While yesterday it was the sovereigns who suffered the wrath of the IMF's wholesale growth outlook downgrade (unbeknownst to Christine Lagarde), today it is the turn of the financial sector (which is increasingly being blurred with the former in a world in which central banks are used to both backstop bank liabilities and fund endless public deficits, unafraid of the consequences in a closed loop fiat world in which defection is, so far, impossible) to be greeted by a cold dose of reality emanating from the IMF's "Global Financial Stability Report" especially as pertains to Europe's insolvent banking system. The most notable finding of said report is the admission that the IMF was only kidding when it said six months ago, in April of this year, that the worst case outlook now has European banks deleveraging to the tune of $3.8 trillion through the end of 2013, or over the next 14 months: now this number is 18% higher, or a gargantuan $4.5 trillion (12% of bank assets). This is how much debt Eurobanks will need to shed in a "weak policies" case in which Europe continues to delay implementing fiscal reform, aka austerity, as per Figure 2.14. Even the baseline (and this being the IMF it means it has zero chance of happening) scenario is not much better, at a revised $2.8 (7.3%) trillion in deleveraging. The reason for the increase is due to "lower expected earnings, higher losses linked to worsened economic conditions, and greater funding pressures on banks."
Ironically as Figure 2.15 indicates, one of the primary drivers for deleveraging is none other than the central banks, whose "financial repression" regime is crushing not only savers, but banks as well, who are now forced to dump hundreds of billions in debt for which they get no economic benefit. The only real question left is: just who will buy all this debt. And the only real answer is, of course, the ECB, which is why all those devising 2013 EURUSD forecasts, model an ECB balance sheet that will be about 100% larger than it is currently (a move which the Fed will not idly stand by and watch without taking corresponding action).
Breakdown of IMF deleveraging forecasts for the three scenarios, of which the realistic one is highlighted:
How does the IMF define the three set of underlying policies:
- Under baseline policies, foreign investors’ share of the total debt stock is assumed to continue to decline at the same pace as seen during 2009–11. For periphery countries, the share of foreign debt holdings is assumed to move halfway toward pre-euro era levels. The assumptions on sovereign spreads reflect positive market developments following the announcements by the European Central Bank on July 26 and September 6 launching the Outright Monetary Transactions program. Periphery sovereign spreads are assumed to stabilize and/or gradually decline by end-2013
- Under complete policies, by contrast, confidence returns and foreign investors increase their share of the total debt stock as funds flow back to the periphery. Periphery spreads tighten by one to two standard deviations below the baseline.
- Under weak policies, the withdrawal of foreign investors accelerates to twice the pace seen since 2009. Periphery spreads widen by about one standard deviation above the baseline.
One can easily see why with the situation in Europe deteriorating ever faster courtesy precisely to the ECB, which has now taken over all credit formation, leaving no reason for foreigners to suffer the same pain and suffering as Greek bondholders did initially, and as Spanish, and all other PIIGS private holders will go through soon.
Some further color from the IMF:
- The deterioration in financial and economic conditions entails greater pressure on bank asset quality and capital. The scarcity and higher costs of bank funding, sovereign stress, and a weaker economy are adding to the pressure on bank profits, while weakening economic conditions have led to a deterioration in the quality of bank loans, as indicated by a rise in nonperforming loan (NPL) ratios. Among the four factors analyzed here—capital, funding, financial repression, and financial fragmentation— capital emerges as one of the key factors, particularly for weaker periphery banks (Figure 2.15). This means, for example, that even if funding gaps are closed, bank deleveraging pressures will remain.
- The periphery bears the brunt of shrinking credit supply. The cutbacks in the supply of credit to the periphery countries are much larger than in the core euro area (Figure 2.16). The supply of total credit in the periphery (including cross-border lending) is expected to decline 9 percent under the baseline policies scenario and almost 18 percent under the weak policies scenario.
- EU banks cut back the supply of credit outside the euro area as well, notably in emerging Europe, Latin America, and the United States. In some cases, however, domestic banks and foreign banks operating in these three regions are expected to step in and offset the impact that the EU banks’ pullback will have on credit supply (Figure 2.17). For example, recent European asset sales in the United States and Latin America have so far been orderly.
