from Follow the Money

Give the IMF credit (literally, and figuratively)

April 21, 2009

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One issue to watch over the next few days, as the world’s finance ministers gather for the IMF’s spring meetings: whether or not the G-20 (and other) countries carry through on their pledge to expand the resources available to the IMF.

The IMF cannot supply credit to a host of troubled emerging markets unless it gets credit (via its supplementary credit line, or a bond issue sold to key central banks with excess reserves) from a bunch of countries in a (somewhat) stronger financial position.

But also give the IMF credit for producing analysis that has become an essential guide to the current crisis. Like Dr. Krugman, I am eagerly awaiting the release of first few chapters of the WEO tomorrow. That is something that I couldn’t have credibly said all that often in the past. The detailed WEO will provide a baseline, among other things, for assessing whether the fall in the world’s macroeconomic imbalances in the first quarter can be expected to persist for this year, and for the next.

The IMF’s Global Financial Stability Report – released today – already provides a baseline for assessing the scale of the losses that the last credit cycle will generate (gulp, over $4 trillion, with $2.8 trillion from the US – two times as much as the IMF forecast in October) and thus, in broad terms, the scale of the new capital the financial sector needs.

This crisis challenged the IMF. A truly global crisis calls out for a global response, underpinned by high-quality global analysis. A few years back, the IMF’s surveillance wasn’t perhaps as focused on the underlying risks of an unbalanced and highly leveraged world as it should have been. Just look at the IMF’s 2007 economic health check for the US , which declared – a minus a caveat or two - that the core of the US financial sector was well capitalized and “relatively protected from credit risk” (see paragraph 5, on p 10 of the staff report/ and paragraph 5 of the PIN/ ). Oops.

Of course, the IMF’s assessment of the US financial sector echoed the conventional wisdom of the time. And, in other areas, the IMF can credibly argue that it highlighted risks that others wanted to ignore. It, for example, consistently called attention to the build-up of balance sheet risk in emerging Europe.

Suffice to say that the IMF didn’t risk making the same mistake in its current Global Financial Stability Report. Chapter 1 of the Global Financial Stability Report makes for sobering reading.

The IMF paints a picture of a global economy where neither large financial institutions in the world’s economic and financial core nor those emerging market governments with large external financing needs can count on financing themselves in private markets. Both sets of borrowers, in effect, now rely on the support of official institutions, whether the IMF, the the world’s large central banks or taxpayers. The financial sector relies on official support for the money it can no longer raise in the “wholesale” funding market*, and emerging markets to offset the withdrawal of cross-border bank lending.

On p. 39, the IMF writes: “private bank funding markets are mostly closed – banks rely on central banks and the government (for guaranteed unsecured financing)” Even relatively healthy large the banks – the kind that are assumed to be too systemically important to fail – still cannot consistently obtain long-term financing without an explicit government guarantee. Call it the Fannie and Freddie problem: right now, a still-nervous market isn’t willing to accept implicit guarantees.

Table 1.7 shows the scale of European (eurozone and UK) banks reliance on wholesale financing. It is rather extraordinary. I would though be interested if Alea thinks the IMF’s analysis overstates European banks wholesale funding needs.

And on p. 58 (annex 2, figure 1.45): The IMF’s model for emerging market lending that the world’s big banks, which the emerging world about 2.5% of the emerging world’s GDP, will pull twice that much credit from the emerging world over the next few years.

“the model’s projection … implies a sudden stop, with substantial net outflows of other investment [bank lending, in balance of payments-ese] that average 5% of GDP over the next few years. Outflows of this magnitude were registered in the late 1990s by several southeast Asian countries in the 1990s, and in the early 1980s by Latin American countries.”

That may be a bit too pessimistic, but it does illustrate the overarching risk. The IMF, in effect, says that the there is a real risk that the world of the next few years will be marked by a long hard slog of deleveraging, not a quick rebound of confidence.

The good news – such as it is – comes on p. 34, in the widely cited IMF’s table 1.4. It shows the IMF’s estimates of the size of the financial sector’s losses. The IMF estimates that US banks need about $300 billion to get back to their pre-crisis leverage levels, and $500 billion to get back to their leverage levels of the 1990s. That is (roughly) 2-3% of US GDP.

I fully understand the political difficulties of getting this money – and putting equity into the banks it in a way that is perceived as fair by both the taxpayer and the banks’ employees. But this – as Dr. Bernanke has noted -- isn’t a sum that is beyond the United States’ fiscal capacity.

The UK, frankly, has it far worse. Its banks are estimated to need about ½ as much capital as US banks, and the UK’s economy isn’t close to half the size of the US economy.

Other tidbits that jumped out at me (underlying data can be found here):

-- The IMF forecasts emerging markets will see outflows of 2% of their GDP from the banking sector (“other investment”) and 1% of GDP from the sale of their securities by investors in advanced economies (“portfolio investment”). On the banking side, the outflows seem a bit smaller than what the IMF’s model would blindly forecast based on its input variables. (p. 7)

-- The IMF forecasts that the UAE will run almost as large a current account deficit as Pakistan (both are in the 5-6% of GDP range). Given its maturing debts and this financing need, the Emirates isn’t – based on this analysis – cash rich, though ADIA still has a large stock of assets. (p. 10/ table 1.1)

-- The IMF forecasts a far bigger contraction in private credit growth to emerging economies than in the 97/98 crisis. That is probably too pessimistic – China will make sure of that. But most emerging economies are in a quite different position than China, which pushed up its external surplus by holding loan growth below deposit growth from 04 on (p. 16/ figure 1.15)

-- Figure 1.20 (on p. 23) shows expected loan losses in the US relative to the history of the past 30 years – it isn’t a pretty picture. Figure 1.30 (p. 30) shows bank loan charge-offs over a very long time period. Forecasts charges (i.e. losses) aren’t expected to exceed those in the 1930s, but they are very large. Look at the figure. A core function of the financial system, presumably, is to lend money to those who can pay it back. If the IMF’s analysis is right, the US financial sector didn’t too a particularly good job of this – And presumably scaling bad loans across this lending cycle to financial sector pay across this lending cycle wouldn’t improve the picture.

After reading the IMF’s financial stability report, I find it hard to argue with Dr. Wolf, who writes:

‘Governments of wealthy countries have also put their healthy credit ratings at the disposal of their misbehaving financial systems in the most far-reaching socialisation of market risk in world history.

To take an extreme example, Ireland is -- per the IMF (Table 1.10) planning to try to issue something like $640 billion in guaranteed debt. And Ireland is a rather small country.

* wholesale funding is, in very broad, terms bank financing that doesn’t come from small insured depositors.

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