IMF delays loans to Latvia

from FT

The International Monetary Fund has suspended lending to Latvia until it sees more progress in cutting public spending, the Latvian government confirmed on Thursday.

Latvia is racing to prepare more cuts to keep its €7.5bn ($9.9bn, £6.9bn) stabilisation plan on track and dispel fears that it will be forced to abandon its peg to the euro and devalue the lat, after the IMF postponed transferring about €200m last month.

“The first review has not been completed,” the IMF said. “This must be completed before the executive board can approve the disbursement.”

The news caused the cost of insuring Latvian debt against default to rise 71 basis points to 930. The credit default swap spread is regarded as a yardstick of confidence because the peg to the euro means the currency is little traded.

The second tranche of Latvia’s IMF loans has been postponed until June, when the government plans to put a new austerity package before parliament.

The budget deficit threatens to overshoot the target of 5 per cent of gross domestic product agreed with the IMF because the Latvian economy is contracting more severely than forecast.

The government now predicts the economy will shrink by 12 per cent this year – the worst recession in the European Union – compared with 5 per cent when the proposal to the IMF was drawn up in December. According to analysts, this could double the budget deficit to about 1.5bn lats ($2.8bn, €2bn, £1.9bn), close to 12 per cent of GDP.

The incoming government of Valdis Dombrovskis initially hoped to persuade the IMF to accept a slightly higher budget deficit of about 7 per cent of GDP and floated the idea of borrowing another €1bn from the international consortium that includes the European Commission, EU member states and financial institutions.

But an IMF mission to Riga, the capital, last week emphasised the need for reforms to achieve lasting reductions in the budget deficit, essential if Latvia wants to meet the conditions to enter the eurozone in 2012.

“This shows that the IMF is serious,” said Martins Kazaks, chief economist of Swedbank in Riga. “If you don’t solve the structural issues it’s not sustainable.”

The previous government slashed the wage bill for central government officials by 15 per cent but became mired in coalition disputes and collapsed in February.

The new government has asked ministers to put together proposals for cuts amounting to 20, 30 and 40 per cent of planned spending by mid-April.

IMF urges eastern EU to adopt euro

From FT

Crisis-hit European Union states in central and eastern Europe should consider scrapping their currencies in favour of the euro even without formally joining the eurozone, according to the International Monetary Fund.

The eurozone could relax its entry rules so countries could join as quasi-members, without European Central Bank board seats, says the fund.

“For countries in the EU, euro­isation offers the largest benefits in terms of resolving the foreign currency debt overhang [accumulation], removing uncertainty and restoring confidence.

“Without euroisation, addressing the foreign debt currency overhang would require massive domestic retrenchment in some countries, against growing political resistance.”

Disclosure of the confidential report, prepared about a month ago, could reignite a fierce debate over strategies to assist central and east Europe.

Even though global leaders hailed last week’s G20 summit as a success, eastern Europe’s challenges remain. Amid deepening recession, Ukraine and Latvia, two states already in IMF programmes, have in recent days balked at approving IMF-mandated reforms. A third, Hungary, is struggling to create a government capable of implementing reforms.

The IMF report was compiled to support a campaign by the fund, the World Bank and the European Bank for Reconstruction and Development to persuade the EU and eastern European states to back a region-wide anti-crisis strategy, including a regional rescue fund. The campaign failed amid widespread opposition from both west and east European states.

Eurozone members also oppose easing the eurozone’s entry rules, as does the ECB.

The IMF, which forecasts a 2.5 per cent decline in regional gross domestic product in 2009, estimates that “emerging Europe” – including Turkey – must roll over $413bn in maturing external debt in 2009 and cover $84bn in projected current account deficits.

The report estimates that “the financing gap” – money needed from international financial institutions, the EU and governments – will be $123bn this year and $63bn next, or $186bn in total.

Much could come from the IMF. But the report says “up to $105bn” could be needed from other sources, including the EU.

