat
was some three billion euro at end-November 2003. With
respect to Italy's ten largest banks, Parmalat loans were
only equal to 2.3 percent of total assets. (Note: we do not
know whether the banks had reserved against possible losses,
or would take any losses out of current earnings. End
Note.)


13. Regarding Alitalia, the solution now under discussion
would not involve any direct GOI investment in the company -
outside of a bridge loan to Alitalia, which the company must
pay back. However, a solution could include GOI
unemployment payments (80 percent of salary for one year) to
a substantial number of Alitalia employees laid off.

The Trend in Wages
--------------


14. The econmy at large - and the GOI budget - will
probablynot be further battered by any widespread call for
wage increases this year. Analysts expect Italia wages to
rise by no more than three percent in 004. In addition,
many of the largest union conracts were already
successfully negotiated -- pecefully -- in the last quarter
of 2003: these inluded contracts in the insurance industry,
the Naional Health System, and city transportation. In
February 2003, a large contract in the publishingsector was
signed, and just this week, FIAT reaced agreement with its
workers at its southern Itly plant. That agreement
provided for very modest salary increases spread out over
the next eighteen months.

Comment
--------------


15. Up until the May 11 announcement of a "deal" with the EU
on the possible issuance of an early warning to Italy,
Finance Minister Tremonti had been working towards two
sometimes conflicting goals: to raise languishing domestic
demand and growth, and to resist pressure for increased
spending that would push Italy's deficit clearly beyond the
three percent EU limit. Tremonti now seems focused on
controlling spending and the budget deficit in 2004. We do
not know what spending cuts Tremonti plans in the GOI budget
to slash Euro five billion, but we anticipate that enough
fat can be found for this amount to be cut without causing
wide-spread reduction in public services. Tremonti will try
to sweeten any negative reaction to his budget cuts through
simultaneous tax reductions. End Comment.
SKODON


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2004ROME01955 - Classification: UNCLASSIFIED