The IMF Can't See The Forest For The Trees

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Includes: AGG, DIA, IWM, QQQ, SPY
by: David Deuchar

Summary

The stock market shake-ups in the past year (August and January) have put the weakness of the global financial system back in full display.

Between the emergence of a more multi-polar political order, the rise of sovereign wealth funds, and continued entitlement spending/deficit-financing, the system is clearly still vulnerable.

Bouts of international capital flow volatility and competitive devaluation measures (e.g. "currency wars") are major symptoms of this weak financial order.

The IMF is keenly aware of these challenges and is seeking to significantly bolster existing measures as well as create new mechanisms to build a global financial safety net (GFSN).

In discussing possible intervention in capital flow management and forex, however, the IMF is only treating the symptoms of a global disease spreading rapidly throughout the advanced economies.

In one sense, as investors, we often disdain and bemoan any kind of distortion or intrusion into free enterprise, especially by governmental or financial organizations, and financial engineering is especially reviled. The colossal failure of financial institutions to safeguard against clear risks prior to the Great Recession of 2008 further worsened this image. However, from another perspective, I think we in the investment community should always step back and look at things in proportion. Eight years on, it is a testament to the diligent efforts of the global financial community, especially the IMF, that, despite recent bouts of capital flow, equity, and currency volatility, such as in August 2015 or January 2016, the global financial system is generally quite stable and functioning normally, albeit sub-optimally and slower than usual. In fact, just recently, the S&P 500 (NYSEARCA:SPY) made it back over the 2,000 mark even with so many uncertainties still facing U.S. business and credit conditions and equity markets in general.

And despite a huge number of structural weaknesses and flashpoints, such as a shifting geopolitical order, ballooning domestic imbalances, deficit-financing programs, regressive/anti-liberal policies (such as in Japan), and slower financial integration, financial interconnectedness is still growing. Even greater still, through the Washington Consensus and other efforts, the International Monetary Fund (IMF) has incentivized more and more countries, specifically those less developed, into the liberal economic standard, i.e. free markets, floating exchange rates, privatisation, foreign investment protocols, etc. Through the conditionality principle and by taking advantage of these cyclical stressors and adjustments, I think the IMF has actually managed to do far more good than any one governmental or eleemosynary institution for the well-being and welfare of the common man.

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(Source: IMF Survey)

However, the global financial system is not out of the woods yet, and there is much work to be done. The veneer of a rallying stock market is no substitute for a truly healthy international capital system. Between the emergence of a more multipolar political order, the rise of sovereign wealth funds, and continued entitlement spending/deficit-financing, the system is clearly still vulnerable. Constant shocks that show up in capital flows and currency markets are symptoms of a growing financial instability lying beneath the surface.

With the growing power and activity of the IMF, it is no surprise that its upcoming strategies and measures to address these problems will be of utmost importance to any investor; currently, the IMF's "firepower" stands at about $1 trillion, thanks to increased Quotas and the New Arrangements to Borrow* introduced in 2011. In its latest IMF survey (as of March 17, 2016), the staff addresses some of these key risks and proposals to mitigate any possible future contagion. However, I believe the IMF staff, despite addressing these risks extensively, is failing to see the forest for the trees, focusing too much on the specific symptoms of a global disease that most dangerously plagues the advanced economies.

*The New Arrangements to Borrow (NAB) are essentially a mechanism through which the IMF, after a majority consensus vote, can increase its quota power by increasing its leverage in the event of extraneous circumstances.

The IMF cites three key weaknesses of the international monetary system including (1) weak global adjustment mechanisms (2) regulatory gaps and (3) limited and fragmented global liquidity mechanism. The survey goes into detail addressing possible ways to bolster these mechanisms, promote cooperation, etc., including possible intervention in capital flow management and forex. However, I want to add my own key risks or issues that I think the IMF fails to address that may be even more important to the health of the international monetary system:

  1. Lack of "punishment" mechanism (carrots and sticks)
  2. Lack of focus on fiscal policy
  3. Lack of defining economic philosophy

Lack of "Punishment" Mechanism

Currently, the IMF has no expressed ability or intent to respond to what I see as a growing amount of regressive and anti-liberal policies, especially in the Advanced Economy sphere. As with any incentive-based organization, it is necessary to have both "carrots" and "sticks", that is, mechanisms to reward good behavior and punish bad behavior. Right now, the IMF can act only as a rewarder in the international financial community. As a matter of principle, if the IMF is to maintain the conditionality rule on its lending facility, it should work the other way as well. Due to the nature of the IMF's primary power, i.e. as a lending vehicle, the IMF can only encourage countries to the liberal economic standard in the event of a crisis when it is too late. But what of AEs with highly developed markets, significant sources of funding, and/or geopolitical advantages?

