24/11/2011: Insolvent Europe

The following link is to my article on EU-wide debt crisis for presseurope.eu (and no - not just that Government debt crisis  we've heard all about): here.

22/11/2011: Contagion Complete - IMF goes leverage

So, the IMF has made a ‘bold’ move, announcing two measures custom-tailored to shore up the insolvent Euro zone until something else, miraculously and unexpectedly cures its deadly disease of too much debt against too low of the quality of its growth.

Details of the latest ‘Leverage Like Lehmans’ scheme.

The Precautionary Credit Line (PCL) “has been established to provide effective crisis prevention to members with sound fundamentals, policies, and institutional policy frameworks that have no actual balance of payments need at the time of approval of the PCL, but moderate vulnerabilities that would not meet the FCL’s [The Flexible Credit Line – see below] qualification standard.”

That’s a mouthful of gibberish. According to the IMF, totally healthy economies will be lining up to borrow from IMF even though they can access funding in the normal markets. Otherwise, they’d be in a distress and ‘prevention’ would really mean ‘once sh*t hits the fan’. Oh, and per IMF, it will be countries that actually don’t really need to borrow as such at all, as they will “have no actual balance of payments need at the time of approval of the PCL”. In other words, PCL aims to supply emergency credit to countries not in emergency and in no need of credit. Yes, folks, indeed they will.

“Members may request an arrangement with duration of between one and two years. Access under an arrangement with one-year duration shall not exceed 500 percent of quota, with the entire amount being made available upon approval of such arrangement and remaining available throughout the arrangement period subject to an interim six-monthly review.”

Here we have it again – if the PCL-using members sport “sound fundamentals, policies, and institutional policy frameworks” and “have no actual balance of payments need at the time of approval of the PCL”, why would IMF need to perform an interim review, especially within such a short time frame as 6 months? Normally, such reviews are carried out to ensure compliance with lending conditions that are designed to stabilize and fiscally improve borrowers’ performance. But, clearly, borrowers with ‘sound fundamentals’ etc have no need to improve their fiscal and economic performance.

“Access under an arrangement with a duration of more than one year shall not exceed 1000 percent of quota, with an initial amount not in excess of 500 percent being made available upon approval of the arrangement and the remaining amount being made available at the beginning of the second year of the arrangement subject to completion of the relevant six-monthly review. Purchases under PCL arrangements are repayable in 8 quarterly instalments 3¼ - 5 years after disbursement.”

So in effect, the IMF has created an up to 7 years lending facility (5 years to repayment from disbursement, plus 2 years to repay) which is roughly speaking similar to their ‘normal’ Lender of Last Resort (LOLR) loans. And that is for members with, recall, ‘sound fundamentals’ and in no need of borrowing. Presumably, you can see Sarko applying for one of them PCL loans to build Disneyland Paris Deux.

And notice the number – at 1000 percent the IMF will be leveraging member contribution some 10 times, to lend against SDRs. That’s a hefty leverage, especially in today’s terms.

The second facility created is less bizarre, although no less disturbing.

“Flexible Credit Line The Flexible Credit Line (FCL) has been established to allow members with very strong track records to access IMF resources based on pre-set qualification criteria to deal with all types of balance of payments problems. The FCL could be used both on a precautionary (crisis prevention) and nonprecautionary (crisis resolution) basis.”

So now, distressed sovereigns can borrow from the IMF either on the needs-based principle (just as the current lending by the IMF goes, except without any caps on how much they can borrow – see below) or on the ‘precautionary’ basis (presumably once you smell the rot, you can get IMF pre-approve you for a mortgage). The former is really a blank cheque for loans to existent and future delinquents. The latter is for those delinquents playing chicken with the markets: who finds out who first – the markets find out the dodgy sovereign or the dodgy sovereign finds the IMF.

“Members may request either a one-year arrangement with no interim reviews, or a two-year arrangement with an interim review of qualification required after twelve months.”

Now there’s something funny going on here. In PCL, a non-distressed sovereign with ‘sound fundamentals’ and in no need of borrowing will be lent to on the back of bi-annual reviews. In the FCL, a dodgy sovereign with unsound fundamentals (BOP crisis) will be borrowing without a review. I have no idea what is going on through the IMF minds, but might this be that the Fund’s effectively abrogating from any enforcement on LOLR loans in the Euro area?

“Upon expiration, the Fund may approve additional FCL arrangements for the member.”

Re: there is no time limit on the loans, so in effect the FCL can be the replacement of the existent more stringent LOLR loans

“Access is determined based on individual country financing needs and is not subject to a pre-set cap. Purchases under FCL arrangements are repayable in 8 quarterly instalments 3¼ - 5 years after disbursement.”

So there is unlimited leverage that is allowed under the FCL. Not even 1,000% or 10,000%, but ‘not subject to a pre-set cap’. Potentially, we are talking Lehman^n where n is any number between zero and… well ‘not subject to a pre-set cap’. The reason such extreme levels of leveraging are needed is that the European clients for whom such programmes are designed need well in excess of their SDR-linked funds, even if these are leveraged at 1,000%.

