Wednesday, April 17, 2013

IMF confirms solvency problem not fixed by response to financial crisis

According to a Guardian article, the IMF warns that the global economy still faces chronic risk until the excess debt in the global financial system is dealt with.

The International Monetary Fund has warned that the repair job on the world's battered financial system is only partly completed and said failure to finish the job risks propelling the crisis into a chronic new phase....

But with only a modest recovery in the global economy since the deep slump of 2008-09, the report said the improvement in financial market conditions could only be sustained through measures to address issues that posed risks both to financial stability and growth. 
"Continued improvements will require further balance sheet repair in the financial sector and a smooth unwinding of public and private debt overhangs. If progress in addressing these medium-term challenges falters, risks could reappear. The global financial crisis could morph into a more chronic phase marked by a deterioration of financial conditions and recurring bouts of financial stability."
A Bloomberg article gave an explicit example of the excess debt that needs to be dealt with.

As much as 20 percent of non-bank corporate debt in the weakest euro-area economies is unsustainable and may force companies to cut dividends and sell assets, dealing further blows to investor confidence, the International Monetary Fund said. 
Businesses (SXXP) in Italy, Spain and Portugal have the largest “debt overhang,” according to the IMF’s Global Financial Stability Report released today, which analyzed 1,500 publicly traded non-financial European firms. 
Strains in the corporate sector may in turn hurt banks’ asset quality, the report showed. 
“Firms in the euro-area periphery have built a sizable debt overhang during the credit boom, on the back of high profit expectations and easy credit conditions,” the IMF said. Now they “face the challenge of reducing the debt overhang in an environment of lower growth and higher interest rates, in part related to financial fragmentation in the euro area.”
The IMF's findings are not a surprise as the global policymakers and financial regulators response to a bank solvency led financial crisis was not to address this excess debt.

Instead, they adopted the Japanese Model under which bank book capital levels and banker bonuses are protect at all costs.  By doing this, the burden of the excess debt in the financial system has been placed on the real economy where it is diverting capital needed for growth and reinvestment to debt service.

As predicted by your humble blogger, the result has been a global Japanese-style economic slump.

Fortunately, the excess debt in the global financial system can still be dealt with.  This requires the global policymakers and financial regulators to abandon the failed Japanese Model and adopt the proven Swedish Model.

Under the Swedish Model, banks recognize upfront their losses on the excess debt in the financial system.  This protects the real economy and allows it to resume growing.  

Adopting the Swedish Model ends the diversion of capital from the real economy to cover the debt service on the excess debt.  Instead, under the Swedish Model, all of the capital that the real economy generates for growth and reinvestment is retained for use by the real economy.

One of the many benefits of adopting the Swedish Model is that it ends the need for austerity and rewriting the social contract.

From the Guardian, the IMF recommended that as part of cleaning up the banks, they adopt enhanced disclosure.
Enhanced disclosure for banks and conducting selective asset quality reviews will help restore confidence in bank balance sheets and improve market discipline

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