In recent years, the IMF has substantially improved its analytical coverage of the world economy. In addition to its semi-annual World Economic Outlook, it now also publishes reports focused on the global financial system (the Global Financial Stability Review) and government fiscal policy (the Fiscal Monitor). The most recent versions of these three reports were released in September, 2011. They do not make for encouraging reading. Nonetheless, any investor struggling to take appropriate action in the face of the complexity and uncertainty we confront today must be familiar with their contents, which we will briefly summarize here.
Let's start with the latest Fiscal Monitor, as questions surrounding sovereign debt sustainability lie at the heart of the growing crisis we face today. The IMF notes that "Global fiscal risks remain very high, stemming from several unresolved, interrelated challenges:
Sustainability and market sentiment in the euro area. Despite significant fiscal adjustment in most advanced European economies and the mid-July 2011 agreement by leaders of the euro area countries to improve the tools available to fight crises, borrowing costs remain high in several euro members, reflecting market participants' concerns about the sustainability of fiscal policies and public debts. Such concerns - which had their origin in weak fiscal fundamentals but subsequently intensified owing to doubts about the credibility of the euro area crisis resolution mechanisms - jeopardize the stability of the area, with major potential spillovers for other sovereign debt markets."
"Medium-term fiscal adjustment in the United States and Japan. Fiscal deficits remain at near-record levels in the two largest advanced economies, and their debt ratios continue to rise. These two countries benefit from large stores of goodwill from investors, but these favorable conditions could shift if needed policy changes are not forthcoming."
"Using good times wisely in emerging economies. There are risks of complacency, with the key question being whether fiscal balances should not be strengthened more rapidly, given output gaps that have essentially closed in many emerging economies, rising inflation, and strong revenues, particularly for commodity exporters."
"Debt overhang from the crisis and long-term challenges. For both advanced and emerging economies, the debt burden created by the crisis needs to be reduced, over the longer term, against the rising tide of health care and pension spending. The challenges confronting many economies in this regard are essentially without precedent."
The Fiscal Monitor has some pointed words of caution for governments in Japan and the United States: "The speed and severity with which financial pressures spread in the euro area should serve as a cautionary tale to Japan and the United States...Low interest rates in the United States and Japan partly reflect structural factors, including some that do not seem likely to change abruptly in the near term:
A substantial share of domestic debt holdings. In Japan, close to 95 percent of public debt is held domestically. The share is lower for the U.S. federal government, but rises to 70 percent for the general government. Moreover, the share of debt held domestically increases further for the United States if holdings by foreign central banks are excluded. This is significant, because private nonresidents maybe more willing to shift their investments out of a country than are domestic investors, and foreign central banks may follow different investment practices than do other market participants."
"Significant local central bank debt purchases. The U.S. Federal Reserve has purchased 7 percent of GDP in Treasury securities (cumulative, under its quantitative easing programs), an amount equivalent to 12 percent of publicly held Treasury securities. Government securities purchases under the Bank of Japan's Asset Purchase Program have so far amounted to 1 percent of GDP. (If transactions undertaken as part of traditional monetary policy operations are included, the share of bond purchases undertaken by the Bank of Japan rises to17 percent of GDP.) Large purchases by local central banks also took place elsewhere (gilt purchases by the Bank of England under the Asset Purchasing Facility amounted to 11 percent of GDP, and the purchases by the ECB amount to a large share of securities issued mean that not all debt issued by these countries has yet been subjected to a market test."
"Strong demand by a relatively stable investor base. Institutional investors - including insurance companies, mutual funds, and pension funds - hold 24 percent of government securities in Japan and 12 percent of Treasury securities in the United States. A further 22 percent of U.S. Treasuries and an estimated 2 percent of Japanese government bonds are held by foreign official entities. In addition, more than one third of U.S. Treasuries issued by the federal government are held by other government agencies, including the Social Security Fund, and 20 percent of Japanese government bonds are held by Japan Post Bank... The widening crisis in the euro area should nevertheless serve as a cautionary tale for the United States and Japan, as well as other countries with high debts and deficits..."