- A rapid move to the complete policies scenario would avoid additional economic damage to periphery economies due to the credit supply shock (Figures 2.18 and 2.19). The estimated impact on euro area credit supply under the baseline policies scenario is broadly in line with the WEO baseline. Under the weak policies scenario, the credit supply shock from the EU bank deleveraging would lower periphery euro area GDP by more than 4 percentage points relative to the WEO baseline in 2013. In the core euro area, GDP would contract much less, in line with the relatively moderate impact on credit, but still significantly—by 1.5 percentage points relative to the WEO baseline. In the complete policies scenario, GDP at end-2013 relative to the baseline policies scenario would be two-thirds of a percentage point higher in the core, and almost 2 percentage points higher in the periphery.
And while Greece is a goner, the jury is still (supposedly) out on Spain and Italy. What will not help them is that due to the unbreakable linkage between banks and sovereigns, absent massive deleveraging, the GDP of these two countries will continue to collapse.
It gets worse. As we have long discussed, one of the key topics that everyone loves to ignore when talking Europe is the trillions in contingent liabilities, which just because they are not directly held on the books, does not mean they do not exist. In Europe's case not only do they exist, but are rising, as the IMF warns.
The slow pace of crisis resolution has pushed up the size of contingent liabilities for economies in the core of the euro area. Contingent liabilities reflect the size of potential ultimate fiscal transfers, or the costs of potential defaults in the periphery under a breakup scenario, should the crisis deepen. Under the assumption that the ECB provides unlimited support to fill in the funding gap left by capital flight from the periphery, one measure of the size of contingent liabilities is given by the estimated size of payment system (Target 2) balances, the commitments on bilateral loans, and support for domestic banks with exposure to the periphery. Under the assumption of unlimited support from the Eurosystem, Target 2 liabilities could be expected to continue to rise for the periphery (Figures 2.25 and 2.26). In the baseline policies scenario, capital flows from the periphery to the core would continue, marked by further financial fragmentation and consolidation of bank balance sheets within national borders. The weak policies scenario would result in stronger outflows from the periphery and net outflows from the euro area as investors seek to evade the impact of a potential breakup of the euro area. Roll-offs by foreign investors would climb, the pace of overall outflows would rise further still, and the euro would likely come under substantial depreciation pressure. Under the complete policies scenario, confidence returns and foreign investors increase their share of outstanding debt.
The biggest loser here, as in every other category: Germany, which will end up seeing €2 trillion in TARGET2 claims which in turn will never be satisfied as the system merely accelerates its collapse into a debt supernova.
The big picture, of course, is that even the IMF now concedes Europe is in a closed loop Catch 22: unless European countries manage to restore "foreign" confidence which in turn would mean putting their fiscal houses in order, something which has proven absolutely impossible in Europe absent such one-time gimmicks as LTROs and otherwise hollow confidence boosters as ECB warnings to not fight the ECB (which work until they are tested, but first need to be activated, ahem Mariano Rajoy), the banks will be forced to delever even more, which would mean the ECB would have to "onboard" even more of their debt as nobody else will, which means even more foreign creditor flight, which means greater deposit outflows, which means more ECB intervention, until finally, the ECB is the only player in town, a process which can be visualized (in progress) in the following capital flow image, especially Figure 1.7:
At the point when the ECB is the sole owner of all European financial debt (and sovereign debt via repo), the endgame for the fiat system will finally be here, as the only thing more dangerous than the ECB will be all other central banks which will have no choice but to follow suit and monetize everything in the global race to debase currencies, and monetize ever more budget deficits in a world in which the rich increasingly preserve their wealth, and refuse to pay taxes (converting financial assets into hard ones), having finally grasped the endgame.
As for the immediate task at hand: how European banks will deleverage to the tune of $4.5 trillion over the next 14 months, Europe has our blessings.
Source: IMF Global Financial Stability Report