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Italy’s deus ex machina bows out

Italy’s deus ex machina bows out

Euro worries and IMF stance on capital flows
Preventing euro-style distortions in emerging markets

by David Marsh

Mon 10 Dec 2012

The bond markets’ hopes that a deus ex machina could durably bestride the Roman stage have been dashed. Italian prime minister Mario Monti will resign shortly. (He may be back, of course). But in the meantime his predecessor Silvio Berlusconi is poised for an attempted return to power that – whether it succeeds or fails – promises to be spectacular and disruptive. Berlusconi’s chances of a fourth prime ministerial term after elections, to be held possibly as early as February, look slim. Opinion polls put the centre-left Democratic party headed by former communist Pier Luigi Bersani well ahead of Berlusconi’s revamped People of Liberty party.

The world will watch as a discredited billionaire showman-politician seeks to refuel his electioneering machinery. Even a shadow of a possibility that the former right-wing premier may return would send a tremour through financial markets. And Bersani, though judged a reasonably competent possible future leader, will never be viewed as solidly as Monti.

The Italian drama presents an intriguing counterpoint to an important international financial policy change announced last week: the reversal of the International Monetary Fund’s long-time policy on capital controls, itself partly prompted by European upheavals.

The IMF shift, after a thorough three-year review, moves the Fund’s policies powerfully in a direction favoured by emerging market economies.

On the European scene, any hint that Berlusconi could re-enter Rome’s Palazzo Chigi would complicate further enactment of the European Central Bank’s vaunted but unused Official Monetary Transactions programme, agreed in September, for potentially unlimited purchases of weaker countries’ bonds. Certainly, Berlusconi has some scores to settle. In August 2011, Jean-Claude Trichet, then ECB president, and Mario Draghi, his successor, then governor of Banca d’Italia, sent to Berlusconi a confidential list of necessary reform measures that were widely seen as conditions for ECB purchases of Italian debt. The letter sparked consequences that led to Berlusconi’s eventual resignation and replacement by Monti in November 2011.

In early August 2011, at the height of a bond market scare, Italian 10-year government bond yields stood at over 6%, a spread over equivalent German yields of above 3.5 percentage points. Showing the scale of the task confronting the Italian authorities, even now, after favourable market reaction to the OMT announcement in recent months, Italian spreads are still around 3.2 percentage points, although the yield in absolute terms has fallen more sharply to around 4.5%.

The Italian imbroglio is linked to last week’s IMF announcement accepting curbs on movement of international capital into and out of countries affected by economic overheating. Such measures have been used extensively by emerging market economies in recent years in an attempt to ward off the kind of destabilising capital movements that affected Europe in the European Monetary System flare-up 20 years ago, as well as in the continuing euro crisis.

Last week the IMF stated that there is ‘no presumption’ that ‘full liberalisation [of capital movements] is an appropriate goal for all countries at all times.’

For years, and especially since the 1997-98 Asian financial crisis, when countries like Malaysia sought to introduce controls on speculative capital movements to damp exchange rate declines, the international consensus as broadcast by the IMF was firmly on the side of liberalisation. Violations were condemned as significant infringements of the world monetary rulebook. The IMF ignored the historical reality that measures to prevent speculative inflows and outflows were central elements of the post-Second World War Bretton Woods system of fixed exchange rates.

Now, the IMF centre of decision-making gravity is moving heavily in favour of the authorities from Asia and Latin America, especially from emerging market economies.

The IMF’s espousal, under certain conditions, of what it coyly calls Capital Flow Management measures, bears the hallmark of influential Asian people such as Singapore finance minister Tharman Shanmugaratnam and Zhu Min, deputy IMF managing director and former deputy governor of the People's Bank of China. The new guidelines reflect too the arguments of influential critics of global conventional financial wisdom such as Rakesh Mohan, former deputy governor of the Reserve Bank of India, Bank Negara Malaysia governor Zeti Akhtar Aziz and Brazilian finance minister Guido Mantega.

Especially at times of low growth and interest rates in western industrialised countries, developing countries say they have no choice but to take measures against short-term capital inflows that would otherwise expose them to recession-inducing exchange rate appreciation.

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