9/6/2012: Why IMF 'vision' on EA crisis is missing major points

An interesting speech given by the IMF Managing Director, Ms Christine Lagarde to the Annual Leaders’ Dialogue Hosted by Süddeutsche Zeitung last night. Here are some extensive exerts from it and my thoughts - sketched out, rather than focused - about her ideas.


Part 2 of the speech focused on the need for breaking the cycles of the crisis(that amplify risks to the economy, including global economy). Do note - coincidentally, the theme is exactly identical to my forthcoming Sunday Times article and to the research note currently awaiting legal clearance (both will be posted here early next week).


Per Ms Lagarde:
"One is an economic cycle. The feedback loop between weak sovereigns, weak banks and weak growth that continually undermine each other.

"...Another cycle on my mind: the political economy. It is a cycle that has become too familiar since the start of the crisis, like a movie we have watched one too many times. It looks something like this. Tensions escalate and, out of necessity, policymakers take action. But, just enough for the danger to subside. Then the urgency is lost, momentum wanes, and the policy discourse begins to fracture, too focused on their own backyards and not enough on the big picture. And so tensions start to rise again.
But, with the passing of each cycle, we reach a higher and higher level of uncertainty, and the stakes rise.

"In the case of Europe, the cycles are now threatening the very existence of the European project. We must break both of these cycles if we are to break the back of this crisis. And one cannot happen without the other."

So far, on the money, although Ms Lagarde seems to be unwilling to recognize that we also have a structural growth problem in Europe, a problem linked with the above cycles, but also independently grave enough to warrant concern.

To break these cycles, "...the policy debate needs to move beyond the false dichotomies of growth versus austerity, stability versus opportunity, national versus international interests. We need to agree on a comprehensive strategy that is good for stability and good for growth."

So, per Ms Lagarde, the core pillars of such a strategy are: "First, macroeconomic policies should help support the recovery and also tackle the underlying causes of the crisis.

• Monetary policy should continue to be very supportive. Central banks, in particular the ECB, should further loosen monetary conditions, and remain ready to use unconventional tools to ease tensions and provide funding to address liquidity constraints. [In other words, Ms Lagarde is wisely going well beyond the rates policy alone. Good news, but no specifics.]
• Public debt remains too high and countries need credible and ambitious roadmaps to bring it down over the medium term. For the most part, that adjustment should be gradual and steady, unless countries are forced by markets to move more aggressively—which is, of course, the case for several countries in the Eurozone. If growth becomes weaker than expected, countries should stick to announced fiscal measures, rather than announced fiscal targets—as economists say, they should let the automatic stabilizers to operate. [Basically: do austerity policies, but don't chase targets too much. Unless you have to. In which case... well, nothing really new. Just do something?]

"Second, more effective crisis management. This is very urgent and mainly an issue for the euro area. But, a broader element is the collective effort to reinforce the global financial safety net. In this context, I welcome the increase in the IMF’s resources by $430 billion." [A complete 'Fail' for Ms Lagarde here. Increasing 'global safety net' is hardly the only factor in carrying out effective crisis management. How about recognizing that all problems are inter-linked with each other, and thus effective crisis management should be not about creating another pot from which lending can occur to the sovereigns, but actually creating a system that can permanently and swiftly resolve the singular core pressure cause that might be specific for each country? E.g. for Ireland - a system that can address the banking sector debts loaded into the real economy, for Greece - a system that can write off a large portion of the country sovereign debt without restructuring it into new debt, and so on]

"Third, we need more determined progress on structural reforms. For example, labor market and product market reforms that can carry the torch of growth beyond the immediate support from macroeconomic policies.' [Again, Ms Lagarde is exceptionally weak on specifics, in part because structural reforms are country-specific, but in part despite the fact that structural reforms for the euro area must include some - e.g. markets structure changes, moving economy away from state-dominated management and investment etc.]


In part 3 of her speech, Ms Lagarde focused on financial sector reforms.


