US embassy cable - 04ROME1955

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