7/10/15: Bubbles Troubles and IMF Spectacles

As was noted in the previous post (link here), IMF is quite rightly concerned with the extent of the global financial bubbles that have emerged in the wake of the years-long QE waves.

This chart shows the extent of over-valuation in sovereign debt markets:

But the following charts show the potential impact of partial unwinding of the bubbles. First up: bonds:

Then, equity:

Per IMF: “The scenario generates moderate to large output losses worldwide” as chart below shows changes in the output in 2017 under stress scenario compared to benign scenario:

And here’s what happens to projected Government debt by 2018:

         Toasty!

7/10/15: On the Illusion of Financial Stability

IMF’s Global Financial Stability Report for October 2015 is out, titled, predictably “Vulnerabilities, Legacies, and Policy Challenges: Risks Rotating to Emerging Markets”.

It is a hefty read, but some key points are the following.

“Th e Federal Reserve is poised to raise interest rates as the preconditions for liftoff are nearly in place. This increase should help slow the further buildup of excesses in financial risk taking.” As if this is something new… albeit any conjecture that the Fed move will somehow take out some of the risks built up over years of aggressive priming of the liquidity pump is a bit, err… absurd. The IMF is saying risk taking will slow down, not abate.

“Partly due to con fidence in the European Central Bank’s (ECB’s) policies, credit conditions are improving and credit demand is picking up. Corporate sectors are showing tentative signs of improvement that could spawn increased investment and economic risk taking, including in the United States and Japan, albeit from low levels.” So, as before, don’t expect a de-risking, expect slower upticks in risks. The bubbles won’t be popping, or even deflating… they will be inflating at a more gradual pace.

All of which should give us that warm sense of comfort.

Meanwhile, “risks continue to rotate toward emerging markets, amid greater market liquidity risks.” In other words, now’s the turn of EMs to start pumping in cash, as the Fed steps aside.

In summary, therefore, that which went on for years will continue going on. The shovel will change, the proverbial brown stuff will remain the same.

Still, at the very least, the IMF is more realistic than the La-La gang of european politicians and investors. Here are some warning signs:

1. “Legacy issues from the crisis in advanced economies. High public and private debt in advanced economies and remaining gaps in the euro area architecture need to be addressed to consolidate financial stability, and avoid political tensions and headwinds to confidence and growth. In the euro area, addressing remaining sovereign and banking vulnerabilities is still a challenge.” You wouldn’t know that much, but the idea of rising rates and rising cost of funding has that cold steely feel to it when you think of your outstanding mortgage…
2. “Weak systemic market liquidity… poses a challenge in adjusting to new equilibria in markets and the wider economy. Extraordinarily accommodative policies have contributed to a compression of risk premiums across a range of markets including sovereign bonds and corporate credit, as well as a compression of liquidity and equity risk premiums. While recent market developments have unwound some of this compression, risk premiums could still rise further.” Wait a second here. We had years of unprecedented money printing by the Central Banks around the world. And we have managed to inflate a massive bubble in bonds markets on foot of that. But liquidity is still ‘challenged’? Oh dear… but what about all this ‘credibility’ that the likes of ECB have raised over the recent programmes? Does it not count for anything when it comes to systemic liquidity?..
3. The system is far from shocks-proof, again contrary to what we heard during this Summer from European dodos populating the Eurogroup. “Without the implementation of policies to ensure successful normalization, potential adverse shocks or policy missteps could trigger an abrupt rise in market risk premiums and a rapid erosion of policy con fidence. Shocks may originate in advanced or emerging markets and, combined with unaddressed system vulnerabilities, could lead to a global asset market disruption and a sudden drying up of market liquidity in many asset classes. Under these conditions, a signifi cant—even if temporary— mispricing of assets may ensue, with negative repercussions on fi nancial stability.”

In summary, then, lots done, nothing achieved: we wasted trillions in monetary policy firepower and the system is still prone to exogenous and endogenous shocks.

“In… an adverse scenario, substantially tighter fi nancial conditions could stall the cyclical recovery and weaken confi dence in medium-term growth prospects. Low nominal growth would put pressure on debt-laden sovereign and private balance sheets, raising credit risks.

• Emerging markets would face higher global risk premiums and substantial capital out flows, putting particular pressure on economies with domestic imbalances. 
• Corporate default rates would rise, particularly in China, raising fi nancial system strains, with implications for growth.
• Th ese events would lead to a reappearance of risks on sovereign balance sheets, especially in Europe’s vulnerable economies, and the emergence of an adverse feedback loop between corporate and sovereign risks in emerging markets. 
• As a result, aggregate global output could be as much as 2.4 percent lower by 2017, relative to the baseline. This implies lower but still positive global growth.”

Note, the IMF doesn’t even mention in this adverse scenario what happens to households up to their necks in debt, e.g. those in Ireland, the Netherlands, Spain, and so on.

So let’s take a look at a handy IMF map plotting their own assessments of the financial systems stability in October 2015 report compared to April 2015 report. Do note that April 2015 report covers the period right before the ECB deployed its famed, fabled and all-so-credible (per IMF) QE.

Just take a look at the lot. Market & liquidity risks are up (not down), Risk Appetite is down. Macroeconomic risks improved, but everything else remains the same. That is a picture of no real achievement of any significant variety, regardless of what the IMF tells us. Worse, IMF analysis shows that risk appetite deteriorated across all 3 sub-metrics and as chart below shows, market & liquidity conditions have deteriorated across all 4 sub-metrics.

