30/12/16: In IMF's Forecasts, Happiness is Always Around the Corner

Remember the promises of the imminent global growth recovery 'next year'? IMF, the leading light of exuberant growth expectations has been at this game for some years now. And every time, turning the calendar resets the fabled 'growth recovery' out another 12 months.

Well, here's a simple view of the extent to which the IMF has missed the boat called Realism and jumped onboard the boat called Hope

Table above posts cumulative 2010-2016 real GDP growth that was forecast by the IMF back in September 2011, against what the Fund now anticipates / estimates as of October 2016. The sea of red marks all the countries for which IMF's forecasts have been wildly on an optimistic side. Green marks the lonely four cases, including tax arbitrage-driven GDPs of Ireland and Luxembourg, where IMF forecasts turned out to be too conservative. German gap is minor in size - in fact, it is not even statistically different from zero. But Maltese one is a bit of an issue. Maltese economy has been growing fast in recent years, prompting the IMF to warn the Government this year that its banking sector is starting to get overexposed to construction sector, and its construction sector is becoming a bit of a bubble, and that all of this is too closely linked to Government spending and investment boom that cannot be sustained. Oh, and then there are inflows of labour from abroad to sustain all of this growth. Remember Ireland ca 2005-2006? Yep, Malta is a slightly milder version.

Notice the large negative gaps: Greece at -21 percentage points, Cyprus at -18 percentage points, Finland at -15 percentage points and so on... the bird-eye's view of the IMF's horrific errors is:

• Two 'programme' countries - where the IMF is one of the economic policy 'masters', so at the very least it should have known what was happening on the ground; and 
• IMF's sheer incomprehension of economic drivers for growth in the case of Finland, which, until the recession hit it, was the darling of IMF's 'competitiveness leaders board'.  

Median-average miss is between 4.33 and 4.97 percentage points in cumulative growth undershoot over 7 years, compared to IMF end-of-2011 projections.

So next time the Fund starts issuing 'happiness is just around the corner' updates, and anchoring them to the 'convincing' view of 'competitiveness' and 'structural drivers' stuff, take them with a grain of salt.

13/12/2011: European Summit and Markets Efficiency

One thing that clearly must be disheartening for the perfect markets efficiency theory buffs (supposedly there are loads of them around, judging by the arguments from the 'State Knows Best' camp, though I personally know not a single one who thinks that markets are perfectly efficient) is the speed with which the markets produced an assessment of the Euro zone's latest 'Grand Plan'.

Frankly speaking, the ink was still drying on the last week's summit paper pads and it was already clear that the new 'Solution' is not a solution at all and that the Euro zone crisis is not about to be repaired by vacuous promises of the serial sinners not to sin in the future.

This blog highlighted back on the 10th of December (here) the simple fact that Euro zone is highly unlikely to deliver on its newly re-set old SGP criteria targets, no matter what enforcement (short of Panzer divisions) Merkozy deploy. And in a comment to Portuguese L'Expresso (see excerpts here and full text here) and elsewhere I have said that instead of resolving the debt crisis, European leaders decided to create a political crisis.

Many other observers had a similar assessment of the latest Euro Land Fiasco pantomime that was the Summit. And yet, despite the factual nature of analysis provided, I was immediately attacked as a token Euro skeptic and an Anglophile.

Now, more confirmation - this time from the EU Commission itself (presumably this too has evolved into a Euro skeptic and an Anglophile institution overnight) - that the propposed Merkozy Pact is (1) extra-judicial and (2) largely irrelevant to the problem at hand. Today's Frankfurter Allgemeine reports that the new Pact will be - per EU Commission opinion - part of an inter-governmental treaty, which is subordinate - in international law - to any European treaty. This, in turn, means that a country in breach of the 'quasi-automatic fiscal rules - 3%-0.5%-60% formula - can simply claim adherence to existent weaker rules established under the fully functioning European treaties. This, in turn, will mean that there can be no application of the new Pact rules.

Thus, the new Merkozy Pact is subordinated to the weaker fiscal rules under the SGP and any extra-SGP enforcement of these rules is subordinated to the SGP procedures. Can anyone explain how, say Italy, can be compelled to implement the new Pact, then?