G20 and what is in it for EU10

The G20 leaders agreed on their London summit to the following commitments:

Restore confidence, growth, and jobs by:

• fiscal expansion in 2009 of up to $5 trillion, plus $1 trillion package added at the summit;
• exceptional easing of monetary policy by central banks;
• recapitalisation, liquidity and impaired assets removal from banks;
• commitment to cooperation to return to trend growth;
• promise of credible exit strategies to ensure long-term fiscal sustainability and price stability of the above;
• refrain from competitive devaluations.

Repair the financial system to restore lending by:

• establishing a new Financial Stability Board (FSB) with a strengthened mandate including all G20 countries, Financial Stability Forum (FSF) members, Spain, and the European Commission;
• ensuring that the FSB collaborates with the IMF to provide early warning of macroeconomic and financial risks and the actions needed to address them;
• reshaping our regulatory systems so that our authorities are able to identify and take account of macro-prudential risks;
• extending regulation and oversight to all systemically important financial institutions, instruments and markets, including systemically important hedge funds;
• endorsing and implementing the FSF’s tough new principles on pay and compensation and to support sustainable compensation schemes;
• taking action, once recovery is assured, to improve the quality, quantity, and international consistency of capital in the banking system so that regulation prevents excessive leverage and require buffers of resources to be built up in good times;
• ending the era of banking secrecy by taking action against non-cooperative jurisdictions (on OECD black list), including tax havens to protect our public finances and financial systems;
• calling on the accounting standard setters to work urgently with supervisors and regulators to improve standards on valuation and provisioning and achieve a single set of high-quality global accounting standards; and
• extending regulatory oversight and registration to Credit Rating Agencies to ensure they meet the international code of good practice, particularly to prevent unacceptable conflicts of interest.

Strengthen financial regulation to rebuild trust by:

• providing up to $750bn of new funds to IMF's that is to provide it via Flexible Credit Line and reformed lending and conditionality framework;
• completing the next review of IMF voting quotas by January 2011 and ensure open, meritocratic selection of leadership for IMF and the World Bank
• deliberating on a new global consensus desirable on the key values and principles that will promote sustainable economic activity.

Promote global trade and investment and reject protectionism by:

• refraining from measures that in their consequences reduce trade and investment flows (even though they may be accoptable under the WTO rules);
• supporting trade financing with to $250 bn channeled trhough export credit agencies and multilateral development banks; and
• remaining commited to Doha Round of WTO negotiations.

Build an inclusive, fair, green, and sustainable recovery by:

• limit the impact of the crisis on poorest countries and people by sticking to pre-existing commitments for development and social financing and using additional $6 bn of IMF surplus and procees from gold sales to this end over next 2 to 3 years;
• channel the stimulus funding towards sustainable green projects as much as possible.

What is in it for EU10?

• The EU10 development models are crucially depend on their connections to global economy via open trade and capital flows. Commitment to preserve the former and provide better institutional underpinnings for the latter must be welcome in EU10 capitals. EU10 economies are bound to benefit from increased demand for their exports that stimully is likely to deliver, providing that thier trading partners do not impose any "buy American" or "build in France" type of restrictions. This may be especially relevant to stimully focused on European car demand.
• Given that Hungary, Latvia and Romania depend for elementary macroeconomic stability on IMF lending, beefed up IMF is a good news. It is likely that more countries will have to reach for a stand-by agreements. If they can do so under more creative and flexible conditions, then reforms of IMF practices are welcome.
• None of the EU10 economies is a member of G20 (although Czech Prime Minister was present in Londan as he holds the rotating EU presidency now). EU10 have limited role in global affairs and will have to adjust to whatever new regulatory regime evolves. However, better regulation will definitely reduce the uncertainty stemming from gaping holes in the EU and global banking regulation that keeps host-country supervisors on the sidelines. In case of failures of foreign banks dominating EU10 financial sectors, the host country regulators, central banks and governments can only hope that their home-country counterparts, will succeed in restructuring and limit the sillover-effects on EU10 economies. Improvement of the international regulatory regime that would strenghten involvement of host-country authorities and define credible ex ante rules for burden sharing is better than current vagueness and uncertainty.