Meanwhile (Chart below), save for household risks, all other credit-related risks worsened too.

Meanwhile, markets are sustained by debt. That’s right: stock prices remain driven by debt-funded net equity buybacks and domestic acquisitions:

Meanwhile, Government bonds are in a massive bubble territory, especially for the little champions of the Euro:

You can see the extent of IMF’s thinking on the topic of just how bad the financial assets bubbles have grown in the following post.

The basic core of the IMF analysis is that although everything was made better, nothing is really much better. In the world of financial stability fetishists, that is like saying we have a steady state of no steady state. In the world of those of us living in the real economy, that is like saying all that cash pumped into the markets over the last seven years and across the globe has been largely wasted. 

Daily Economics 22/04/09: IMF's GFSR

IMF's Global Financial Stability Report (available here) is a lengthy read worthy of attention, both for its finance world-view and a diplomatically correct version of the 'Office' comedy. Subtle language turns tell more of a story of IMF's desperation from looking at APIIGS' incompetent macroeconomic management than the direct phrases. That said, there is little in the report, aside from two tests of financial contagion, that is either new or forward-looking.

"The United States, United Kingdom, and Ireland face some of the largest potential costs of financial stabilization given the scale of mortgage defaults."

Emphasis on the word 'mortgage' is mine, of course, added precisely because the IMF concern has not been, to date, echoed by many Irish economists or banks. In fact, all Irish banks currently assume that mortgage defaults will not happen. Instead, policymakers (via NAMA and debt issuance), bankers (via impairment charges and recapitalization funding) and economists (via RTE / Irish Times opinion pages) have been preoccupied with 'toxic' assets (development loans). Poor households have largely been left out of the 'They deserve help too' circle. The Government actually is so confident that mortgage defaults will not be a problem, that it is taxing households into the recession. As I have noted before, this presents a problem - should inflationary pressures rise, interest rates will regain upward momentum and Ireland will be plunged into a mortgages implosion.

How costly are Lenihan's commitments?
Moving on, two illustrations from the IMF report are worth putting together: First, the sheer size of the so-called 'costless' (Brian Lenihan's grasp of economics), guarantees written by Ireland Inc on our banks:Second, the real-world cost of these guarantees...I've identified this link between the throwaway promises Irish Government has been issuing since September and the cost of our debt before. It is nice to see IMF finally saying the same: "Figure 1.37 highlights that the spread on the issues guaranteed by sovereigns perceived as less capable of backing their guarantee is wider than for those that are deemed well able to stand behind their promises, such as the United States and France."
But here is another proof of the link between Brian Lenihan's guarantees and the cost of these to you and me:
Note the coincident timing: September 2008, and spreads on Government debt shooting through the roof to reach banks bonds spreads and trending from there on side-by-side to Anglo's Nationalization (another spike), then to recapitalization (a slight decline)...

Go long, not short...
The IMF advises the Governments to switch debt issuance to longer term maturities. Exactly the opposite is the strategy adopted by the Irish Government that has launched increasing quantities of new 3-9mo bonds into the markets. "...Authorities should take the opportunity of the currently low level of real long-term yields to lengthen the maturity of issuance where possible to reduce their refinancing risk," says the IMF, implying in simple terms that you shouldn't really pile on short term debt at the time of a prolonged crisis.

For all its faults, even the IMF knows that you can't run the country on the back of credit card debt. But Brian, Brian & Mary wouldn't have a clue, would they? All their experience relates to managing a cash cow for the public sector unions that is our public purse.

Shock scenarios
More interesting stuff is in the IMF's modeling of financial shocks: Scenario 1 (pure credit shock with no fire sale of assets - more like a situation in the US in recent months) v Scenario 2(credit shock with fire sale of assets - a more relevant case scenario for the likes of AIB). Here are the results of the latter test:
In scenario 2, Australia shows 7 double-digit responses to shocks to other countries' financial systems, Austria, Italy, Portugal, Sweden & UK 6; Canada, Japan, Spain & US 5; France 8; Belgium, Germany & Ireland 9; The Netherlands 12; Switzerland 13. This hardly supports an assertion that we are driven by external markets crises in our own financial sector to any exceptional degree. Yes, we are less exposed than Switzerland and the Netherlands, but we are way more exposed than the many other countries.

The table below (it is the same table that was reported by me in December 2008) shows that we have the second highest (after Luxembourg) ratio of Bonds, Equities and Banks Assets to GDP in the world - a whooping 900%!

Furthermore, Table 23 provides some amazing evidence: Banks Capital to Assets in Ireland stood at only 4.1% in 2008, down from the high of 5.2% in 2003. Only Belgium and The Netherlands have managed to get lower ratio in 2008. Irish Central Bank actually provided these figures to the IMF and yet the CB has managed to do precious nothing to correct the steadily deteriorating capital ratios throughout 2003-2008 period. This, presumably is why we pay our CB Governor a higher salary than the one awarded to his boss, the ECB Chief.

So the 'comedy' part now being played in Dublin has a simple scenario that IMF, with its diplomatic mission, will not reveal to us, but that is visible to a naked eye though the prism of the IMF report:

1. Incompetent state regulators (CBFSAI and more) get golden parachutes for damaging the financial services sector and the economy;
2. Incompetent and greedy politicos are shielding their unions', banks' and developers' cronies from risk and pain caused by (1);
3. The ordinary people and businesses of Ireland are paying for (1) and (2).

And the markets still show willingness to powder this charade with 110% bids cover on Irish Government bonds? For how long?