The Euro Crisis: Thinking Inside the IMF

by Elliott R. Morss

Introduction

The IMF (International Monetary Fund) IS maligned and misunderstood. I know. I used to work there. The Fund was not set up to design and implement stimulus packages, nor has unemployment ever been a high-priority concern. But when an economy is overheated, usually manifested by a rapidly expanding money supply, large government and trade deficits, and inflation, it knows how to apply the screws. And it would appear that in the case of Greece and a number several other Euro countries, it is most definitely time to apply the screws.

In what follows, I give a brief summary on economic problems in Euro countries followed by my interpretation of what the IMF really thinks about these problems.

The Euro Countries

In earlier pieces, I have documented the problems facing certain Euro countries. Here I will summarize what they are facing. Table 1 provides population and GDP/P data on the largest countries using the Euro (with the UK and the US as reference points). Note that with the exception of Ireland, the “problem” countries have lower per capita incomes.

Table 2 provides “economic performance data on the same set of countries. Remember that these countries do not have their own central bank. That means the same monetary policy applies to all of them. To say this is problematic is putting it mildly. Applying the same monetary policy to countries with unemployment rates ranging from 4% to 19% means it is impossible “to get it right” for them all.

Consider next what the IMF considers to be “problem indicators”:

  • government debt,
  • government deficits, and
  • current account deficits.

It is clear why Greece is in such trouble, and why Italy, Ireland, Belgium, and Portugal are to a somewhat lesser degree. And how about France and the US? In contrast, look at the economically strong Euro countries: Germany, Austria, and the Netherlands.

It is important to understand what happens to countries that use an international currency. When you run a current account deficit, the money supply falls as it is used to cover the deficit. And if a government cannot borrow, it becomes totally dependent its own revenues. The ability to borrow? It depends on what potential lenders think….

With this as background, we turn back to the IMF thinking on Greece.

What Does the IMF Think?

There are really two faces of the IMF – the political/public one and what its well-trained staff really thinks. By looking carefully at some fund documents we can get a reading on what its staff is thinking.

Consider first quotes appearing in its Fourth Review of the joint European Central Bank (ECB) /IMF support for Greece. My comments are in caps.

“Since March, spreads on 2-year and 10-year debt over German bunds have soared to record highs, exceeding 2650 bps and 1400 bps, respectively. Rating agencies have at the same time downgraded Greece to near-default status, with current ratings now at CCC (Standard & Poors), Caa1 (Moody’s), and B+ (Fitch).”

IF I GOT MY DECIMALS RIGHT, THIS MEANS GREECE MUST PAY MORE THAN 27% TO GET BORROWERS FOR 2-YEAR LOANS – OUCH. NOT SUSTAINABLE.

“Recent ratings downgrades have also led to a decrease of value on Greek collateral by the European Central Bank (ECB), necessitating banks to post additional collateral. Wholesale funding markets remain closed and exceptional ECB liquidity support has grown.”

BANKS BORROWING FROM THE ECB USING GREEK DEBT AS COLLATERAL HAVE HAD TO POST MORE COLLATERAL OR REDUCE THEIR BORROWINGS.

“The Greek government deficit appears to have settled at 10½ percent of GDP, ¾ percent of GDP higher than earlier estimated, but the adjustment is still impressive in the context of the recession.”

THE GOVERNMENT DEFICIT IN 2011 HAS TURNED OUT WORSE THAN THE IMF ESTIMATED IT WOULD BE EARLIER.

“An amendment to the Loan Facility Agreement was signed on June 14, allowing for a retroactive maturity extension to EFF-equivalent terms and a lowering of the spread over euribor rates by 100 bps, which would bring the current cost of borrowing to around 3.7 percent. By shifting the amortization profile, this would lower gross market financing needs by some €47 billion over 2012–15.”

ON AVERAGE, GREECE HAS BEEN PAYING 4.7 PERCENT ANNUALLY ON ITS LOANS. UNDER THE LATEST DEFAULT/NON-DEFAULT AGREEMENT WITH CREDITORS, THAT RATE HAS BEEN REDUCED TO 3.7% WITH REPAYMENT STRETCHED OUT OVER MORE YEARS.