Meanwhile, of the other 'agreements' reached at the Summit, the EFSF agreement represents the weakening, not the strengthening of the previous Euro area position. In fact, post Summit, the EFSF is about to lose its AAA status (as France is preparing to lose its own AAA rating). S&P has the EFSF AAA-backers on negative watch and under a review, Moody announced yesterday that it will be reviewing AAA ratings across the Euro zone and Fitch labeled the Summit a failure. And amidst all of this EFSF is going to remain about 1/3 of the size required to start making a dent in the Euro zone problems. That, of course, assuming it can get up to that level - a big question, given pending downgrade and previous difficulties with raising funds.

The third pillar of the Euro zone 'strategy' for dealing with the crisis - the permanent ESM - also emerged from the summit in the shape of a party balloon with a hole in its side. Rapid deflation of the ESM hopes means that even with 'leverage' option, the ESM will not be able to underwrite liquidity to Italy and GIP, let alone Spain & Belgium. Furthermore, there is a question yet to be asked of the European leaders. Fancying ESM at €500 billion might be a wonderful exercise in fictional narrative, but where on earth will they get these funds from?

The fourth pillar of the 'strategy' was the IMF merry-go-round loans carrusel. Now, recall that brilliant scheme. The IMF has strict (kind of strict - see here) rules on volumes of lending it can carry out. But Euro zone problems are so vast, the IMF limits represent a huge constraint on the funding it can provide to the common currency debt junkies. So the EU came up with an 'Cunning Plan'. The EU will lend IMF €200 billion (which EU doesn't really have) and the IMF can then re-lend EU between €800 billion (under old rules on IMF lending) or up to €2 trillion (under that new 'leverage scheme'). Note: IMF doesn't really have this sort of money either.

So a junkie will borrow somewhere some cash, lend it to his dealer-supplier, who will then issue junkie a credit line several times greater than the loan, so the junkie can have access to few more years of quick fixes. Lovely. When you think of it, the irony of the EU passing a new 'Discipline Pact' with one stroke of pen, while leveraging everything it got and even leveraging the IMF to get itself more debt with the next stroke of pen takes some beating in the land of absurdity.

But fear not. The IMF is not likely to engage in this sort of financial engineering. Not because its new leader, Christine Lagarde - who comes from the European tradition of creating massive fudge out of monetary and fiscal policies - objects to it. It is unlikely to do so because its other funders - the US and Japan and BRICs etc are saying 'No way, man' to the Euro zone's plans. The US expressed serious concerns that Euro zone's plan will lead to US losses on IMF funds, while Japan's Fin Min Jun Asumi said that Europe must create a functional firewall first, before any IMF involvement can be approved. He also stated Japan's support for US position.

And so we have it. Post-Summit:

• There is no effective new 'Treaty' or enforceable new rules
• There is no enhanced EFSF and the old one is about to lose all its firepower
• There is no feasible ESM
• There is no Euro-leveraging of the IMF

Oh, and the ECB is becoming increasingly non-cooperative too.

And amidst all of this, the newsflow gets only worse and worse for Europe's battered economies. Greece is now projecting GDP decline of 6% in 2011 and 3% in 2012. The new deficit projections for 2011 are at 9% of GDP or €2.6 billion worse than the annual budgetary forecast of 8.5% deficit. Ditto for Belgium, where 2011 deficit is heading for 4.2% of GDP - 0.6 percentage points above the budgetary target (€2.2 billion shortfall). And, of course, there is that post-boy of austerity - aka Ireland - where Government tax revenues are collapsing as data through November shows (see details here).

So reality bites, folks. Markets are clearly not perfectly efficient. But once they discover the truth about the Euro Summit, fireworks will begin.

2/12/2011: Euro crisis: wrong medicine for a misdiagnosed patient

There's been much talk about the fiscal union and ECB money printing as the two exercises that can resolve the euro area crises. The problem is that all the well-wishers who find solace in these ideas are missing the very iceberg that is about to sink the  Eurotanic.
 (image courtesy of the ZeroHedge.com):

Let's start from the top. Euro area's problem is a simple one:

• There is too much debt - public and private - as detailed here, and
• There is too little growth - including potential growth - as detailed here.