[However], "the relatively benign treatment by market participants of sovereign bonds issued by Japan and the United States may not fully reflect fiscal fundamentals: current general government debt and deficits, and projected increases in debt over the next five years, are at least as high for the United States and Japan as they are for several euro area economies under market pressure or the euro area in general. In addition, projected long-term increases in pension and health care spending in the United States are larger than in many euro area economies. Japan and the United States face the largest gross financing requirements among all advanced economies this year and are projected to do so in 2012 and 2013 as well, reflecting their large deficits and debt stocks as well as their still relatively short debt maturity profiles... Recent developments in Spain and Italy demonstrate how swiftly and severely market confidence can weaken and how even large advanced economies are exposed to changes in market sentiment..."
The Fiscal Monitor also includes this short but very interesting point about China: "New figures indicate that China's debt stock, previously believed to be one of the lowest among emerging economies, is in fact close to the group average. The degree to which the new debt figures may constrain the scope for countercyclical policies in China going forward is difficult to assess."
The IMF concludes that "it is difficult to overstate the challenge confronting many advanced economies and some emerging market economies, as the adjustment required to restore their debt ratios to more moderate levels is daunting...While there is wide variation across countries, adjustment needs average about 8 percent of GDP over the next decade for advanced economies and equal 13 percent of GDP in Japan...Adjustment needs in both advanced and emerging economies are even greater when the projected growth of health and pension spending over the next two decades is taken into account...several advanced economies the required primary surplus is well above levels they have sustained in the past...an extended period of extraordinary fiscal virtue will be required over the coming decades to restore debt ratios to more normal levels."
The Global Financial Stability Report contains a wealth of data, including the following fascinating table:
Indebtedness and Leverage in Selected Advanced Countries
Percent of 2011 GDP
|Government Gross Debt||100||233||81||89|
|Government Primary Balance||-8.0||-8.9||-5.6||-1.5|
|Households Gross Debt||92||77||101||70|
|Nonfinancial Corporate Gross Debt||90||143||118||138|
|Financial Institutions Gross Debt||94||188||547||143|
|Bank Claims on Public Sector||8||80||9||n.a.|
|Total Economy Gross External Liabilities||151||67||607||169|
|Government Debt Held Abroad||30||15||19||25|
|Government Gross Debt||95||87||83||166||109||121||106||67|
|Government Primary Balance||-0.3||-3.4||0.4||-1.3||-6.8||0.5||-1.9||-4.4|
|Households Gross Debt||53||61||60||71||123||50||106||87|
|Nonfinancial Corporate Gross Debt||175||150||80||74||245||110||149||192|
|Financial Institutions Gross Debt||112||151||98||22||689||96||61||111|
|Bank Claims on Public Sector||23||17||23||28||25||32||24||24|
|Total Economy Gross External Liabilities||390||264||200||202||1680||140||284||212|
|Government Debt Held Abroad||58||50||41||91||61||51||53||28|
This table makes a number of critical points. As you can see, high household debt/GDP is much more of a problem in the Anglosphere than it is elsewhere. However, in the global context, the Anglosphere's household debt problem has an outsized effect, as these countries have been much greater contributors to global demand, as evidenced by their ratios of private consumption to GDP (e.g., 66% in the UK and 71% in the US in 2010, compared to 34% in China, 57% in India, 58% in the Eurozone, 59% in Japan, and 61% in Brazil). To the extent that high household debt levels are restraining consumer spending in the Anglosphere (as the evidence indicates), and to the extent that China and other countries do not offset this fall, then global final demand weakens, as it is ultimately final consumption spending by the private and public sectors that drive GDP growth derived from investment spending and net exports.
Another set of interesting data points are those involving the financial sector. The size of Irish banks' gross debt/GDP stands out, and makes clear the roots of the crisis there, where bad property loans in the banking system, and the government's ill-judged decision to stand behind its banks, have forced a tremendous downturn upon that country. The UK is the only other nation that comes close to Ireland on this metric. Another key indicator, which highlights the issue that lies at the heart of the current Eurozone banking crisis, is "Bank Claims on the Public Sector" as a percent of GDP. Essentially, this represents the amount of sovereign debt the banks have on their books. As you can see, this is extremely high in Japan, and much higher in the Eurozone than in the U.S. or U.K. And if the creditworthiness of that sovereign debt comes into question, so too does the quality of banks' assets, and the sufficiency of the capital that supports them. Also interesting is the ratio of non-financial corporate debt/GDP. While in the Anglosphere press the point is often made that corporate have strong balance sheets and large amounts of unspent cash, a look at this table shows that this point does not necessarily apply to Japan and the Eurozone, where corporate balance sheets are more leveraged (with further attendant consequences for bank credit quality).