Restated commitment of foreign bankers (to Romania)

Financial Sector Coordination Meeting on Romania

Held at the Joint Vienna Institute on March 26, 2009, Vienna

Concluding Statement by Participating Banks

We, the parent institutions of the nine largest foreign-owned banks incorporated in Romania, with a market share of 70 percent of assets, met in Vienna, Austria, on March 26, 2009, at the invitation of the Joint Vienna Institute (JVI). The meeting took place under the chairmanship of the International Monetary Fund (IMF), with the participation of the European Commission (EC), the World Bank Group, the EBRD, the EIB, the National Bank of Romania (NBR), the home country banking supervisors and ministries of finance (Austria, France, Greece and Italy), and in the presence of the European Central Bank.

We agreed on the following considerations and conclusions:

1. We accept with satisfaction the shared analysis of the NBR, the IMF Romania team and the EC that all banks in Romania are currently in good financial condition, and that the parent banks of the foreign-owned Romanian banks have so far behaved responsibly, providing their Romanian affiliates with capital, funding, managerial and other types of expertise as the need arose.

2. The IMF, the EC and the World Bank are in the process of finalizing a balance of payments support package for Romania. We welcome this important development that will ensure the consolidation of macro-economic and financial stability in Romania.

3. We are aware that the success of the macroeconomic program, as well as medium term balance of payments sustainability in Romania will also be favorably enhanced by the continued involvement of the foreign-owned banks.

4. We entered the Romanian market as strategic investors and key contributors to its transition toward an open, market-based economy, based on our assessment of and continued confidence in the country’s long-term growth prospects. We have made substantial investments in Romania over a number of years, and we remain committed to doing business in the country.

5. We are aware that it is in our collective interest and in the interest of Romania for all of us to subscribe to coordinated commitments to maintain our overall exposure to Romania,

6. We also acknowledge that our subsidiaries in Romania will have to adjust to the current challenging economic environment. A need for additional capital cannot be excluded, and will be provided as necessary.

7. We have taken note of the agreement reached between the IMF and the NBR to run stress-tests based on established IMF methodology to estimate the potential losses that the Romanian banks might face under diverse scenarios during the period of the IMF/EU program. We support this exercise and agree to support our Romanian subsidiaries in order to: (i) confirm that these affiliates’ current good financial standing will be preserved throughout the period of market turbulences and economic slowdown; (ii) demonstrate our long-term commitment to the development of the Romanian economy; and (iii) signal our willingness to contribute to the efforts of the international community to put in place a comprehensive and well-coordinated response to the crisis.

8. We are therefore prepared to make these commitments, within the framework of the multilateral support programs, on a bilateral basis with the BNR, and with the involvement of our home country supervisory authorities, according to European and the respective national regulatory frameworks.

Erste Bank

Raiffeisen International

Eurobank EFG

National Bank of Greece

Unicredit

Societé Generale

Alpha Bank

Volksbank

Piraeus Bank

Capital controls within EU? Is that possible

Willem Buiter puts another 'impossibility' on the table by predicting that at least one of the EU10 countries will introduce capital controls. In principle, this should be legally impossible as it runs into the face of EC Treaties, IMF articles, WTO rules and OECD agreements etc. On the other hand, all of these texts include clause about 'prudential opt-outs' and 'exceptional circumstances' that a desperate EU10 government could invoke to stop capital outflow or to defend itself against speculative attack.

As the financial crisis successively spills into the real economy and into political crisis, there will be no shortage of desperate governments. They may resort to some last ditch populism to prevent faith of the Latvian (and Icelandic) governments that already fell apart.

However, even if legal window is found and political will is scrambled, can one introduce effective capital controls in the EU?

There has been an attempt to do so, which Buiter misses. As the Bulgarian economy was overheating in the last two years, IMF suggested to curtail credit expansion (which was entirelly financed from abroad). They manage to reduce the growth of bank lending, but not the credit expansion. The flow has just shifted from the banking channels to other channels, including cross-border lending.

Although Bulgarians were trying to keep the money out of the country, whereas capital controls would aim to keep them in, the point is that finding efective policy instruments to stop the flow within EU may be difficult.