"Let me be clear: the heart of European bank repair lies in Europe. That means more Europe, not less. ... To break the vicious cycle of financial-sovereign risks, there simply must be more risk-sharing across borders in the banking system. ...In the near term, this should include a pan-euro area facility that has the capacity to take direct stakes in banks. Looking a little further ahead, monetary union needs to be supported by building a true financial union that includes unified supervision; a single bank resolution authority with a common backstop; and a single deposit insurance fund."

[Aside from the 'true financial union', the common deposits insurance system is exactly what I suggest as well, although my proposals go further to include a common resolution mechanism for banks insolvencies that is systemic, not debt-based, unlike Ms Lagarde's approach that will simply pool bad debts into a larger warehousing facility, other than national one. Sadly, the logic of failed banking resolution policies to-date escapes Ms Lagarde. Pooling bad debts into a pan-European system instead of current national systems is equivalent to suggesting that putting all sick and healthy patients in one ward will somehow prevent contagion.]

"Moves toward deeper fiscal integration should go hand-in-hand with these efforts. In particular, the area needs to take the further step of some form of fiscal risk-sharing. Options here include some form of common bonds or a debt redemption fund. This would allow for common support before economic dislocation in one country develops into a costly crisis for the entire euro area." [This is an extraordinary statement for IMF MD - as I show in my forthcoming Sunday Times article, pooling sovereign debt risks will mean euro area sovereign debt/GDP ratio in excess of 110% by 2014-2015. Where is Europe's capacity to raise such debts and where its economic capacity to finance such debts?]

"And, on the upside, breaking the shackles of the sovereign-financial nexus will allow financial institutions to deliver credit and, in turn, create growth and jobs." [This is a rather silly conclusion/ promise that resembles the Irish Government's promises that first a global systemic guarantee, then Nama, subsequently extensive recaps - all policies advocated in this speech by Ms Lagarde, albeit at EA-wide level, instead of national levels - will create a healthy banking system with ample funding and risk-taking capacity to lend into the economy. In Irish case - this clearly did not happen. Neither has it happened in Japan. Why increasing the scale and spread of the diseases - the insolvent banking system - to supernational level should do the opposite?]

21/09/2011: ESRB warns of contagion across euro area financial systems

The General Board of the European Systemic Risk Board (ESRB) held its third regular meeting today on September 21st, and here are the highlights.

In terms of assessing the current situation, the ESRB stated that "since the previous ESRB General Board meeting on 22 June 2011, risks to the stability of the EU financial system have increased considerably. Key risks stem from potential further adverse feedback effects between sovereign risks, funding vulnerabilities within the EU banking sector, and a weakening of growth outlooks both at global and EU levels."

So what ESRB is saying here is that the crisis has completed full circle: if in 2008-2009 transmission of risks worked from insolvent banking sector to insolvent sovereigns and (technically always solvent) monetary authorities via liquidity supports & recapitalization schemes, since 2010 through today the risks have flown the other way - from insolvent sovereigns to insolvent banks via bust bond valuations. The only question that remains now, is where the vicious spiral swing next. In my view - at least in anti-taxpayer, anti-competition Europe it will force taxpayers to directly recapitalize the banks (see IMF's latest calls and the rumor that France is about to go this way) to protect incumbent banking license holders from bankruptcy, receiverships and competition from healthier and new banks.

"Over the last months, sovereign stress has moved from smaller economies to some of the larger EU countries. Signs of stress are evident in many European government bond markets, while the high volatility in equity markets indicates that tensions have spread across capital markets around the world. The situation has been aggravated by the progressive drying-up of bank term funding markets, and availability of US dollar funding to EU banks had also decreased significantly. In that context, central banks have decided on coordinated US dollar liquidity-providing operations with longer maturities."