On the sovereign debt front, the table highlights different potential sources of vulnerability, including the absolute amount of government debt relative to GDP, the size of the primary government budget surplus or deficit (in the case of the latter, this plus maturing debt must be financed by new borrowing each year), and the amount of government debt held by foreign investors (who, presumably, would be the ones most likely to flee in the face of problems, and potentially trigger a crisis). A comparison of other countries' indicators to those for Greece suggests that current concerns over Spain may be overdrawn, concerns over Italy are appropriate, and worries about Belgium may have been overlooked.
The Global Financial Stability Report bluntly concludes that "Risks are elevated, and time is running out to tackle vulnerabilities that threaten the global financial system and the ongoing economic recovery. The priorities in advanced economies are to address the legacy of the crisis and conclude financial regulatory reforms as soon as possible in order to improve the resilience of the system...Perhaps most crucially, the policy tools available in most advanced economies are geared to combating temporary liquidity shocks rather than tackling concerns about solvency. The result is that balance sheets have not been "cured," and the financial system remains highly vulnerable to sovereign risks."
More broadly, the IMF notes that, "public balance sheets in many advanced economies are highly vulnerable to rising financing costs, in part owing to the transfer of private risk to the public sector. Strained public finances force policymakers to exercise particular care in the use of fiscal policy to support economic activity, while monetary policy has only limited room to provide additional stimulus. Against this backdrop, the crisis -- now in its fifth year -- has moved into a new, more political phase."
"In the euro area, important steps have been taken to address current problems, but political differences within economies undergoing adjustment and among economies providing support have impeded achievement of a lasting solution. Meanwhile, the United States is faced with growing doubts over the ability of the political process to achieve a necessary consensus regarding medium-term fiscal adjustment, which is critically important for global stability. As political leaders in these advanced economies have not yet commanded broad political support for sufficiently strengthening macro-financial stability and for implementing growth-enhancing reforms, markets have begun to question their ability to take needed actions..."
"In the euro area, sovereign pressures threaten to reignite an adverse feedback loop between the banking system and the real economy. The euro area sovereign credit strain from high-spread countries is estimated to have had a direct impact of about 200 billion Euros on banks in the European Union since the outbreak of the sovereign debt crisis in 2010. This estimate does not measure the capital needs of banks, which would require a full assessment of bank balance sheets and income positions. Rather, it seeks to approximate the increase in sovereign credit risk experienced by banks over the past two years. These effects are amplified through the network of highly interconnected and leveraged financial institutions; when including interbank exposures to the same countries, the size of spillovers increases by about one half. Banks in some economies have already lost access to private funding markets. This raises the risk of more severe deleveraging, credit contraction, and economic drag unless adequate actions are taken to deal with the sources of sovereign risk -- through credible fiscal consolidation strategies -- and to address the potential consequences for the financial system -- through enhancing the robustness of banks..."
"With growth remaining sluggish in the advanced economies, low rates are appropriate as a natural policy response to weak economic activity. Nevertheless, in many advanced economies some sectors are still trapped in the repair-and-recovery...phase of the credit cycle because balance sheet repair has been incomplete, while a search for yield is pushing some other segments to become more leveraged and hence vulnerable again. Moreover, low rates are diverting credit creation into more opaque channels, such as the shadow banking system. These conditions increase the potential for a sharper and more powerful turn in the credit cycle, risking greater deterioration in asset quality in the event of new shocks..."
"Emerging market economies are at a more advanced phase in the credit cycle. Brighter growth prospects and stronger fundamentals, combined with low interest rates in advanced economies, have been attracting capital inflows. These flows have helped to fuel expansions in domestic liquidity and credit, boosting balance sheet leverage and asset prices. Especially where domestic policies are loose, the result could be overheating pressures, a gradual buildup of financial imbalances, and a deterioration in credit quality, as nonperforming loans are projected to increase significantly in some regions. At the same time, emerging markets face the risk of sharp reversals prompted by weaker global growth, sudden capital outflows, or a rise in funding costs that could weaken domestic banks."
