19 November 2012

Illusion of “Safe Havens” and IMF’s Three Policy Scenarios

... Now the future of global economy critically depends on how well the European policy makers deliver what they have promised... And all of their efforts should be centred on restoring market confidence towards the financial sector and government finances, even if this simply means enforcing the illusion of diversifying the immense debt hole away by putting everything into one large pot...

This is the impression that one gets when considering the three scenarios (complete policies, baseline policies and weak policies) in the latest Global Financial Stability Report (GFSR) by the IMF (October 2012). I have summarised and commented these scenarios below.

The starting point, not surprisingly, is the weakness in borrower balance sheets, which is being told by the IMF’s experts to “remain at the forefront of investors’ concerns, as high debt burdens weigh on economic performance while creating the risk of a confidence-driven deterioration in market dynamics“. Fine with that, the data is self-explanatory (see Table 1).
I’ll not discuss this data in detail – just note that every explored advanced economy, not only the so-called PIIGS (also referred to as: euro area periphery), has its own Achilles’ heel. Note also that this heel is largely being ignored by Mr. Market when it comes to the US or Japan or the euro area core. But pay attention to: a) reckless public spending and –debt (UK, US, Japan etc.), and/or b) highly leveraged financial sector (core Europe). Typical: if money is cheaper than its risk-based price (which it is for the perceived “safe havens”), then take it. 

PIIGS or the euro area periphery is the almost notorious group of the five countries: Portugal, Ireland, Italy, Greece and Spain. Some refer to them as GIIPS to avoid analogy with certain domestic animal. In any case, I find the distinction between the “good guys” and the “scapegoats” at least somewhat artificial. The only thing is that this sort of communication has a real and severe impact when it comes to the fragmentation of the eurozone...

Core is defined as consisting of: Austria, Belgium, Finland, France, Germany, and the Netherlands. It is supposed to be strong(er). But: France may be in core only because of political reasons (I’m referring to a recent Economist article when it comes to the country’s economic health). Furthermore, there have been several concerns about Belgium (reasons are obvious from the above numbers), yet as the country is one of the early founding members of the EU and Brussels is the de facto capital of Europe, there is just no (political) way to leave the country out.

Table 2 summarises the three IMF’s policy scenarios as they are being presented in the Oct. 2012 GFSR:

Key message of this Table to the European policy makers is: “Just execute, and preferably well ahead of the current schedule.” (The execution would mean moving faster towards an integrated financial framework, an integrated budgetary framework and an integrated economic policy framework.) Indeed, already the baseline scenario would not materialise without policy makers making progress.

This message is being followed by a threatening warning: “Because if you fail, we really don’t know what is going to happen.” At least so I’d read the phrase “Far-reaching threat to the global financial system and the economic outlook.” The numbers for the weak policies scenario (see Table 3) are creating kind of (false?) confidence or sense of control in any case.

What is worth paying attention is the very fact that the most urgent key determinant of the future global economy is the deleveraging of the eurozone banking sector. The estimated 4.5 trillion euros in weak policies scenario already looks pretty close to my estimated debt hole of 5-6 trillions back in August 2012, especially when accounting for the fact that in the IMF’s sample we only have the 58 largest banks. The way of how this deleveraging would be achieved remains unarticulated though: is it via “money printing” or restructuring and defaults of the many insolvent financial institutions, or via a combination of those two, or...?

The good news is that we have some data to play with. The fact is that this data is just an illusion depending on how we define, measure and forecast economic phenomena. At this point, we should not forget that the World of Finance is just a human creation consisting of subjective opinions and truths that can be adjusted, redefined etc. if we only want to shape them.

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