During 1985-90, Italy progressively removed the system of capital controls that had been in place during the previous decade. At the same time, it strengthened its commitment to the exchange rate mechanism of the European Monetary System (EMS) and registered a strong increase in gross capital flows, with a positive and increasing net inflow through mid-1991. This paper reviews the developments in exchange regulations in Italy during the 1980s. Using simple indicators of the effectiveness of capital controls and target zone credibility, it assesses the pace and sequencing of the policies of capital liberalization and exchange rate stabilization.
The paper concludes that Italy achieved virtual integration of its domestic capital market with the offshore market well before achieving credibility of the exchange rate commitment. Nevertheless, the process of capital liberalization developed within a relatively stable financial environment. Furthermore, after binding restrictions on capital outflows were eliminated, a large net capital inflow took place, a development that is difficult to interpret on the basis of standard models of portfolio choice. These events suggest that capital liberalization may have played an indirect role in the development of the Italian capital account in the second half of the 1980s: by raising the potential costs of exchange rate instability, the removal of capital controls increased the credibility of the commitment to the EMS and therefore contributed to calming devaluation expectations. This allowed the Italian system to borrow increasingly on the world market without paying the price in terms of higher interest rates. This interpretation is consistent with the reduction of net capital inflows observed since mid-1991, along with the slowdown of progress toward exchange rate stabilization.