The World Economic Outlook opens with what is, by the standards of typical diplomat-speak, a blunt, succinct letter from Olivier Blanchard, the IMF's chief economist. It is worth reading in full, as the WEO is really just an elaboration of the key points he makes:
"Relative to our previous World Economic Outlook last April, the economic recovery has become much more uncertain. The world economy suffers from the confluence of two adverse developments. The first is a much slower recovery in advanced economies since the beginning of the year, a development we largely failed to perceive as it was happening. The second is a large increase in fiscal and financial uncertainty, which has been particularly pronounced since August. Each of these developments is worrisome -- their combination and their interactions more so. Strong policies are urgently needed to improve the outlook and reduce the risks.
Growth, which had been strong in 2010, decreased in 2011. This slowdown did not initially cause too much worry. We had forecast some slowdown, due to the end of the inventory cycle and fiscal consolidation. One-time events, from the earthquake and tsunami in Japan to shocks to the supply of oil, offered plausible explanations for a further slowdown. And the initial U.S. data understated the size of the slowdown itself. Now that the numbers are in, it is clear that more was going on.
What was going on was the stalling of the two rebalancing acts, which we have argued in many previous issues of the World Economic Outlook are needed to deliver "strong, balanced, and sustainable growth." Take first internal rebalancing: What is needed is a shift from fiscal stimulus to private demand. Fiscal consolidation is indeed taking place in most advanced economies (although not in Japan). But private demand is not taking the relay. The reasons vary, depending on the country. But tight bank lending, the legacy of the housing boom, and high leverage for many households all turn out to be putting stronger brakes on the recovery than we anticipated.
Turn to external rebalancing: Advanced economies with current account deficits, most notably the United States, need to compensate for low domestic demand through an increase in foreign demand. This implies a symmetric shift away from foreign demand toward domestic demand in emerging market economies with current account surpluses, most notably China. This rebalancing act is not taking place. While imbalances decreased during the crisis, this was due more to a large decrease in output in advanced relative to emerging market economies than to structural adjustment in these economies. Looking forward, the forecast is for an increase rather than a decrease in imbalances.
Now turn to the second adverse development, increased fiscal and financial uncertainty: Markets have clearly become more skeptical about the ability of many countries to stabilize their public debt. For some time, their worries were mostly limited to a few small countries on the periphery of Europe. As time has passed, and as growth prospects have dimmed, their worries have extended to more European countries and to countries beyond Europe -- from Japan to the United States. Worries about sovereigns have translated into worries about the banks holding these sovereign bonds, mainly in Europe. These worries have led to a partial freeze of financial flows, with banks keeping high levels of liquidity and tightening lending. Fear of the unknown is high. Stock prices have fallen. These will adversely affect spending in the months to come. Indeed, August numbers indicate that this is already happening. Low underlying growth and fiscal and financial linkages may well feed back on each other, and this is where the risks are. Low growth makes it more difficult to achieve debt sustainability and leads markets to worry even more about fiscal stability.
Low growth also leads to more nonperforming loans and weakens banks. Front-loaded fiscal consolidation in turn may lead to even lower growth. Weak banks and tight bank lending may have the same effect. Weak banks and the potential need for more capital lead to more worry about fiscal stability. Downside risks are very real.
I have been focusing so far on advanced economies. The reason is that, until now, emerging market economies have been largely immune to these adverse developments. They have had to deal with volatile capital flows, but in general have continued to sustain high growth. Indeed, some are close to overheating, although prospects are more uncertain again for many others. Under the risk scenarios, they may well suffer more adverse export conditions and even more volatile capital flows. Low exports and, perhaps, lower commodity prices will also create challenges for low-income countries. In light of the weak baseline and high downside risks, strong policy action is of the essence. It must rely on three main legs.
The first leg is fiscal policy. Fiscal consolidation cannot be too fast or it will kill growth. It cannot be too slow or it will kill credibility. The speed must depend on individual country circumstances, but the key continues to be credible medium-term consolidation. Some countries need substantial outside help to succeed. Going beyond fiscal policy, measures to prop up domestic demand, ranging from continued low interest rates, to increased bank lending, to resolution programs for housing, are also of the essence.
The second leg is financial measures. Fiscal uncertainty will not go away overnight. And even under the most optimistic assumptions, growth in advanced economies will remain low for some time. During that time, banks have to be made stronger, not only to increase bank lending and baseline growth, but also -- and more important -- to reduce risks of vicious feedback loops. For a number of banks, especially in Europe, this is likely to require additional capital buffers, either from private or from public sources.