Buitler may still be right about the non-EU countries, which at least have officers on the borders who can check whether truckers switch to smuggling euros if their flow over the optical wires is somehow curtailed. In any case, I would not take his provocation lightly; few days back he suggested another impossibile scenario - nationalization of banks - and it took about a week to get from the fringe to the mainstream of policy discourse on the financial crisis. Impossible is increasingly possible these days.

IMF and Latvia, round 2

Latvia's Government Resigns Amid Economic Crisis: IMF Deal In Doubt?
Print

* Latvia’s four-party coalition government, facing the steepest economic decline in the EU, double-digit contraction in 2009 and plunging public opinion ratings, resigned after two parties called for Prime Minister Ivars Godmanis to step down. President Valdis Zatlers said he had accepted the resignation and would start talks with all parties on a new government (See related spotlight issue: Latvia: Hard Landing In Effect, Can It Meet Conditions Of Its IMF Rescue Package?)
* Christensen of Danske: There will only be one issue at stake and that will be the austerity measures and the IMF deal. It is possible that means some parties may look to move away from the IMF deal, which would be very bad news for the Latvian economy
* In Jan, Latvia’s president threatened to call early elections after hundreds of demonstrators clashed with police during the anti-government protest organized by opposition parties and trade unions. Discontent has been brewing since the country slid into recession and the government had to seek a 7.5b euro ($10b) rescue from the IMF and EU
* An IMF-backed bailout was conditional on wide-ranging and deeply unpopular expenditure cuts: public-sector wages were being cut by 15% and the main VAT rate was increased to 21% (Danske). The finance ministry has forecast a drop in the economy this year of 12%, meaning further budget cuts are likely (Reuters)
* Vukotic: Many European governments are between a rock and a hard place. Deeply unpopular austerity measures aimed to battle the crisis fan social unrest and the political parties most likely to benefit are those who run on populist economic platforms
* EIU: Unrest was partly prompted by a painful economic downturn, but also reflects the long-standing unpopularity of the government as a result of corruption scandals
* Alvarez-Rivera: There is widespread discontent with the political establishment. Recent surveys indicate trust in government has fallen to its lowest levels since 1996 but only two opposition parties - the pro-Russian Harmony Center and the populist New Era Party - stand above the 5% threshold required to secure parliamentary representation
* In 2006, GDP expanded 12.2%, the highest rate in the EU. The economy contracted by 10.5% yoy in Q4 of 2008. According to European Commision (EC), unemployment is set to rise to 10.4% in 2009, from 6.5% in 2008
* The Latvian government was the second European government to succumb to the economic crisis after Iceland

IMF and Hungary, round 1

IMF Announces Staff-Level Agreement with Hungary
on First Review of Stand-By Arrangement
Press Release No. 09/36
February 16, 2009

An International Monetary Fund (IMF) mission issued the following statement in Budapest today at the end of the first review under Hungary's Stand-By Arrangement with the IMF:

"An IMF mission, led by Mr. James Morsink, held discussions with the Hungarian authorities during February 4-16, 2009 and reached a staff-level agreement with the authorities on a package of policies that aims at completing the first review under the Stand-By Arrangement. The mission worked in close cooperation with a parallel mission from the European Commission carried out in the context of the European Union balance of payments assistance.

"In the weeks ahead, IMF staff and the authorities will work together to finalize a Letter of Intent, with a view to allowing the IMF Executive Board to consider the completion of the first review under the arrangement in late March. The completion of this review will enable Hungary to draw an amount equivalent to SDR 2.1 billion (about €2.5 billion).

"The Hungarian authorities have implemented the policies described in their previous Letter of Intent of November 2008. The quantitative performance criteria and indicative target for December 2008 were all met. Inflation was broadly as envisaged under the program. The structural performance criterion and benchmarks were also all met.

"Looking forward, the key objectives of the program remain to improve fiscal sustainability and preserve the stability of the financial sector. The worsening global environment implies a downward revision of Hungary's macroeconomic outlook and therefore the need for additional policy measures. Important measures in the fiscal area will reduce the government's immediate financing needs relative to 2008 and contribute to restoring debt sustainability over the medium term. In the financial sector, the core measures aim to maintain ample liquidity and strong levels of capital in the banking system.