I INTERJECT THE FOLLOWING FROM A RECENT ECONINTERSECT ARTICLE:

“European banks are facing huge losses as a result of the restructuring/bailout hybrid solution reached last week by EU ministers in Brussels. Private creditors agreed to take a 21% writedown loss on their Greek debt holdings, according to Reuters. The same source says about €98 billion of Greek debt is held by European banks. Of that, about 2/3 is in domestic hands. That leads to hit for non-Greek banks in Europe to take a loss of €6.8 billion (98 x 0.33 x 0.21 = 6.79). Reuters says the loss is €5.4 billion; presumably the difference is buried in the minutiae of the distribution of the bailout funds. They have now been increased by additional €15 billion to bring the total to €25 billion.”

HOW IMPORTANT ARE €25 BILLION TO EUROPEAN BANKS? QUITE IMPORTANT. THE ECB REPORTS THAT REQUIRED RESERVES FOR EUROPEAN MEMBER BANKS WERE APPROXIMATELY €208 IN EARLY JULY.THAT MEANS A WRITE-DOWN OF €25 WILL HURT.

BACK TO THE IMF:

“If the authorities are able to implement their very ambitious fiscal and privatization programs, public debt would peak at 172 percent of GDP in 2012 and decline to 130 percent of GDP by end-2020 (compared with 159 and 130 percent of GDP at the third review)….

However, stress testing shows that full and timely program implementation is absolutely critical: incomplete fiscal adjustment, privatization shortfalls, or delays in structural reform implementation (producing a considerably slower economic recovery and fiscal adjustment) would see debt remain at very high and likely unsustainable levels through 2020.”

MY INTERPRETATION OF IMF QUOTE IN BOLD – FUND STAFF BELIEVE IT IS HIGHLY UNLIKELY GREEK AUTHORITIES WILL REALIZE PROGRAM TARGETS.

“The problems of public finance that Greece is confronting—a weak revenue administration, bloated public employment, untargeted social support, a fragmented and oversized public administration—are not easy to overcome, not least against the headwinds of a deep recession and rising interest payments. This explains the five year time path for the adjustment.

Staff did express concern that too much reliance is being placed on revenue measures, noting the lack of broad popular support in Greece for such an approach, and that this could work against efforts to improve tax administration. It was therefore agreed that tax reform would be on the agenda for the fall….”

SINCE THE THIRD REVIEW, THINGS HAVE GOTTEN MUCH WORSE.

The following quotes come from an IMF Staff Report on the 2011 Article IV Consultation with Euro Member Countries. Once again, my comments are in CAPS.

“Banks in Greece, Ireland and Portugal have significantly increased their government debt exposure during 2010. Shunned by financial markets and faced with deposit withdrawals, they survive only because the ECB meets in full their demands for liquidity against collateral of rapidly declining quality.

THE SOVEREIGN DEBT OF THE EURO “PROBLEM” COUNTRIES IS LOOSING VALUE. THE ECB HAS BEEN PICKING THE ENTIRE TAB. IN GREECE, THE ECB SUPPORT IS PROJECTED TO CONSTITUTE 22% OF TOTAL BANKING SECTOR ASSETS (€100 BILLION) BY THE END OF 2011.

“Sudden large credit losses may trigger a bank run in the absence of adequate liquidity and bank recapitalization facilities. Strengthened commitments to deposit insurance schemes, and domestic guarantees on bank assets and new debt issuances would further reduce market fears. A sovereign or bank default may affect the incentive structure of other sovereigns and banks.”

THE FUND IS WORRIED ABOUT HOW PROBLEMS MIGHT SPREAD. IT APPEARS UNSURE THAT DEPOSITS HAVE ADEQUATE INSURANCE RESERVES.

“A credit event may reveal unexpected counterparty risks if sellers of default protection cannot live up to commitments.”

LET’S SEE. SELLERS OF DEFAULT PROTECTION NOT LIVING UP TO COMMITMENTS? IT SOUNDS FAMILIAR. OH YES. AIG.

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