Italian Economic Policy and Challenges Under

UNCLAS ROME 001588

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TAGS: ECON EFIN ELAB PGOV IT EUN KPRP ITALIAN POLITICS
SUBJECT: Italian Economic Policy and Challenges Under
Berlusconi III

Ref: A) ROME 1409; B) ROME 1150; C) ROME 1043; D) 04 Rome
2630

SUMMARY
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1. (SBU) By reluctantly agreeing to resign and form a new
Government, PM Berlusconi bought himself and the governing
coalition another year to convince Italian voters to re-
elect them in 2006. Growing evidence indicates that a weak
economy is a leading contributor to public dissatisfaction
with the Berlusconi Government. However, budget woes will
limit Berlusconi's ability to kick-start the economy through
tax cuts or government spending. New Deputy Prime Minister
Tremonti, who was ousted as Finance Minister in mid-2004, is
the economic policy wildcard; and it is unclear how much of
a role he will play in setting Italy's economic policy. The
Government has sought to shift the blame for economic blues
to procrustean eurozone monetary policy and cheap Chinese
imports. Berlusconi will face the ire of the European
Commission and sovereign debt markets, if deficit spending
balloons significantly above three percent of GDP; but
without additional pre-election pork, and some credible
actions to improve voters' perception of economic progress,
Berlusconi faces long odds at the ballot box. End Summary.

TREMONTI - THE KEY "NEW" PLAYER
--------------


2. (SBU) The new Berlusconi Cabinet, sworn in by President
Ciampi April 23, was not that different from the one it
replaced (Ref A). The key change affecting economic policy
may be the return of ousted Finance Minister Giulio Tremonti
as Deputy Prime Minister. In the first days of the newly
formed Government, Tremonti made several economic proposals,
including a ham-handed suggestion to raise revenue by
leasing government-owned beachfront property in the
underdeveloped south of Italy. (Comment: Retaining
political support in the south is essential for Berlusconi
to win in the next national elections. End Comment.) As
Finance Minister, Tremonti relied heavily on one-off
measures, such as tax amnesties, to shrink the budget
deficit. His successor, Domenico Siniscalco, indirectly
disparaged Tremonti's policies by declaring an end to
creative public finance, and proposed the most sweeping
budget reform package of the last decade. The dynamic
between Tremonti, a political insider close to Berlusconi,
and Siniscalco, a technocrat, but respected by the European
Commission and the IMF (and, seemingly, the governing
coalition, as well),will substantially affect Italy's
economic policy over the next year.

OTHER NEW FACES...AND OLD FACES IN NEW PLACES
--------------


3. (U) Berlusconi also replaced three new ministers with
portfolios related to economic policy: Communications (Mario
Landolfi),Productive Activities (Claudio Scajola),and
Health (Francesco Storace). Gianfranco Micciche' was named
to the new Ministry (without portfolio) of Development and
Territorial Unity. Micciche' will focus on strategies to
help the south. See bios on these ministers in para. 17.

CONFLICTING DOMESTIC/INTERNATIONAL DEMANDS
--------------


4. (U) The Government faces conflicting demands 1) by voters
(and some in the coalition),who want tax breaks, government
jobs/pay raises, and relief from the impact of Chinese
exports; and 2) by the European Commission and bond markets,
which seek fiscal discipline, coherent and consistent
economic reform, and a repudiation of emergency, one-off
funding measures. The Government will be hard pressed to
please either grouping, let alone both at the same time.

CHALLENGING ECONOMIC ENVIRONMENT; TEXTILES SLUMP
-------------- ---


5. (U) GDP growth has been anemic over the last three years,
averaging just 0.6 percent annually. The Government has
ratcheted down its 2005 growth forecast from 2.7 to a still-
optimistic 1.2 percent. The manufacturing sector has had
negative growth in six of the last eight quarters. Italian
exports have become less competitive, in part because
productivity increases have not kept up with wage growth.
The textile industry, centered in the northern political
base of Deputy PM Tremonti, has been hard hit. Italy has
nearly 50,000 small textile companies, averaging about a
dozen employees each and exporting well over half their
goods.

