Italian car industry
A Lamborghini worker is seen on the Aventador production line at a Lamborghini factory in Sant'agata Bolognese, November 15, 2011.REUTERS

The Italian economy has yet to emerge from a prolonged recession and prospects remain uncertain with downside risks, the International Monetary Fund said on Thursday.

"(Italy's) unemployment remains high and inflation has declined further. Meanwhile, tight credit conditions, weak corporate balance sheets, and deeply-rooted structural rigidities continue to weigh on domestic demand," the IMF release said.

The high level of public debt has magnified these challenges, the Fund said, in the statement after concluding its Article IV consultation with Italy.

IMF noted that Italian economy is struggling to emerge from a balance sheet recession.

Against the background of significant economic slack, inflation fell well below 1% and unemployment reached 12.3%. Sovereign spreads narrowed but financing conditions remain very tight for the corporate sector and non-performing loans continue to increase.

Optimism

Italy's GDP growth is expected to pick up to 1.1% in 2015 as credit conditions normalise and the effects of the easing measures by the European Central Bank are felt, even though risks are still tilted to the downside.

Prime Minister Renzi has outlined a bold reform agenda: firm implementation is now essential to create jobs, increase productivity, and lift potential growth from a low estimate of about 1⁄2%, IMF said.

IMF expects Italy's nominal budget deficit to be around 3% of GDP this year. In structural terms, a deficit of 0.8% of GDP is expected. Public debt will peak this year at about 136% of GDP may decline thereafter.

What Is Needed

Deep structural changes are needed for Italy to unleash the couture's growth potential, secure a recovery, and address debt overhang issues.

The IMF stressed the urgency of labor market reforms to reduce duality and increase flexibility, building on recent gains.

Cleaning up banks' bad loans remains an immediate priority for Italy, IMF said.

The Fund noted that Italy has achieved remarkable fiscal consolidation over the past few years.

"Going forward, the need will be for the fiscal policy to strike a balance between securing near-term growth and setting the debt ratio on a downward path over the medium term," IMF added.

The priority for growth-friendly adjustment should be to create space for lowering marginal tax rates through spending savings and lower tax expenditures.