Oh, and in case you think that discipline is a cure to debt, here's the austerity-impacted expected Government debt changes in 2010-2013, courtesy of the OECD:

In other words, it's not the lack of monetary easing or fiscal discipline, stupid. It's the lack of dynamism in European economy.

Let me explain this in the context of Euro area policies proposals.

• The EU, including member states Governments, believes that causality of the crisis follows as: Loss of market confidence leads to increased funding cost of debt, which in turn causes debt to become unsustainable, which in turn leads to the need for austerity and thus reduces growth rates in the Euro area economies.
• My view is that low growth historically combined with high expectations in terms of social benefits have resulted over the decades in a build up of debt, which was not sustainable even absent the economic recession. Economic recession caused the tipping point in debt sustainability beyond which markets lost confidence in European fundamentals both within the crisis environment, but also, crucially, beyond cyclical recession. My data on structural deficits (linked above) proves the last point.

So while Europe believes that its core malaise is lack of confidence from the markets, I believe that Europe's real disease is lack of growth and resulting high debt levels. Confidence is but a symptom of the disease. 

You can police fiscal neighborhood as much as you want (and some policing is desperately needed), but you can't turn European economy from growth slum to growth engine by doing so. You can also let ECB buy all of the debt of the Euro area members, but short of the ECB then burning the Government bonds on a massively inflationary pyre, you can't do away with the debt overhang. Neither the Euro-bonds (opposed by Germany) nor warehousing these debts on the ECB balance sheet (opposed by Germany & the ECB) will do the trick. Only long-term growth can. And in that department, Europe has no track record to stand on.

Take Italy as an example. Charts below illustrate the country plight today and into 2016. I use two projections scenarios - the mid-range one is from the IMF WEO for September 2011, the adverse one is incorporating OECD forecasts of November 2011, plus the cost of funding Italian debt increasing by 100bps on the current average (quite benign assumption, given that it has increased, per latest auctions by ca 300bps plus).

As chart below shows, Italy is facing a gargantuan-sized funding problem in 2012-2016. Note that the time horizon chosen for the assessment of fiscal sustainability is significant here. You can take two assumptions - the implicit assumption behind the Euro area policy approach that the entire problem of 'lack of markets confidence' in the peripheral states can be resolved fully by 2013, allowing the peripheral countries access to funding markets at costs close to those before the crisis some time around 2013-2014. Or you can make the assumption I am more comfortable with that such access to funding markets for PIIGS is structurally restricted by their debt levels and growth fundamentals. In which case, that date of regaining reasonable access to the funding is pushed well past 2015-2016.

Government deficits form a significant part of the above debt problem in Italy (see below), but what is more important is that even with rosy austerity=success model deployed by the IMF, the rate of decline in Italian public debt envisioned in 2013-2016 is abysmally small (again, see chart below). This rate of decline is driven not by the lack of austerity (deficits are relatively benign), but by the lack of economic growth that deflates debt/GDP and deficit/GDP ratios and contributed to nominal reductions in both debt and deficits.

But the proverbial rabbit hole goes deeper, in the case of Italy. IMF projections - made before September 2011 - were based on rather robust euro area-wide growth of the first quarter of 2011. Since then two things have happened: 

1. There is a massive slowdown in growth in Italy and across the euro area (see here), and
2. Cost of funding Italian debt has risen dramatically (see the second chart below).

These two factors, imperfectly reflected in the forecasts yield my estimation for Italian fiscal sustainability parameters under the 'adverse' scenario.

The above shows why, in the case of Italy, none of the solutions to the crisis presented to-date will work. Alas, pretty much the same applies to all other peripheral countries, including Ireland.

Which means that the latest round of euro area policies activism from Merkozy is simply equivalent to administering wrong medicine in greater doses to the misdiagnosed patient. What can possibly go wrong here?

