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IMF: Financial fragilities and deterioration catalyses eurozone crisis

The International Monetary Fund has unveiled a cripplingly bearish set of reports that reveals widespread financial deterioration, dimmed growth prospects and escalated downside risks are to continue in 2012. Bank funding and losses cause the most concern.

The International Monetary Fund (IMF) has unveiled a set of three reports – World Economic Outlook (WEO) 2012, Global Financial Stability Report Update and the Fiscal Monitor Update – which have all revealed that "financial conditions have deteriorated, growth prospects have dimmed and downside risks have escalated".


The IMF says global growth prospects dimmed and risks sharply escalated during the fourth quarter of 2011, as the "euro-area crisis entered a perilous new phase", which has led them to downwardly revise the global output by 0.75 of a percentage point, relative to the September 2011 WEO.   Global output is projected to expand by 3.25% in 2012 (Figure 1).

As Euromoney has reported for some time, emerging and developing markets have not remained unscathed.

According to the IMF's WEO report, "growth in emerging and developing economies slowed more than forecast, possibly due to a greater-than-expected effect of macroeconomic policy tightening or weaker underlying growth".


Previously, Euromoney reported on how the sovereign-debt contagion would spread eastwards. The World Bank and the IMF had been warning for some time that there would be overhang for the developing markets.

In November, Bert Hofman, the World Bank’s chief economist for the East Asia and Pacific region, outlined his concerns.

"Lower growth in Europe in the course of fiscal austerity and the banks' need to increase capital coverage would affect East Asia," said Hofman. "Less credit from European banks can also affect capital flows to East Asia, but high reserves and current account surpluses protect most countries in the region against the impact of possible renewed financial stress."

 (Figure 2)
Net fund flows to emerging markets

 Source: IMF and EPFR Global

And in October, the IMF also warned of a a macroeconomic and financial spillover in Asia, as it forecast a slowdown in the area’s growth, while increasing the number of downside risks.

Despite market participants ploughing resources and efforts to expand into emerging markets, such as Asia, the IMF also warned in October that the liquidation of foreign investor positions was a huge concern.

“Since 2009, investors from advanced economies have built up substantial positions in Asian markets, including Indonesia and other Asian sovereign debt markets,” stated the IMF in the 55-page report. “A sudden liquidation of these positions could trigger a loss of confidence, and contagion could spread from bond and equity markets to currency and other markets.  'Crossover’ investors in Asia – funds that are benchmarked against a mature market index but engage in investments in Asian emerging markets to boost returns – have expanded in recent years and they could cut positions more quickly than dedicated funds that are benchmarked against a regional index.”

Also, with the global financial crisis continuing – now with more of a focus on sovereign debt concerns – the IMF has highlighted worries over the repatriation of liquidity by European banks.

Asian banks have cut exposures to European banks and sovereigns since May 2010, but contagion could still occur through foreign banks, which could sell assets, not roll over maturing loans, and cut credit lines in Asia if they face large losses at home,” the IMF states. “Such cutbacks could have a sizeable impact in Asian economies that have large exposures to European and US banks.”

 (Figure 3)
Recent Financial Market Developments


Sources: Bloomberg Financial Markets
and IMF Staff Calculations
1.Vertical lines on each panel correspond to May 10
and November 30, 2010.
2.ECB = European Central Bank; LIBOR = London interbank
offered rate; OIS = overnight index swap.
3.VIX = Chicago Board Options Exchange Market Volatility
Index, a measure of the implied volatility of options on the
S&P 500 index; VXY = JPMorgan emerging markets implied
volatility index, a measure of the aggregate volatility in
currency markets.
4.TOPIX = Tokyo stock price index; MSCI = emerging markets
stock price index.
5.Bilateral exchange rates against the U.S. dollar
(increase denotes depreciation).
6.APSP = average petroleum spot price

This has all since been confirmed in the three IMF reports (Figure 2).

"In emerging and developing economies, the near-term focus should be on responding to moderating domestic demand and slowing external demand from advanced economies, while dealing with volatile capital flows," says the IMF in the 2012 WEO report. "The specific conditions facing these economies and the policy room available to them vary widely, and so will the appropriate policy response. In general, inflation pressures have eased, credit growth has peaked, and capital inflows have diminished (Figure 2)."


"Economies where inflation is under control, public debt is not high, and external surpluses are appreciable (including China and selected emerging economies in Asia) can afford to deploy additional social spending to support poorer households in the face of weakening external demand," it adds.

Furthermore, the most crucial part of the report seems to fall on the near-term outlook and the latest developments in the financial markets (Figure 3).

"The near-term outlook has noticeably

deteriorated, as evidenced by worsening high-frequency indicators in the last quarter of 2011 [Figure 3]," says the IMF. "The main reason is the escalating euro-area crisis, which is interacting with financial fragilities elsewhere. Specifically, concerns about banking sector losses and fiscal sustainability widened sovereign spreads for many euro-area countries, which reached highs not seen since the launch of the Economic and Monetary Union."

Crucially, bank funding is in the spotlight.

"Bank funding all but dried up in the euro
, prompting the European Central Bank (ECB) to offer a three-year Long-Term Refinancing Operation (LTRO)," says the IMF. "Bank lending conditions moved sideways or deteriorated across a number of advanced economies."

In our January edition of the magazine, Euromoney asked whether Europe’s leaders will do enough to convince banks to finance its problem sovereigns through an ECB-led carry trade?

The ECB’s first three-year long-term refinancing operation on December 21 achieved its main task of easing funding pressures on European banks facing large-scale redemptions in the first half of this year.

It has not, however, eased the pressures on governments and if they continue to struggle to roll over financing at affordable cost, the European sovereign and financial system crisis could return with a vengeance at any time.

Also, in the same edition of Euromoney magazine, as the European bank-funding crisis pushes banks to fund themselves ever shorter-term, concerns are growing that collateral, the lifeblood of all secured borrowing, is running out.

"The events of the summer have not been conducive for the good collateral to stay in the system," said Manmohan Singh, senior economist at the IMF in an exclusive interview with Euromoney in December 2011. "The reduction in the stock of collateral and length of collateral chains that I mention in my papers is very likely to have increased this year. Markets have been even more timid given what we have seen in the eurozone. I would not expect to see a better collateral stock than $5 trillion. People are simply too scared of counterparty risks.

"Every monetary transmission needs lubrication, and if it dries up, the machine probably won’t work as expected. Global financial lubrication cannot be ignored in the context of monetary policy. If financial lubrication is reduced, then the objective of interest-rate policy cannot be passed into the real economy."

Across today's IMF reports, "decisive and consistent policy action is urgently needed". It outlined four key issues that would need to tackled: fiscal adjustment; liquidity; bank deleveraging; and financial adjustment.

"The current environment – characterized by fragile financial systems, high public deficits and debt, and interest rates close to the zero bound – provides fertile ground for self-perpetuating pessimism and the propagation of adverse shocks, the most critical of which is a worsening of the crisis in the euro area," says the IMF. "In this setting, there are three requirements for a more resilient recovery: sustained but gradual adjustment; ample liquidity and easy monetary policy, mainly in advanced economies; and restored confidence in policymakers’ ability to act."

"Importantly, not all countries should adjust in the same way, to the same extent, or at the same time, lest their efforts become self-defeating. Countries with relatively strong fiscal and external positions, for example, should not adjust to the same extent as countries lacking those strengths or facing market pressures. Through mutually consistent actions, policymakers can help anchor expectations and re-establish confidence," it adds.

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