Nothing new in the above, but it is nice to see an honest admission of the ongoing liquidity crisis. Now, recall that I have said on numerous occasions that bank runs start with a run on the bank by its funders. This is what we term a liquidity crunch - interbank markets freeze, banks bonds funding streams dry out. Only after that can the depositor run develop, usually starting with corporate depositors. Funny enough - the ESRB wouldn't say it out-loud, but in effect it already called in the above statement a bank run in funding markets. Worse, we also know - from the likes of Siemens transaction reported here (http://trueeconomics.blogspot.com/2011/09/20092011-eu-banks-losing-corporate.html ) - that to some extent (unknown) corporate deposits run might be taking place as well. Next?

"The high interconnectedness in the EU financial system has led to a rapidly rising risk of significant contagion. This threatens financial stability in the EU as a whole and adversely impacts the real economy in Europe and beyond."
Boom!

So, per ESRB:
"Decisive and swift action is required from all authorities. In the immediate future this includes:
* implementing, fully and rapidly, the measures agreed upon at the 21 July meeting of the Heads of State or Government of the euro area;
* adopting sustainable fiscal policies and growth-enhancing structural measures so as to achieve or maintain credibility of sovereign signatures in global markets; and
* enhancing the coordination and consistency of communication.
Now, I am not a fan of July 21 decisions, primarily because they do not address the core issue of the crisis - too much debt in the system and too little growth. EFSF purchasing sovereign bonds and lending to insolvent states is not going to reduce the debt pile accumulated by European Governments. Nor will extending maturity and lowering interest rates on its loans help improve economic situation in PIIGS and beyond. So I would disagree with ESRB on the first bullet point.

Calling for adoption of sustainable fiscal policies and growth enhancing measures is like telling a person sinking in a bog to pull harder on his hair. Fiscal sustainability is not being delivered in any of the PIIGS so far, and there is absolutely no appetite for any Government in Europe to take properly drastic measures required to get their finances on sustainable path. Even the very definition of sustainability used by EU is a mad one (let alone not a single state actually adhered to it so far with exception of Finland). A deficit of 3% pa means that you get to 100% debt/GDP ratio in longer time than with a deficit of 5% pa. But you will still get there, folks. Debt to GDP ratio of 60% is only sustainable if, in the environment of 3% 10-year yields your economy expands by more than 1.8% pa (assuming no population growth and no amortization and depreciation under balanced budget). That has not happened in the euro zone in any single 10 year period since we have full data for its members.

Growth-enhancing measures adoption is another case of pure 'wishful' thinking. In most of the Euro area and indeed in the EU Commission, this usually means more subsidies and more state spending. In parts of Central and Eastern Europe it usually means promoting real private sector competition and investment. Of course, we know who weathered the storm best in the last two recessions. But, hey, ESRB wouldn't make a call as to what it means by this "adopting... growth-enhancing measures" despite the fact that much of "growth enhancements" unleashed on euro area economies in recent past is precisely what got us into the current sovereign debt mess in the first place.

As per its last bullet point, one starts to wonder if ESRB is going down the slippery line of 'rhetoric ahead of action'. What does "enhancing the coordination and consistency of communication" mean? All of the EU policymakers 'speaking with one voice'? Curtailing or otherwise minimizing dissent? Controlling information flows? What the hell, pardon my French here, does it really mean, folks?

On a beefy ending, ESRB prescribes that: "Supervisors should coordinate efforts to strengthen bank capital, including having recourse to backstop facilities, taking also into account the need for transparent and consistent valuation of sovereign exposures. If necessary, this could benefit from the possibility for the European Financial Stability Facility to lend to governments in order to recapitalise banks, including in non-programme countries."

I am sorry to say this, but if anyone reading this is going to vote in the Dail on the European Financial Stability Facility and Euro Area Loan Facility (Amendment) Bill 2011 you really have to understand this statement. In effect, ESRB here welcomes loading of the risks of insolvent banking systems - including in non-programme countries - into one single facility, the EFSF, which will have preventative powers to intervene in the markets to buy distressed debts of banks and sovereigns. In a sense, EFSF will become a super-dump - a motherload of super toxic financial refuse from both radioactively insolvent sovereigns and biochemically toxic banks. You wouldn't want THIS anywhere near your local constituency.