27/11/2011: Even with IMF's €600bn - Italy is too big to bail

There are some interesting reports in the media over the weekend, speculating that the IMF is preparing a super package for Italy, rumored to reach €600 billion. Here's a link from zerohedge that outlines the details of these rumors (here). There are several reasons to be skeptical as the feasibility of such a package and the potential effectiveness of it.

Here are these reasons.

Firstly, the IMF is a rules-based organization that normally can lend only 4-5 times (400-500%) of the country quota. Italy's country quota is SDR7.8823 billion or €10.7bn which can allow IMF to lend under normal arrangements up to €53.5 billion (at a severe stretch, I must add as the fund prefers not to lend to the full leverage of 500%).

In addition, IMF has announced two new programmes last week (discussed here). The Flexible Credit Line programme - whereby IMF does not specify lending leverage to be achieved, applies only to "members with very strong track records... based on pre-set qualification criteria to deal with all types of balance of payments problems." So IMF would have to qualify Italy as a country with "strong track record" and its solvency problems as "balance of payments problem". This, of couse, is possible, though not probable, as Italy's "strong track record" is hardly that "strong". In addition, the new lending will have to take place outside the normal arrangements mentioned above, as the deployment of such arrangements would not be consistent with "strong track record" even in theory. So to raise €600 billion, IMF will have to leverage Italy's SDR allocation 6,000%.

Let's put this number into perspective. Lehman Bros TCE leverage ratio was 4,400% at the time of collapse and its average TCE leverage ratio prior to collapse was 3,100%.

At any rate, IMF is most likely to assign Italy a precautionary borrower status under Precautionary Credit Line (see link above) which allows for 24 months leveraging up to 1,000%. This, of course means Italy will be able to raise just €107 billion through IMF loans or about 1/3rd of its roll-over requirements (not to mention new borrowings demand) through 2012.

Secondly, suppose IMF does indeed lend Italy €600 billion - enough to barely cover the country refinancing needs for 2012-2013. Then, two things happen:

1. 1/3rd of Italy's total Gross Government Debt becomes overnight senior to the rest of its debt - as IMF always assumes seniority in lending. This will push existent Italian bonds yields to 15% or 18% or more. We do not know, of course, exactly where the debt will be traded, but what we do know with almost certainty is that there is not a snowball's chance in hell Italy will be able to refinance maturing debt after 2013 on its own. So IMF lending Italy today commits IMF to lend to Italy in 2014 and on.
2. €600 billion is unlikely to cover all Italian needs for 2012-2013, especially if Italian banks are to take a hit on other sovereign bonds. let me run through the EBA banks stress tests model under the following assumptions: Greece haircut 80%, Italy haircut 10%, Portugal haircut 25%, Spain haircut 10% (notice - all very benign) and CT1 ratio of 9%. Italian banks shortfall on capital is €34 billion. Now, recall that Italy also has insurance companies (e.g. A.Gen) and pensions funds - which will see some fall-outs from the haircuts as well. Say €10 billion. Italian bonds downgrade due to IMF lending (see item 1 above) is likely to cost banks and other financial sector companies another  €11 billion and €4 billion. So we are into total bill of ca €60 billion right there. Italian deficits in 2012-2014 are expected to gross €76 billion per IMF latests forecasts. As shown in the chart above, debt maturity, plus new deficits financing will consume some €453.4 billion in 2012-2014 and €630.5 billion in 2012-2016. 

So the total funding that Italy might require is in the neighborhood of €510-690 billion, depending on which period we assume the package will cover (2012 through either 2014 or 2016 respectively).

And this assumes no deterioration in GDP growth (tax revenues) or deficit spending etc. It also assumes that market funding costs IMF built into its deficit forecasts (4% 10-year average pre-November 2010) remain under the IMF lending deal. In fact, of course, that is open to speculation if IMF can lend Italy €600 billion at anything below 5.3-5.8%.

So overall, folks, I am skeptical as to the IMF's ability to conjure €600 billion for Italy. And furthermore, I am skeptical as to Italy's ability to manage cover for its deficits, banks and roll-over needs under such a package. This doesn't even begin to address my concerns as to Spain waiting in the shadows.

