Tuesday, November 15, 2011

The Italian Debt Crisis and the International Monetary Fund

Sources:
Reuters: Analysis: Losing Credibility, EU Seeks IMF's Embrace
Traders Magazine: G20 Summit Roundup
WSJ: UPDATE: UK: G-20 Withheld IMF Commitments, Want Euro-Zone Action

As the European sovereign debt crisis continues to worsen and many countries and investors are questioning the EU leadership’s ability to remedy the crisis, many investors are looking to the International Monetary Fund (“IMF”) to help stabilize and restore market confidence in the region. Market confidence is of upmost importance because the market’s perception of the troubled economies (Italy, for example) will significantly affect the interest rates the countries have to pay on bonds. In the case of Italy, market confidence is of extreme importance because Italy may be able to pay its debts if it is able to receive bonds at low interest rates, but if market confidence falls and Italy appears more risky investors will demand a higher risk premium on their investment in Italian bonds, which will increase Italy’s cost to borrow money and may cause the country to default.

Italy, the third-largest economy in the EU and eighth-largest in the world, is the most recent EU member to find itself in financial trouble. Because of the importance of market confidence in Italy, EU leadership recently forced the country to accept tighter oversight of the country’s economy from the IMF and European Central Bank (ECB). While the EU hoped the move would increase market confidence, some investors believe the move shows that the EU cannot maintain market confidence without outside assistance.

A large factor in market confidence is the ability and willingness of the IMF to offer a bailout to Italy, and potentially the entire EU, if the need arises. At a recent G-20 Summit in France on November 3rd and 4th, the group discussed potentially increasing the IMF’s funding to make a European bailout more plausible. However, before the G-20 will commit to additional funding it first wants to see the EU take more internal actions to control their debt. The G-20 also has specific concerns about the EU’s political structure, which makes quick or firm action almost impossible. Some developing countries that are also members of the G-20 (Brazil, China, and India) stated that they are willing to increase IMF funding if the EU can first show that it has adequate leadership, a clear vision, and the ability to respond to problems rapidly.

While at the current time it seems unlikely that the IMF will make a large loan to the EU, and will instead be involved in more intense economic monitoring, the EU is hoping the IMF’s presence will increase market confidence. However, if EU leadership cannot take concrete steps to confront the growing debt problem and market confidence continues to deteriorate, it may be necessary for the IMF and ECB to play a much more direct role to avert an economic collapse.

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