"The continued success of the policy package will be a shared responsibility between all stakeholders in the country and the international community. The IMF, in close coordination with the European Union and the World Bank, will continue assisting the Hungarian authorities on how to adapt to the current global financial turmoil and to catalyze financing as needed."

Lucid summary on the future course of financial regulation

The debate about new regulatory regime of the new 'innovative' financial products, many of which turned 'toxic' over th elast year, is relevant primarily to global financial centres. In this regard, the EU10 markets enjoy the 'advantage of backwardness' as bank exposure to complex securities and derivatives seem to be limited. On the other hand, new regulations in the US and UK, will sooner or later proliferate to the list of international financial standards (such as the one maintained by the Financial Stability Forum) and then to EU rules and thus to EU10 legal codes.

The testimony of the Adrew Lo to the US congress, provides rather sober and specific proposals for what may come. It is also one of the few public policy proposals that explicitly builds on behavioral finance and argues for construction of brand new institutions (such as risk focused accounting). He argues that the following seven themes are the key:

1. Crises are to stay, but transparency may limit impact: Financial crises may be an unavoidable aspect of modern capitalism, a consequence of the interactions between hardwired human behavior and the unfettered ability to innovate, compete, and evolve.  But even if crises cannot be avoided, their disruptive effects can be reduced significantly by ensuring that the appropriate parties are bearing the appropriate risks, and this is best achieved through greater transparency, particularly in the so-called “shadow banking system”[i.e. hedge funds].  Government can play a central role in providing such transparency. 
2. Define and measure systemic risk: Before we can hope to manage the risks of financial crises effectively, we must be able to define and measure those risks explicitly.  Therefore, the first order of business for designing new regulations is to develop a formal definition of systemic risk and to construct specific measures that are sufficiently practical and encompassing to be used by policymakers and the public.  Such measures may require hedge funds and other parts of the shadow banking system to provide more transparency on a confidential basis to regulators, e.g., information regarding their assets under management, leverage, liquidity, counterparties, and holdings. 
3. Rutine investigation of collapses and learning: The most pressing regulatory change with respect to the financial system is to provide the public with information regarding those institutions that have “blown up”, i.e., failed in one sense or another.  This could be accomplished by establishing an independent investigatory agency or department patterned after the National Transportation Safety Board, e.g., a “Capital Markets Safety Board”, in which a dedicated and experienced team of forensic accountants, lawyers, and financial engineers sift through the wreckage of every failed financial institution and produces a publicly available report documenting the details of each failure and providing recommendations for avoiding such fates in the future. 
   
4. Good comminication with public durign crisis: To the average American, the current financial crisis is a mystery, and concepts like subprime mortgages, CDO’s, CDS’s, and the “seizing up” of credit markets only creates more confusion and fear.  A critical part of any crisis management protocol is to establish clear and regular lines of communication with the public, and a dedicated inter-agency team of public relations professionals should be formed for this express purpose, possibly within the Capital Markets Safety Board. 
   
5. Construct risk accounting: Current GAAP accounting methods are backward-looking by definition and not ideally suited for providing risk transparency, yet accounting measures are the primary inputs to corporate decisions and regulatory requirements.  A new branch of accounting—“risk accounting”—must be developed and widely implemented before we can truly measure and manage systemic risk on a global scale. 
   
6. Create capacity to handle financial complexity by paying PhDs: All technology-focused industries run the risk of technological innovations temporarily exceeding our ability to use those technologies wisely.  In the same way that government grants currently support the majority of Ph.D. programs in science and engineering, new funding should be allocated to major universities to greatly expand degree programs in financial technology. 
   
7. Ratcheting standardization: The complexity of financial markets is straining the capacity of regulators to keep up with its innovations, many of which were not contemplated when the existing regulatory bodies were first formed.  New regulations should be adaptive and focused on financial functions rather than institutions, making them more flexible and dynamic.  An example of an adaptive regulation is a requirement to standardize an OTC contract and create an organized exchange for it whenever its size—as measured by open interest, trading volume, or notional exposure—exceeds a certain threshold. 
   

