BERLUSCONOMICS - THE RECORD UNDER TREMONTI'S

UNCLAS SECTION 01 OF 04 ROME 002653

SIPDIS


DEPT FOR EUR/WE, EUR/ERA, EB/IFB/OMA
PARIS ALSO FOR USOECD
TREAS FOR OASIA HARLOW, STUART
FRANKFURT FOR WALLAR

E.O. 12958: N/A
TAGS: ECON EFIN ELAB PGOV IT ITALIAN POLITICS
SUBJECT: BERLUSCONOMICS - THE RECORD UNDER TREMONTI'S
LEADERSHIP

REF: A) ROME 2630
B) ROME 2280
C) ROME 2389
D) ROME 791
E) ROME 402
F) 03 ROME 3679
G) 03 ROME 2674

1. SUMMARY: PRIME MINISTER BERLUSCONI HAS ANNOUNCED HIS
INTENTION TO STAY AT THE HELM OF ITALIAN ECONOMIC DECISION-
MAKING, FOLLOWING THE FORCED RESIGNATION OF FINANCE MINISTER
GIULIO TREMONTI (REF A). WHILE THERE IS PRESSURE FOR THE PM
TO APPOINT A PERMANENT SUCCESSOR SOONER, BERLUSCONI HAS
HINTED HE MAY RETAIN THE PORTFOLIO UNTIL THE END OF THE
YEAR, IN ORDER TO SEE THROUGH THE CONTENTIOUS DEBATE OVER
THE 2005 BUDGET. WHOEVER REMAINS AT THE HELM OF THE
MINISTRY OF ECONOMY AND FINANCE WILL FACE A SERIES OF
DAUNTING CHALLENGES: REVIVING A STAGNANT ECONOMY AND
DECLINING ITALIAN COMPETITIVENESS, MANAGING THE LARGEST
NATIONAL PUBLIC DEBT IN THE EURO ZONE, AND TACKLING A HUGELY
BURDENSOME, BUT POLITICALLY RADIOACTIVE, PENSION SYSTEM.

2. FINANCE MINISTER TREMONTI WAS ADEPT - SOME SAY TOO
CLEVER -- AT FINDING WAYS TO CONTAIN ITALY'S BUDGET DEFICIT
UNDER DIFFICULT INTERNATIONAL CIRCUMSTANCES. HE TOOK SOME
STEPS TO ENCOURAGE BUSINESS SECTOR INVESTMENT AND ENCOURAGE
THE REPATRIATION OF PRIVATE CAPITAL. DURING HIS WATCH, THE
BERLUSCONI GOVERNMENT ALSO ENACTED SOME NOTEWORTHY LABOR
MARKET REFORMS AND INTRODUCED A MODEST PENSION REFORM BILL
(STILL TO BE ENACTED). HOWEVER, ON THE MOST IMPORTANT
ISSUES - SERIOUS REFORM OF THE PENSION SYSTEM AND TAX
STRUCTURE - TREMONTI AND HIS ECONOMIC TEAM FAILED TO MAKE
SIGNIFICANT PROGRESS. THIS CABLE REVIEWS THE BERLUSCONI
GOVERNMENT'S ECONOMIC RECORD UNDER TREMONTI'S TENURE AND
EXAMINES THE CHALLENGES THAT FACE THE GOVERNING COALITION
BETWEEN NOW AND THE NEXT NATIONAL ELECTIONS, WHICH MUST BE
HELD NOT LATER THAN 2006. END SUMMARY.

THE STATE OF THE ECONOMY - THEN AND NOW
--------------


3. WHEN PRIME MINISTER BERLUSCONI TOOK OFFICE, HE INHERITED
A CRUSHING PUBLIC DEBT OF 110.6 PERCENT OF GDP, A RIGID
LABOR MARKET, TEN PERCENT UNEMPLOYMENT, A BLOATED PUBLQ4-QL|CH
BETTER. ITALY'S PUBLIC DEBT, 106.2 OF GDP PERCENT IN 2003
AND 105 PERCENT EXPECTED IN 2004, IS STILL THE HIGHEST IN
THE EURO ZONE. GDP GROWTH IS EXPECTED TO BE ONLY 1.2 PERCENT
THIS YEAR. GROWTH RATES IN 2002 AND 2003 WERE A PALTRY 0.4
AND 0.3 PERCENT, RESPECTIVELY. ITALY'S DEFICIT/GDP RATIO IS
CLIMBING, AND COULD BREACH THE THREE PERCENT CEILING OF THE
EU STABILITY PACT IN 2004, UNLESS A SPENDING CUT PACKAGE IS
PASSED. ON A POSITIVE NOTE, UNEMPLOYMENT HAS FALLEN TO
ABOUT NINE PERCENT. HOWEVER, REGIONAL DISPARITIES ARE
STILL NOTABLE; WHILE NORTHERN ITALIAN FIRMS ARE DESPERATE
FOR SKILLED LABOR, THE SOUTH'S UNEMPLOYMENT RATE IS NEARLY
EIGHTEEN PERCENT (ADMITTEDLY SOFTENED BY A THRIVING
UNDERGROUND ECONOMY).