Now, lastly, you might suggest that the IMF loans can come in conjunction with EFSF loans. Alas, the EFSF has some serious troubles itself - the following two posts from the zerohedge amply illustrate: here and here.

You see, Italy is too big to bail. Even if it is also too big to fail.

Economics 6/12/10: IMF stress tests for Irish banks

Here are three things that are worth asking about the latest details of the EU/IMF 'rescue' package released over the weekend. All relate to the issue of banking sector restructuring:

1. According to reports, some €2 billion will be available to enable the banks to sell €20 billion worth of assets (which, of course, implies sales of performing loans, as all other assets, such as foreign divisions, auxiliary services providers, asset management branches etc have already been flogged or put on the market). As reports issued today specify: the funds may come in the form of a loss protection or as a guarantee for asset purchasers. These €2 billion come on top of the €10 billion set aside for the immediate re-capitalization of the banks, and on top of further €25 billion in contingency funding allocated. So it appears that it either comes from the Exchequer side of the EU/IMF deal, reducing deficit financing available to the Government or, alternatively, on top of the €67 billion in lending extended under the whole deal. In effect, the EU/IMF will now engage Irish taxpayers funds (remember - these €2 billion are loans) to sweeten the bitter pill for buyers of Irish banks assets. A small, but lovely morsel of taxpayers income that will be spent on artificially propping Irish assets for sale.
   
2. According to the Irish Times, stress testing scenarios deployed by the IMF in pricing the overall demand for taxpayers funding for the banks involved the following assumptions: losses of 10% on buy to let mortgage books and 6.5% for residential mortgages. These assumptions underwritten the demand for €25 billion in contingency funding, spread as €15 billion in required capital, plus €10 billion additional cushion. This is rather interesting and worrying. Buy-to-let mortgages are most certainly completely under water right now, given collapsed rents and capital values, as well as more recent vintage of these mortgages. If investment and commercial books are facing up to 35-40% losses currently (as consistent with the Government own estimate of €50 billion final cost of banking sector recapitalization), is it safe to assume that buy-to-rent mortgages will tank at 10%? Similar questions arise with respect to 6.5% assumption on mortgages defaults. In fact, we already know that over 100,000 mortgages are either in official distress or under renegotiated repayment holidays or interest rates adjustments. This pushes the effective default and at-risk of default numbers will in excess of 6.5% as of today.
3. If contingency fund of €10 billion were to be taken as covering any losses in excess of 6.5% defaults on mortgages and 10% default on buy-to-rents, then this amount is expected to cover: (1) Haircuts by Nama on additional €14 billion in loans transfers (cost ca €6-7 billion at past haircuts), plus (2) Losses in excess of assumed rates on mortgages and buy-to-rents, plus (3) any further losses on investment and development books, plus (4) any further losses on derivatives exposures. This is hardly realistic of a cushion. So it appears that the IMF was either not given the full realistic picture of the Irish banks balance sheets, or it is seriously underestimating the demand for future losses cover in the banks.
   

Either way, the numbers continue to suggest that the €67 billion package of loans will not be enough to provide simultaneously a cover for Exchequer deficits and the funds required to underwrite losses and capital requirements of the banks. Somehow, the Irish Exchequer will have to make up for this shortfall.

Economics 26/11/10: Contagion is spreading to Spain & Italy

Another day, another spike of contagion from Ireland's Sovereign bonds to other Eurozone countries:
Yesterday's closing bell marked another day in which markets have completely disagreed with the EU officials and Irish Government view of the reality of our and PIIGS' ability to weather out the current crisis.

Economics 22/11/10: November 12 - on the record re 'bailout'

This is an unedited version of my November 12 article in the Irish Examiner. Of course, since then the events have taken over the core premises of the article, but for archival purposes and also to posit the article into the context (at the time of print, the official position was 'we don't need a bailout'), I am posting this here.

Despite all the intensifying talk about the EU support, despite the growing number of assurances from the various officials and social partners that we can ‘grow out of our difficulties’, this week has clearly shown that Ireland is nearing the end game of the crisis. Tellingly, even the usual official policies cheerleaders, our stockbrokers, have by now one by one deserted the State-side of the arguments. As one analyst from IFSC put it earlier this week: ‘you know the game’s up when you can’t round up your own sales team to sell Irish bonds’.