Financial crisis foretold

As the financial crisis spread through the world, so does the disbelief that no one was able to predict what is to come. The banks, banking regulators, governments and international organizations, have armies of analysts and consultants, but they all seem to be surprised. This is however only partially the case.

It is true that no one at the top table of global finance - the FED, the G8, the IMF - stood up and told the world that the period of easy money is unsustainable and unless we take action to constrain it, we would hit the wall. However, many of the analysts buried deep in the hierarchies of these organizations indicated the problem. This is a quote from the 2005 speech of the IMF's Deputy Managing Director about financial sectors in EU15:

A first issue is the increasing exposure of domestic banking systems to economic cycles and developments in other countries¸ as banks extend their operations outside their home bases. In some cases, stress tests conducted during the FSAPs found that depreciation of the dollar combined with a global slowdown could be a source of significant risk to the loan portfolios; in other cases, growing exposure to transition economies in central and eastern European countries, while important for boosting profitability, was identified as a potential source of risk.

A second risk factor is the sizeable exposure of banking systems to what appear to be substantially over-valued property markets in several countries. This point has been flagged by the IMF in its regular analyses of global economic developments in recent years.

And about EU10:

... various FSAPs pointed to a number of risks, including those stemming from rapid credit growth in new and potentially riskier sectors. In nearly all the CEE countries, credit risk in loan portfolios, including that arising from exchange rate fluctuations, remains the main systemic vulnerability, although sensitivity analysis suggests, in many cases, considerable banking system resilience to a deterioration in credit quality. Another risk factor is that growing banking competition in CEE countries, and the ensuing pressure on profit margins, may encourage some banks to venture into more risky lending in order to protect returns.

In retrospect it clearly may be more the problem of bosses of these analysts who failed to pick up the key line in the cacophony of economic debates and repeat it bluntly at the top table. Especially, to Americans and Chinese ....

... who did not really want to hear this message derived from the Financial Sector Assessment Program of the IMF and World Bank that has been finished over the last 9 years for 140 countries (out of 185 members of WB/IMF). The program is non-binding and voluntary so only countries who apply are assessed. There are two important members who never applied - USA and China.

So states have no power vis-a-vis efficient financial markets?

James Surowiecki of the Wisdom of the crowds fame, pointed out in his New Yorker blog:

When news broke that Timothy Geithner was Barack Obama’s pick for Secretary of the Treasury, the stock market jumped more than six per cent in the space of an hour. Obviously, this was a good thing, but there was also something weird about the spectacle of the Street’s once fearless free marketeers exulting over a government appointment, as if they were nomenklatura members cheering a new Politburo chief. It showed just how central a few government officials have become to the well-being not just of the markets but of the economy as a whole. For better or worse, we now live in a world in which the Treasury Secretary controls hundreds of billions of dollars in spending and shapes the fate of some of the nation’s biggest companies. That’s quite a job to ask someone to do.

Indeed, the "masters of the universe" start to cling to the nanny state as overconfident adolescents to their mother after they smashed their noses on reality. Despite all the proclamations that states do not have powers to regulate global financial markets, this is a refreshing return to normality. Financial markets as as embedded in the political communities (states) as most adolescents in their families.

Robert Skidelsky, while examining the intellectual foundations of the finance adolescent (here and here), takes the disembedding idea a notch further. It is not the problem of political dissembedding, but moral one. He claims that

The key theoretical point in the transition to a debt-fueled economy was the redefinition of uncertainty as risk. This was the main achievement of mathematical economics. Whereas guarding against uncertainty had traditionally been a moral issue, hedging against risk is a purely technical question.

Well it is easy to play schadenfreude on the Wall Street bankers, but the more I read about the financial crisis, the deeper it seems to go. It is not just regulatory failure compounded by the macro profligacy, which would be the issues of wrong state policies and institutions. The underlying intellectual models - such as efficient market hypothesis and a bundle of formalized mathematical models that build on it - seem to get it very wrong. May be I just read the wrong books like Black Swan and Engine, not a camera.