JUGGLING BUDGET DEFICITS...
--------------


6. (U) On April 29, the Government revised its 2005 budget
deficit forecast from 2.9 to 3.5 percent of GDP, putting it
in line with earlier estimates by the IMF and European
Commission. The Government also indicated that it would
lower its stock of debt from 105.8 percent of GDP (end-2004)
to 105.3 percent (end-2005). Both figures are in excess of
the EU's ceilings of three percent of GDP (deficit) and 60
percent of GDP (debt). The Government will seek to convince
the EU that the weak economy justifies exceeding the deficit
ceiling, while telling voters that the economy is on the
mend.

...AND DEBT
--------------


7. (U) Italy has been bringing down its stock of debt,
thanks largely to low interest rates and privatizations.
However, having already sold off its most attractive assets
and with interest rates rising, the Government will strain
to continue shrinking its debt. Until 1999, Italian
government debt was held mostly by Italians. However, the
trend has shifted since the introduction of the euro, and
most Italian foreign debt is now held outside of Italy.
Foreign bondholders will be watching closely for signs that
the newly revamped EU Stability and Growth Pact will result
in even greater divergence in fiscal policy among eurozone
economies. If so, Italy's outlier status would translate
into a higher risk premium on its sovereign debt. Standard
and Poors has already downgraded Italian sovereign debt in
July 2004.

COMPETITIVENESS PACKAGE TOPS ECONOMIC AGENDA.
--------------


8. (U) The Senate passed the first part of the Government's
competitiveness package May 4, and it now moves to the
Chamber of Deputies for expected quick consideration. The
decree law includes provisions on corporate incentives,
public works funding, bankruptcy reform, unemployment, and
pension funds; and creates a new entity to promote foreign
direct investment in Italy. On the revenue side, the
package also increases alcohol consumption taxes, fines for
purchasing knockoff goods, and penalties for employers
hiring off the books. The second part of the
competitiveness package is under consideration in the
Chamber of Deputies as standard, not decree, legislation.
Professional associations killed a provision that would have
diminished their control over who can work in their
occupation. Lack of open access to enter many professions
causes distortions in the Italian labor market. In March,
junior coalition partner the Northern League threatened to
oppose the package if it did not address economic impact of
Chinese textile exports. At the EU-level, the Government
has sought help combating counterfeit goods and remediation
for alleged textile dumping from China (Ref B).

"IRAP" BUMPS TAX CUTS OFF THE AGENDA.
--------------


9. (U) The European Court of Justice (ECJ) Advocate General
issued an opinion March 17 that Italy's regional tax on
productive activities (IRAP),a value-add tax on business,
conflicts with EU legislation because the tax is too similar
to the VAT. The ECJ will soon issue its ruling. If the ECJ
rules that IRAP must be eliminated or changed, it would
almost certainly include a phase-out period to keep from
inducing a public sector funding crisis in Italy.
Abolishing IRAP would slash 33 billion euro in GOI revenue.


10. (U) Finance Minister Siniscalco declared, "The
Government has always considered IRAP inefficient and poorly
conceived...Now the Government must replace it as soon as
possible...to make firms competitive and in line with the EU
Stability and Growth Pact." As the Government considers
alternatives to replace IRAP revenue, it will have the
opportunity to craft a tax alternative that will minimize
market distortions on employers, investors, consumers, and
property owners. Confindustria, the Italian association of
industrialists, has long called for abolishing IRAP and has
recently pushed for elimination of any charge on
labor/payroll in the taxes that replaces IRAP.