5. THE BERLUSCONI GOVERNMENT CLAIMS THAT MACRO-ECONOMIC
PERFORMANCE REMAINS POOR BECAUSE OF THE SLOW RECOVERY OF
WORLD MARKETS, AND THE HUGE PUBLIC DEBT BURDEN IT INHERITED.
CRITICS, HOWEVER, CHARGE THAT THE GOVERNMENT HAS FAILED TO
ENACT MEANINGFUL STRUCTURAL REFORMS THAT WOULD HAVE HELPED
TO TURN AROUND THE ECONOMY, POINTING SPECIFICALLY AT LABOR
MARKET, TAX REFORM AND PENSION REFORM.

LABOR MARKET FLEXIBILITY
--------------


6. ITALY LONG HAD ONE OF THE MOST SCLEROTIC LEGAL LABOR
MARKETS IN EUROPE, WITH SEVERE LEGAL OBSTACLES TO HIRING AND
FIRING WORKERS. EARLY ON, THE BERLUSCONI GOVERNMENT
LIBERALIZED FIXED-TERM CONTRACTS, AND ANNOUNCED ITS
INTENTION TO ABOLISH ARTICLE 18 OF THE LABOR CODE, WHICH
ALLOWED THE REINSTATEMENT, USUALLY UNDER COURT ORDER, OF
WORKERS DEEMED TO HAVE BEEN UNFAIRLY DISMISSED FROM
COMPANIES WITH SIXTEEN OR MORE EMPLOYEES. THE PROSPECT OF
ABOLISHING ARTICLE 18 SPARKED A PROTRACTED BATTLE WITH UNION
FEDERATIONS, AND LED TO GENERAL STRIKES AGAINST THE
GOVERNMENT. THE FIGHT WAS OVER MORE THAN JUST ARTICLE 18;
AT STAKE APPEARED TO BE THE SOCIAL COMPACT - "CONCERTAZIONE"

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NCERTAZIONE DESCRIBES
THE 1993 TRIPARTITE AGREEMENT AMONG UNIONS, EMPLOYERS AND
THE GOI, WHEREBY UNIONS ACCEPTED WAGE MODER!RQ"QLQ*V AFTER NEARLY TWO YEARS OF FIGHTING, THE GOVERNMENT
SETTLED FOR A COMPROMISE SOLUTION THAT ALL THREE PARTIES
(WITH THE EXCEPTION OF ITALY'S LARGEST TRADE UNION
FEDERATION CGIL) ACCEPTED: ARTICLE 18 WOULD BE SUSPENDED FOR
THREE YEARS, BUT THE THREE-YEAR PERIOD WOULD ONLY START WHEN
A PENSION REFORM BILL WAS PASSED. (MORE ON PENSIONS BELOW.)
ALTHOUGH APPROVING THE AGREEMENT, PARLIAMENT WILL HOLD A
HEARING ON HOW THIS AGREEMENT WOULD AFFECDDQ>NZ)MITICS WITHIN AND OUTSIDE OF THE COALITION ARGUED THAT
THE BERLUSCONI GOVERNMENT WASTED TIME AND POLITICAL CAPITAL
OVER ARTICLE 18, WHEN MORE PRESSING LABOR MARKET REFORM WAS
REQUIRED. WHILE PROBABLY ACCURATE, THIS CRITICISM FAILS TO
ACKNOWLEDGE THAT THE CENTER-RIGHT GOVERNMENT HAS ENACTED
OTHER MEASURES THAT HAVE MADE THE LABOR MARKET MORE
FLEXIBLE.


9. THE MOST NOTABLE OF THESE WAS THE SO-CALLED BIAGI LAW,
WHICH ENCOURAGES MORE PART-TIME EMPLOYMENT BY REDUCING
EMPLOYER SOCIAL SECURITY CONTRIBUTIONS FOR THESE WORKERS.
THE BIAGI LAW ALSO CREATED OPPORTUNITIES FOR OUTSOURCING,
JOB-SHARING AND THE USE OF PRIVATE EMPLOYMENT SERVICES.
U.S. COMPANIES HERE REPEATEDLY TELL US THEY ARE QUITE
SATISFIED WITH THE FLEXIBILITIES THEY HAVE FOR HIRING
EMPLOYEES. HOWEVER, THE "EXIT" OR FIRING OF WORKERS REMAINS
AN IMPORTANT OBSTACLE FOR EMPLOYERS.