The game is almost up. Were we to go into borrowing today, Irish debt will be more costly to finance than that of any other developed country, save Greece. On the assumption of a 70% recovery rate, the Irish 10 year Credit Default Swaps imply an 85% probability of Ireland defaulting sometime in the next 10 years. This, of course, is not the real probability, but an estimate. However, in comparison, even countries that availed over the last 3 years of IMF assistance, including Iceland, are enjoying much greater confidence of the markets.

We all know how we got into this predicament. Three years into the crisis, Irish Government continues to spend well beyond its means. Our current spending keeps rising. Tax revenue, despite significant tax hikes, is running below 2008 levels.

The markets know that the Irish Government has by now exhausted all means for extracting more cash out of this devastated economy. If, as expected, Minister Lenihan hikes taxes in the Budget 2011 again, he will be shifting more of our economic activity into the grey market where the taxman is a distant and powerless overlord.

Much anticipated Budget 2011 is unlikely to solve this problem. Cuts of €6 billion from the deficit this year will do very little to restore any credibility to the Government policy. As anyone with an ounce of common sense will know in the current conditions, the whole exercise will be equivalent to taking money out of one pocket – Government total spending – and putting it in the other – the banks, bondholders, social welfare and pay and pensions bill.

By avoiding soaking the bondholders from the start of this crisis, the Government has boxed itself into a proverbial corner. Instead of standing on a morally and economically high ground and soaking the bondholders early on in the crisis, as Iceland did, we have created a full-blown contagion from the banks to the sovereign. With liquidity evaporating from the shorter end of the banks funding market, this contagion is now a two-way street. Untangling this today, without going into a renegotiation of the sovereign bonds and/or guarantees, cannot constitute a credible policy position.

All of this comes before we even consider the real economy-side of the matters. With private investment on its knees, and companies, starved of trade and operational credits, operating outside the realm of normal corporate finance, can anyone really claim that we have a private sector capacity to escape a restructuring of the private or public or both debts?

Irish families are now so deep in debt and negative equity that consumption and household investment stalled, while deposits are vanishing to pay rising state and semi-state bills. Squeezed on both ends of their incomes – by falling earning and rising taxes and charges – these very households cannot be expected to provide more funding for our fiscal policy pyramid scheme.

But the final straw that broke the proverbial camel’s back is the belated realisation that the EU has no plan B for dealing with this crisis. In fact, it doesn’t even have a plan A. This was made absolutely clear by the vacuous nature of statements issued by the EU Commissioner Olli Rehn during and after his visit to Dublin this week.

The fundamental EU problem is that the much-lauded EFSF (European Financial Stabilization Facility) – the fund used to put Greece into a bond markets deep-freezer earlier this year – is not designed to address the problems we face. EFSF is designed to help cash strapped governments for a period of 3 years at ‘near market’ rates. Ireland is not cash-strapped. Nor are ‘near-market rates’ a sustainable lending option for us.

We are plain insolvent when one takes three to five years forward view. Our sovereign debt to GNP ratio is likely to exceed 140% by the end of 2015 and this is before we factor in the highly probable wave of mortgages defaults. Our household and corporate debts are more than double those of Greece. And we are staring at the abyss of rising interest rates and strong euro into the next 3-5 years.

EFSF is simply not fit for the purpose of rescuing Ireland.

At current yields, Ireland will need to grow its economy at some 6.5-7% on average annually for the next decade to counterbalance the mountain of debt we are carrying. At the ESFS rates – at ca 4.5%. Anyone expecting this to happen without radical and extremely painful structural reforms of the economy (not just budget cuts) should really go back to the basics of economics. With exception of exporting sectors our economy has slipped into a coma. Jolting it out of this state will require complete rethinking of our fiscal and economic policies.

As an optimist, I can tell you that this can be done. As a pragmatic observer of the current policy and economic environment, I have little hope that it can be done without restructuring our debts – either public or private or both – and issuing a new policies mandate for the political leadership.