11. (U) Despite Italy's fiscal woes, Berlusconi continued
his mantra of income tax cuts right up to the Coalition's
lopsided defeat in the early April regional elections. Post-
election analysis showed that tax cuts did not resonate with
many voters, who were not convinced the cuts were
sustainable into the future, and therefore, of little
meaningful long-term value. Voters also realized that tax
cuts would be accompanied by offsetting fees and service
charges, which on balance left little extra money in their
pockets. Finally, the tax cuts were not part of a systemic
reform to make government spending more efficient and to
reduce waste and redundancy in the bureaucracy -- changes
that would have addressed key factors in Italy's economic
stagnation and helped to stimulate the economy. Since
forming the new Government, Berlusconi has been silent on
future income tax cuts.

PROGRESS ON MARKET OVERSIGHT REFORM MAY SLOW.
--------------


12. (U) After the collapse of Parmalat in late 2003, then-
Finance Minister Tremonti proposed sweeping market oversight
reform legislation. Subsequently, the reform was divided
into separate bills, the first of which was passed April 13,
2005, and implemented the EU Market Abuse Directive. The
second tranche of the reform has passed the Chamber of
Deputies and is under Committee review in the Senate (Ref
C). However, since the Senate is likely to make changes to
the bill, it would then need to return to the lower Chamber
for reconsideration. Competing legislative demands to
prepare the 2006 budget and pass voter-popular measures,
will likely delay progress on oversight reform. If the
Parliament does not pass the reform before dissolving for
the 2006 elections, the reform package will be sent back to
square one; and the next Government will need to submit a
new bill for consideration.


13. (SBU) The version passed by the Deputies would create
tough oversight on conflict of interest between banks and
companies and requires banks to provide potential retail
investors with a prospectus for bonds that the banks sell.
Consob, Italy's securities market regulator, would gain
powers in the supervision of auditing firms, while the
financial police (Guardia di Finanza) would work more
closely with Consob. The bill would make mega-fraud a new
category of crime (fraud affecting more than 289,000
investors or holdings greater than USD 7.5 billion). The
bill also puts limits on the credit that banks can extend to
major shareholders (75 percent of the value of the shares
the investor owns) and requires that company boards include
an outside member who represents minority shareholders.

THE SOUTH...AND OTHER MEASURES ON THE HORIZON
--------------

14. (SBU) The Government will be looking for low/no-cost
actions attractive to disaffected voters, especially in the
Mezzogiorno South. One of the first of these, a proposal to
raise revenue and increase tourism in the south by leasing
Government beachfront property, was hurriedly conceived and
poorly presented. (Comment: The presentation was
reminiscent of the lack of consultation that contributed to
Tremonti's resignation last year (Ref D). End Comment.)
Rather than garner support in the south, the proposal was
viewed by many in the target region as a sign that the
Government was out of touch with the south and unwilling to
take on core issues, such as infrastructure development.


15. (U) Separately, the public sector is pushing for a wage
increase in 2005, which, if implemented, could increase the
federal budget deficit by as much as 0.2 percent of GDP.
Also, as a nod to the European Commission, the Government
has discussed submitting to the Parliament earlier than
usual the DPEF 2006-2009 (four-year budget plan) and 2006
budget. (Comment: DPEF is usually presented in July and the
budget, at end-September. End Comment.) Early submission
would give the Government an opportunity to demonstrate to
the Commission that the excessive 2005 deficit was an
anomaly.

COMMENT
--------------


16. (SBU) In 2001, Berlusconi swept into office as a reform-
minded, practical businessman. Over the intervening four
years, however, he has accumulated a spotty record (at best)
of implementing the systemic reform Italy's economy badly
needs. He will be even less likely to focus on reform over
the next yeaQ especially the unpopular measures needed to
rein in government spending and reduce bureaucracy. Despite
Finance Minister Siniscalco's abhorrence of one-off
measures, we expect the Government to look for quick fixes
to cut both the deficit and the debt. Whichever side wins
the next national elections will still be confronted with
the tough challenge of getting Italy's economy back on
track. End Comment.