10. OVERALL, THEREFORE, THE GOVERNMENT RATES A B-MINUS IN
TERMS OF LABOR MARKET REFORM: SOME PROGRESS, BUT MUCH STILL
NEEDS TO BE DONE.

PENSION REFORM
--------------


11. ITALY'S PENSION SYSTEM IS EXTRAORDINARILY GENEROUS:
MANY ITALIANS QUALIFY FOR A FULL STATE PENSION AT AGE 57.
AS A RESULT, THE GOVERNMENT IS HEMORRHAGING MONEY TO FUND
PENSIONS, SPENDING ABOUT FOURTEEN PERCENT OF GDP (ALMOST 30
PERCENT OF THE ITALIAN BUDGET). WITHOUT MEANINGFUL REFORM,
THE PERCENTAGE IS EXPECTED TO CLIMB TO SIXTEEN PERCENT IN
2020, AND PERHAPS AS HIGH AS 20 PERCENT IN 2030.


12. THE BERLUSCONI ADMINISTRATION IS TREADING LIGHTLY ON
PENSION REFORM, FOR FEAR OF ALIENATING VOTERS AND TO KEEP
THE COALITION INTACT. (THE 1994 BERLUSCONI GOVERNMENT FELL
PRIMARILY OVER BATTLES WITHIN THE COALITION OVER PENSION
REFORM.) IN 2003, THE GOVERNMENT INTRODUCED LEGISLATION TO
RAISE THE RETIREMENT AGE FOR STATE PENSIONS TO 60 YEARS OF
AGE BEGINNING IN 2008, AND TO PROVIDE INCENTIVES FOR THOSE
WORKING PAST RETIREMENT AGE. ACCORDING TO GOVERNMENT
ESTIMATES, SPENDING ON PENSIONS WOULD INITIALLY INCREASE
BECAUSE OF THESE INCENTIVES; BUT BEGINNING IN 2008, OVERALL
EXPENDITURES WOULD FALL BY 0.5 TO 1 PERCENT. LABOR MINISTER
MARONI HAS ARGUED, HOWEVER, THAT SAVINGS WOULD BE GREATER,
AS GOVERNMENT ESTIMATES ABOVE DO NOT FACTOR IN SAVINGS FROM
INCENTIVES TO EMPLOYEES TO REMAIN IN THE WORKFORCE.


13. THE GOVERNMENT'S INITIAL PROPOSAL WOULD HAVE BROADENED
THE CATEGORY OF WORKERS WHO MUST WORK UNTIL 60. HOWEVER,
BECAUSE OF OPPOSITION WITHIN THE COALITION, THE PROPOSAL WAS
WATERED DOWN, AND ONLY A SMALL CATEGORY OF WORKERS NOW WOULD
HAVE TO WORK UNTIL 60.


14. PROSPECTS FOR TIMELY PASSAGE ARE UNCLEAR. THE SENATE
AND THE CHAMBER OF DEPUTIES HAVE PASSED THE PLAN, BUT THE
DIFFERENCES IN BILLS MUST BE RECONCILED. MARONI ASSERTED
THAT THE CENTER-RIGHT CHAMBER LEADERS WORKED WITH SENATE
COUNTERPARTS AS THE CHANGES WERE NEGOTIATED TO ENSURE THAT
EXPEDITIOUS PASSAGE. LIKEWISE, THE PRIME MINISTER AND
FORMER FINANCE MINISTER TREMONTI EXPRESSED OPTIMISM THAT
PARLIAMENT WILL PASS THE REVISED MEASURE THIS SUMMER.


15. THE GOVERNMENT'S PENSION REFORM PROPOSAL IS NOT FAR-

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ESS, ITS PASSAGE WOULD
BE A MODEST AND HELPFUL STEP IN THE RIGHT DIRECTION. GIVEN
THE DIFFICULTY OF ENACTING PENSION REFORM FOR ANY
GOVERNMENT, THE BERLUSCONI ADMINISTRATION WILL DESERVE A C-
PLUS ON PENSION REFORM - IF THE GOVERNMENT SUCCEEDS IN
PASSING ITS PLAN THIS SUMMER.