You see, leveraging SDRs (see allocations here) at 1,000% would allow

• Spain to borrow some SDR40,234mln or roughly speaking (at 1SDR=€1.355) €54.5bn through which Spain will burn, oh, in about 3 months post borrowing.
• Italy to borrow some SDR78,823 or €107bn which won’t float “Fool” Monti for too long.
• Portugal to borrow SDR10,297mln or €13.95bn which is quite below the €20-25bn that it will require in Bailout-2 (see the story here) and that assuming that we leverage it up on top of already leverage-ridden Bailout-1 SDRs.
• Ireland to borrow SDR12,576mln or €17bn – not bad, but not exactly a windfall should Irish economy take a turn for the worst. Note, this is roughly equivalent to what Blackrock estimated will be the losses on owner-occupied mortgages in IRL3 ‘big banks’. Oh, and don’t forget, like Portugal – we are already levered on our SDRs under the Bailout-1.
• Greece, well, assuming Greece can borrow anything else from the IMF, since it managed to double-lever its SDRs in Bailouts-1 and 2 already, to borrow some SDR11,018mln or a miserly €14.9bn.

All of this simply means that if PCL/FCL to have any effect on Euro area debt crisis, it will have to be used as levered borrowing well by the likes of France and Germany to raise funds for… well, might it be EFSF? In other words, solvent member states can claim access to PCL to ‘insure’ private sector buy-in into EFSF. A sort of borrow to buy insurance policy stuff.

We, thus, are no longer in the world with over-leveraged banks, but in the world with over-leveraged banks, central banks, & at last, the over=leveraged lender of last resort. That’s what I call ‘Contagion Complete’. Next stop on the Euro train – the mine shaft. All aboard!

13/11/2011: Euro area - history of insolvency

Nouriel Roubini makes a very compelling argument as to the nature of the Euro area crisis - the nature revealed by unsustainable economic model based on running excessive external deficits and accumulating debt (see his blogpost here).

I have frequently referenced this problem to a deeper underlying force - the propensity of the European social democratic models to spend beyond their means. As the Euro area economies pursued populist agendas of 'social' services and subsidies expansion throughout the 1990s and 2000s, some (indeed majority) of the European economies stagnated, implying diminished capacity to sustain subsidies transfers within the vested interests-run Union. Thus, current account deficits - mask both Government and private sectors imbalances (with Governments in effect pumping the private economy with steroids of debt and cheap interest rates to extract tax rents that can be used to finance political largesse).

To see this, look no further than the links between Current Account deficits (external imbalances across entire economy - public and private) and Government deficits (fiscal imbalances), as well as Structural deficits (fiscal imbalances corrected for recessionary impacts).

Chart below shows cumulated current account deficits for 12 years since 2000 as well as cumulated structural deficits.

The striking feature of this chart is that over 12 years horizon, only 6 countries of the Euro area have managed to post a cumulative external surplus, while only one country (Finland) has managed to live within its means both in terms of external balance and fiscal balance. Any wonder that Finns are so opposed to the idea of 'burden sharing' that will see their surpluses transferred to the profligate states?

Another striking feature of the graph is that, contrary to Mr Roubini's assertion, France too was running dual external and fiscal deficits. Albeit, its deficit on current account side was small. Germany - another paragon of 'stability' run structural deficits on the fiscal side - i.e. spent beyond its means when it comes to Government expenditure outside that needed to correct for recessionary imbalances. Ditto for the Netherlands.

Ireland - our engine of 'exports-led growth' - is, alas, firmly NOT an engine of external balances. Cumulated current account deficit for the country is -19.5% of GDP. Any hopes for reversing 12 years of that experience, folks, will require re-wiring of our economy, preferences, political and institutional structures etc. Good luck getting there before the whole house of cards comes tumbling down.

In fact, deficits are sticky - hard to reverse. Past deficit experience, it turns out, shapes much of the future achievement, as illustrated in the chart below.

Once you are insolvent for a decade (1990s) you are likely to remain insolvent for the next decade too (2000s). And, hence, the headwinds against us (Ireland) reversing that and moving into strong surpluses on current account in years ahead are strong. Not that they can't be overcome. If we look at transition from 1990s external balance position to 2000s position, the following holds:

• Finland and the Netherlands stand out as the only 2 countries that managed to improve their surpluses on the current account side between 1990s and 2000s averages
• France, Belgium and Luxembourg are 3 countries that managed to retain surpluses, but weakened their performance between 1990s and 2000s
• Malta was the only country that managed to reduce its external deficits between 1990s and 2000s in terms of averages
• Portugal, Greece, estonia, Cyprus, Slovak Republic, Sapin, Ireland, Slovenia and Italy all saw average deficits of the 1990s deepening in the 2000s
• Only two economies - Austria and Germany have managed to reverse previous deficits (in the 1990s) to surpluses in the 2000s. 

That means that, historically, a chance of reversing average current account deficit in the previous decade to a surplus in the next decade is 2/17 or less than 12%. not an impossible feat, but an unlikely one.

And current account deficits do appear to relate closely to the General Government deficits and Structural fiscal deficits as the two charts below show (note of caution - the equations estimated below are imprecise, of course, due to small sample).

At last, a table to summarize:

Yep, insolvency - of the deepest (across all three measures) variety is the domain of 10 out of 17 member states when it comes to the last 12 years of Euro area history. Another 5 member states are insolvent by two out of three criteria. Lastly, only two member states - Finland and Luxembourg - were actually fully solvent since 2000.

That, folks, makes for a rather spectacular failure of the Euro area institutional design.