The third leg is external rebalancing. It is hard to see how, even with the policy measures listed above, domestic demand in the United States and other economies hit by the crisis can, by itself, ensure sufficient growth. Thus, exports from the United States and crisis - hit economies must increase, and, by implication, net exports from the rest of the world must decrease. A number of Asian economies, in particular China, have large current account surpluses and have indicated plans to rebalance from foreign to domestic demand. These plans cannot be implemented overnight. But they must be implemented as fast as possible. Only with this global rebalancing can we hope for stronger growth in advanced economies and, by implication, for the rest of the world."
In sum, last month the IMF provided three different perspectives on different aspect of the challenges that face us today. Unfortunately, the conclusions they reached were relatively bleak. Two other new papers provide further food for thought. In "Political Uncertainty and Risk Premia", Pastor and Veronesi "find that political uncertainty commands a risk premium" in equity returns, "whose magnitude is larger in poorer economic conditions...making stocks more volatile and more correlated when the economy is weak." Closely related to this is another new paper, "Measuring Economic Policy Uncertainty" by Baker, Bloom and Davis. The authors "develop a new index of policy-related economic uncertainty and estimate its dynamic relationship to output, investment, and employment." They find that their index "spikes near consequential presidential elections and after major events such as the Gulf wars and the 9/11 attack. Index values are very high in recent year, with clear jumps around the Lehman bankruptcy and TARP legislation, the 2010 midterm elections [in the US], the Eurozone crisis, and the U.S. debt ceiling dispute." The authors analysis "show that an increase in policy uncertainty equal to the actual change between 2006 and 2011 foreshadows large and persistent declines in aggregate outcomes, with peak declines of 2.2% in real GDP, 13% in private investment, and 2.5 million in aggregate employment." Put differently, reducing the currently high level of policy uncertainty could have a substantial positive impact on the economy -- if such a reduction were possible in today's highly polarized and partisan political environment.
Finally, we call our readers attention to two other excellent articles that have recently appeared, both of which serve to remind us that the future may not be as bleak as it seems. In an article in the October 2011 McKinsey Quarterly titled "The Second Economy", Brian Arthur (a leader in the application of complex adaptive systems thinking to economic questions), notes that "every so often - every 60 years or so - a body of technology comes along and over several decades, quietly, almost unnoticeably, transforms the economy: it brings new social classes to the fore, and creates a different world for business." Arthur believes that such a transformation is currently underway, as multiple "digitized business processes" increasingly intelligently interact with each other, and in so doing "form a second economy alongside the physical economy." Arthur puts it like this: "Think of it this way. With the coming of the Industrial Revolution -- roughly from the 1760s, when Watt's steam engine appeared, through around 1850 and beyond -- the economy developed a muscular system in the form of machine power. Now it is developing a neural system...[which] may be the biggest change ever in the economy. It is a deep qualitative change that is bringing intelligent, automatic responses to the economy." While this is good news for productivity growth over the medium term, and most likely for consumer satisfaction as well, Arthur also notes that the expansion of digitized processes has negative implications for job creation. He thus envisions that in the future, (re)distribution issues will likely play a larger role in our political discourse.
The second paper that is well worth a read is "The Way Forward", by Alpert, Hockett, and Roubini, that was just published by the New America Foundation. The authors do an admirable job of succinctly covering the challenges posed by deleveraging, inadequate and imbalanced demand, and deflation -- though they fail to cover the growing crisis of political legitimacy. More important, they lay out a credible plan for restoring growth, that is based on what they term "three pillars": a focused program of public infrastructure investment to increase demand, a program to accelerate deleveraging via debt reduction, and a program of global economic rebalancing. As always seems to be the case with these analyses -- whether done by the IMF, the New American Foundation, Index Investor, or other analysts -- China's willingness to support the rebalancing of its domestic economy and consequently the global economy is perhaps the most critical uncertainty we face. For this reason, that issue will be our focus next month.
| Investor Herding Risk Analysis: Through September 30, 2011 | This Month's Letters to the Editor: Reponse to Criticism of ETFs and Rhode Island - The Canary in the Coal Mine | The IMF's Gloomy Outlook | Global Asset Class Valuation Updates Detail through September 30, 2011 | October 2011 Issue: Key Points | Table: Fundamental Asset Class Valuation and Recent Return Momentum | Table: Market Implied Regime Expectations and Three Year Return Forecast | Global Asset Class Returns | Uncorrelated Alpha Strategies Detail | Overview of Our Valuation Methodology |