FINANCIAL MARKET REGULATORY REFORM
--------------


16. IN THE WAKE OF PARMALAT'S 18 BILLION DOLLAR FRAUD,
WHICH FOLLOWED ON THE HEELS OF MISMANAGEMENT AND MALFEASANCE
BY ITALIAN FOOD COMPANY CIRIO, THE GOVERNMENT IN JANUARY
DRAFTED MEASURES TO STRENGTHEN THE OVERSIGHT POWERS AND
PUNITIVE AUTHORITY OF CONSOB, ITALY'S SEC-EQUIVALENT, AND TO
REVOKE THE CENTRAL BANK GOVERNOR'S LIFETIME MANDATE. (THE
CENTRAL BANK HAS BEEN HIGHLY CRITICIZED FOR NOT BEING MORE
VIGILANT IN ITS MARKET SUPERVISION.) MANY CONSIDER GREATER
MARKET OVERSIGHT ESSENTIAL TO CALM CONCERNS OF JITTERY
INVESTORS, BOTH DOMESTIC AND FOREIGN. THE LEGISLATION WAS
DRAFTED BY THE FINANCE MINISTRY IN RECORD TIME, BUT HAS
SINCE LANGUISHED. WITHIN THE COALITION, POLITICAL LEADERS
ARE ARGUING OVER WHETHER CONSOB AND THE ANTI-TRUST
AUTHORITY, WHOSE AUTHORITY WOULD ALSO INCREASE, SHOULD HAVE
SUCH POWERS, AND WHETHER CENTRAL BANK GOVERNOR FAZIO SHOULD
HAVE HIS LIFETIME MANDATE REVOKED AND REPLACED BY AN EIGHT
YEARS MANDATE. PRIVATE SECTOR ENTITIES, INCLUDING THE
ITALIAN BANKERS' ASSOCIATION, HAVE CONCERNS ABOUT THE
POTENTIAL FOR INTERFERENCE IN THE MARKETS BY THE INTER-
MINISTERIAL COMMITTEE ON SAVINGS, WHICH ALSO WOULD BE GIVEN
NEW OVERSIGHT AUTHORITY UNDER THE DRAFT MEASURE.


17. GIVEN ITS INABILITY TO REACH CONSENSUS AND ADOPT
MEASURES CRITICAL TO RESTORING TRUST IN THE MARKETS, THE
GOVERNMENT SO FAR DESERVES A FAILING GRADE IN FINANCIAL
MARKET REGULATORY REFORM.

TAX REFORM
--------------


18. AS SOON AS EUROPEAN PARLIAMENTARY ELECTIONS WERE OVER,
THE BERLUSCONI GOVERNMENT RENEWED CALLS FOR FAR-REACHING TAX
MEASURES (AN UNFILLED BERLUSCONI CAMPAIGN PROMISE DATING
FROM THE 2001 ELECTION),INCLUDING BOTH LOWERING OF TAX
RATES AND A REDUCTION IN THE NUMBER OF TAX BRACKETS. THE
CUTS COULD AMOUNT TO AS MUCH AS TWELVE BILLION EURO.


19. LONG SIMMERING DIFFERENCES OVER FISCAL POLICY AMONG
COALITION PARTNERS QUICKLY CAME TO THE SURFACE, HOWEVER, AND
WERE A MAJOR FACTOR IN THE CONFRONTATION THAT LED TO
TREMONTI'S OUSTER. SIMPLY PUT, FORZA ITALIA AND THE
NORTHERN LEAGUE SUPPORTED SOME BREAKS FOR LOW-INCOME
EARNERS, BUT LARGE REDUCTIONS FOR TAXPAYERS WITH INCOMES
BETWEEN 80,000 AND 1,000,000 EUROS. THE ALLEANZA NAZIONALE
AND THE UDC, IN CONTRAST, OPPOSED A TAX BREAK FOR "THE
RICH," BOTH FOR THE POLITICAL MESSAGE IT WOULD SEND AND FOR
THE CONSTRAINTS REDUCED REVENUES WOULD PLACE ON THE
GOVERNMENT'S ABILITY TO FUND AN-FAVORED PROJECTS, ESPECIALLY
IN SOUTHERN ITALY.


20. THE DETAILS OF BOTH FURTHER FY 2004 SPENDING CUTS TO
KEEP ITALY BELOW THE EU'S THREE PERCENT DEFICIT/GDP RATIO,
AS WELL AS TAX AND SPENDING PLANS FOR THE FY 2005 BUDGET,
ARE STILL TO EMERGE. HOWEVER, BASED ON ITS PERFORMANCE
SINCE 2001, IT IS HARD TO CREDIT THE GOVERNMENT WITH MORE
THAN STAVING OFF FISCAL DISASTER IN A DIFFICULT
INTERNATIONAL ENVIRONMENT. POLITICALLY CHALLENGING BUT
ECONOMICALLY ESSENTIAL STRUCTURAL REFORMS HAVE BEEN AVOIDED.
THE TAX AND SPENDING PRIORITIEQQIQI>QLD ACTION IN THE MONTHS AHEAD. WE THEREFORE FIND
IT HARD TO GIVE THE GOVERNMENT MORE THAN A C-MINUS ON FISCAL
POLICY.


TH5RBQ