17. (U) BIOGRAPHIES OF NEW KEY MINISTERS
--------------

Giulio Tremonti, Forza Italia (FI),Deputy Prime Minister
-------------- --------------

Tremonti previously served as Finance Minister from June 11,
2001-July 3, 2004, when he resigned as a result of intra-
coalition infighting. Tremonti is a tax law professor and a
practicing attorney. Tremonti has more than twenty years of
service teaching and cooperating with Governments of both
the left and the right. In 1992, he was economic adviser to
then-Italian Socialist Party (PSI) Prime Minister Giuliano
Amato. Tremonti stayed in that position through 1994 with
Amato's successor and current Italian President Carlo
Azeglio Ciampi. During that time, Tremonti chaired the
committee to streamline Italy's tax system.

In 1994, Tremonti was elected to the Chamber of Deputies
under the centrist ticket "Patto Segni." He was appointed
Finance Minister for the Government headed by Forza Italia's
(FI) Silvio Berlusconi in 1994 and was not only a key
economic adviser to the PM, but one of his closest political
advisers, as well. He is President of the Aspen Institute
Italy and speaks English well.

Claudio Scajola, Forza Italia (FI),Minister of Productive
Activities
-------------- --------------

In 1982, Scajola was elected Mayor of Imperia (region of
Liguria); but in 1983, he was forced to resign as a result
of a local corruption scandal, for which he was arrested
briefly but later fully acquitted. Scajola was re-elected
Mayor of Imperia in 1990. He was elected to the Chamber of
Deputies with FI in 1996, and was re-elected in 2001.
Scajola is one of Berlusconi's closest advisers. He was
instrumental in deciding who to include in -- and who to
exclude from -- FI's electoral ticket in the 2001
parliamentary elections.

In June 2001, Scajola was named Minister of Interior. In
this capacity, he intensified the fight against
international and domestic terrorism and organized crime.
In June 2002, Scajola resigned as Interior Minister, after
he was accused of offending the memory of Marco Biagi, a
Labor Ministry adviser killed by the New Red Brigades. In
November 2002, Berlusconi called on Scajola to coordinate
the 2003 local elections, and on July 31, 2003, Berlusconi
brought Scajola back into the government as Minister for
Enforcement of Government Program. Scajola speaks French,
but does not speak English.

Francesco Storace, National Alliance (AN) Health Minister
-------------- --------------

Storace was one of the promoters and founders of the
National Alliance (AN) party, and formerly one of AN leader
Gianfranco Fini's closest advisers. Tension has emerged
between the two leaders, however. Storace was elected to
Parliament in 1994, under Berlusconi's Freedom Pole (Polo
della Liberta'),and re-elected in 1996. He was elected
Vice President of the Chamber of Deputies' Oversight
Committee on Radio and Television, and was a member of the
Joint Parliamentary Investigative Committee on the Mafia.
As a journalist, Storace headed the AN press office.
Storace was elected President of the central region of Lazio
(Rome's region) in April 2000, but lost his 2005 re-election
bid. He speaks very little English.

Mario Landolfi, National Alliance (AN),Communications
Minister
-------------- --------------

The former AN spokesman is a relative lightweight in the
Cabinet. As AN spokesperson, he has been a working level
embassy contact.


Gianfranco Micciche' Forza Italia (FI),Minister (without
portfolio) of Development and Territorial Unity (new office)
-------------- --------------

Until his recent appointment, Micciche was Deputy Finance
Minister, where his portfolio included Economic Development
of Southern Italy. Previously, he was Manager of the
Regional Institute for Financing of the Industries of Sicily
(IRFIS) for 11 years. He was the founder of Forza Italia in
Sicily. Micciche' is a close advisor to PM Berlusconi, who
appointed him National Vice Coordinator of Forza Italia in

2004.
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2005ROME01588 - Classification: UNCLASSIFIED