Italy reform path rocky despite Prodi's return

The rapid resolution of Italy's government crisis last week came as a relief to markets, but the coalition bickering that briefly sank Romano Prodi leaves no illusions about the prospects for much needed economic reform.

Just before Mr Prodi resigned after losing a key foreign policy vote, data showed Italian growth surged 1.1 per cent in the final three months of last year, the strongest fourth quarter rate in the euro zone and Italy's best performance since 1999.

Full-year growth, at 1.9 per cent, was still below the euro zone average, and few analysts credited Mr Prodi's nine-month-old government as the reason for Italy's recovery.

But they do grant that amid all the infighting he managed to push through reforms which, though piecemeal, had proved beyond successive Italian governments for years and could gradually raise the potential of one of Europe's most sluggish economies.

"The government had actually done quite well on the economy and the outcome the markets really feared was fresh elections," said Deutsche Bank economist Susana Garcia.

While walking a tightrope between the conflicting demands of his nine-party coalition, Mr Prodi began to liberalise the service sector, passed long-awaited legislation to boost private pension schemes, cut tax evasion and reined in the budget deficit.

But he was still widely criticised for not going further and analysts say the real test will be whether he can capitalise on the economic upswing to overhaul the inefficient public sector and reform the labour market and state pension system.

"We are under no illusion about how hard it will be for such a fragmented coalition to make significant progress in reforming pensions and the labour market, which are essential for Italy's medium-term growth outlook," said Unicredit IB's Marco Valli.

After his resignation Mr Prodi rallied fractious allies around 12 priorities including pension reform, more liberalisations, and "an immediate and significant reduction of public spending".

That should be music to markets' ears. But, as has often been the case, the commitments are couched in such vague terms that the main concern is clearly not to irk anyone in the disparate alliance spanning moderate Catholics to communists.

Analysts agree, for example, that Italy's ageing population and public finance constraints give it a stark choice of raising the minimum retirement age, currently 57, or cutting pay-outs.

However this is anathema to the communists and the unions, so the pension reform plan is termed "re-organisation of the pension system giving priority to low pensions and the young".

In a sign of Mr Prodi's daunting task, unions bosses angrily rejected some very mild Treasury pension reform proposals leaked by the press last week, prompting Economy Minister Tommaso Padoa-Schioppa to attack the leakers' "ill-considered" actions.

The case for a decisive cut in public spending is also compelling. Data last week showed that in 2006 outlays rose to 50.5 per cent of GDP, the highest level for a decade, despite the attempted curbs adopted by numerous governments over the years.

While all agree with state savings in principle, the unions resist public lay-offs or even changes to a system of largely automatic salary hikes which has seen public sector pay rise in the last five years by 15 per cent more than private sector salaries.

Latest developments augur badly for fiscal rectitude. With important local elections three months away, ruling politicians are producing a stream of proposals to bolster the government's dwindling popularity by spending more or cutting taxes.