Economics 13/11/10: EFSF, Ireland and a matter of contagion

let me ask the following question: if Ireland is nearing (or already in - see here) a bailout from the EFSF, what does this imply to the overall Euro area stability? Funny thing - it turns out that a little old Ireland can give a big young Euro quite a headache because of the way EFSF is structured.

Let’s step back and take a look at the promise EFSF attempts to deliver.

The fund, set up back in May this year, was supposed to provide an emergency funding backstop to countries finding themselves in a liquidity squeeze (unable to borrow in the markets).

There two basic problems with this idea from the point of view contagion from Ireland

• Ireland’s crisis is that of insolvency, not of a liquidity squeeze 9although it is increasingly looking like the latter will come in the end). If EFSF were to be explicitly used to address Ireland crisis, then Irish Government will be de facto borrowing from the fund with no hope of repaying it ever back (recall – the lending rates under EFSF should be set close to the market rates, which means, say 7-8% currently, which in turn automatically means we can’t be expected to repay this). If so, then any borrower, I repeat – any borrower – from EFSF will not repay the funds borrowed. And this means EFSF borrowings will have to be covered collectively out of the joint funds of the entire Eurozone. You can pretty much count PIIGS out of funding it – they’ll be the very same borrowers. Which leaves it to France and Germany (Belgium hardly can pay much and Austria has it’s own problems etc) to cover the entire fund.
• EFSF own structure implies high risk of contagion from Ireland.
  

That second point is slightly technical and requires some explaining to do.

One can make an argument that Ireland, if it borrows from EFSF, will trigger an increase in the Euro zone systemic risk. EFSF is set up similar to Collateralized Debt Obligation (CDO) with a "credit enhancement" that allows the senior debt tranche to retain higher risk rating because junior tranches are the ones that will carry the first hit on the whole package in the case of default.

The lags in the disbursement of funding and the capped nature, plus ‘enhancement’ bit of the CDO implies that countries in trouble will have to get into the funding stream as early as possible – as there is quick exhaustion of drawdown funds in the EFSF due to the knock on effect on CDO rating. This is known as an accelerated negative feedback mechanism – as sovereign comes under pressure, sovereigns are encouraged to race into EFSF, which removes their own bonds and capacity to carry debt out of the senior CDO tranche and increases their presence in the junior tranches.

So the guaranteed pool of liabilities increases by the amount country borrows from the fund, but the senior pool decreases by the contribution of this country to the fund. This means that as Ireland joint EFSF, it’s past ‘good credit’ rating falls to zero in the senior CDO tranche, its ‘bad debt’ risk contributes to the reduced quality of the liabilities held by the EFSF. Pressure rises on AAA rating of EFSF, unless EFSF draws more of AAA-rated countries debt into its senior tranche to offset this. EFSF will have to expand to be able to do both: lend out to Ireland and maintain AAA rating. Which, of course means that other EFSF contributors will need to issue more debt to recapitalize EFSF. Which means their own AAA ratings are becoming threatened as well.

You see where it all leads, now, don’t you?

The greater is the number of countries seeking help and/or the greater is the overall demand for EFSF funds, the greater the required buffer funding increases from the remaining EFSF-lending AAA-rated sovereigns. All of which, in plain English means that the EFSF will run into its own lending limits quicker if Ireland were to go into borrowing from it. Much quicker than a simple level of our borrowing would suggest.

Now, any sovereign with an once of sense now will know that a race to tap EFSF is on. The faster you get to it to borrow from it, the more likely you’ll arrive to the borrowing window before the limits are reached. Portugal, Spain and possibly even Italy are in the race.

This is why the markets have never been easy about the entire EFSF – they know that Ireland tapping into EFSF simply does two things:

1. It delays the inevitable restructuring of the massive debts accumulated on the Irish economy side – either sovereign or banks or households or any two or all three. EFSF does not remove the need for such a restructuring. It simply delays it.
2. It signifies an exponential increase in the probability of EFSF acting as a conduit for contagion from the PIIGS to the rest of the Euro area.