As many times before, I often look to Japan as a model for how Europe and the U.S. will behave. As we all know from much speculation and talk, the BoJ is pursuing extreme monetary measures to finance its debts and spur inflation such as NIRP and massive asset purchases. Perhaps it is because the government has been injecting forced liquidity and internally financing deficits for decades that there is little interest in what goes on in Japan, but where is the IMF's response to Japan's measures? There should be massive uproar at the IMF, and calls for Japan to change or risk losing funding mechanisms. Surely the IMF, which claims to watch capital flows very closely, is aware that Japan ranks the highest for foreign direct investment, or FDI, outflow-to-inflow ratio, at over ~$140B in FDI outflows with a ratio of ~67.5.

What of the LDP's actions that are increasingly less capitalistic, such as the re-nationalisation of industry, not to mention talk within the government about wage and price controls and direct participation by the BoJ in the boardrooms of companies to force wages higher? Is Japan's geopolitical position perceived as too important; does it not matter that Japan's real economy is floundering or is the IMF too focused on its monetary policy?

Lack of Focus on Fiscal Policy

This brings me to my next point - the IMF, as an international institution focused primarily on monetary cooperation and exchange rate stability, naturally follows more closely the trends of monetary policymakers than the often chaotic tides of politics. However, the IMF is not just another de facto global central bank; its own charter states its mandates are "to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world." The very existence of the conditionality principle implies that the IMF is also deeply involved in fiscal factors in its activities and it should be.

The slow growth, deflationary model that now plagues the AE sphere is a direct result, not of demographics, limited resources, or any theoretical limit to growth, but of specific intentional policies pursued by the domestic governments in the advanced economies. The explosive growth of entitlement spending and deficit-financing and a rapidly shifting geopolitical order are fostering a short-term reactive political model that benefits policymakers to focus on short-term "bandaids" or distractions to serious macroeconomic issues that require long-term shifts in policy. Unfortunately, globalisation itself has contributed to many of the domestic pressures that politicians and policymakers feel the need to respond to, such as high unemployment, stagnant productivity/wages, and low consumer spending.

(Source: UNCTAD World Investment Report)

Even though the IMF has extensively reviewed the recent trend of accommodative monetary policy in AEs, it has failed to see the more dangerous trend - that of the rise of illiberal, nationalist/isolationist fiscal policymakers, not to mention populist theatricalists who openly threaten to tear the whole system apart, such as Donald Trump of the U.S., Marine le Pen of France, Boris Johnson of London, Viktor Orban of Hungary, etc. Writing for the Financial Times, Phillip Stephens sums up how these political opportunists are all stringing the same chord of public anger at stagnating growth:

"Populists in Europe fume against the same supposed conspiracy of the elites that Mr. Trump claims is doing down America's middle classes. The binding threads of the shared populism are angry nationalism and state intervention. Europeans used to call it national socialism. Mr. Trump wants to expel Mexicans and bar Muslims. In France, the National Front's Marine Le Pen is bidding for the presidency on a platform of Islamophobia and state capitalism. Both are unabashed admirers of Russian president Vladimir Putin.

The other day a proudly neo-Nazi party - complete with sinister black uniforms and lightning flashes - won seats in the Slovakian parliament. In neighbouring Hungary, prime minister Viktor Orban presides over an authoritarian regime that is hostile to Muslims, permissive of anti-Semitism and blames foreign capital for the country's economic ills. Poland's politics have swung towards the xenophobic right. Nationalists are on the march in Scandinavia and Italy. And while populists on the far right rail against migrants, their cousins on the extreme left join them in blaming globalisation for economic ills."

The global financial community is finally waking up to this reality, but it may be too little too late, as so many democracies in the West are gripped by this protectionist attitude.

Of course, as many publications note, these populists have by and large failed to overthrow the global capital system as promised. Yet clearly their mere presence remains a plague on the global economy, as with every new crisis and cyclical stressor, more and more capital is left behind in Emerging Markets, such as in developing Asia, never to return to the Advanced Economies again. With the Advanced Economies still in financial repression mode, I think many economists are vastly underestimating just how badly this cocktail of financial repression and protectionist policy will hurt the potential growth of U.S., Europe, and Japan.

Lack of Defining Economic Philosophy

This brings me to my final point regarding the IMF's decision-making and thought process in recent years, or a lack thereof. The defining economic philosophy from which the IMF was created, the notion that crises such as the Great Depression could be prevented by promoting international cooperation, free trade, and liberal economic policy seems to no longer apply. It is still amazing to me that an organization whose objective is...nay, an organization that prides itself on preventing competitive devaluations and promoting liberal economic policy would allow China into the SDR basket. As Ben Bernanke noted back in December, the move was purely symbolic, however, this makes the decision even more detestable:

"If SDR inclusion is only symbolic, then what's the big deal about the IMF's decision? Well, the Chinese authorities, who very much want their country to be recognized as a global economic power, care a lot about symbolism. And SDR inclusion does recognize both the increasing economic power of China and the important steps the Chinese have taken over the years to open up their capital markets, to meet international norms in financial regulation, and to increase the extent to which market forces help determine the renminbi's value."

Is this the same China that simply forces state-owned banks to purchase toxic local debts, bans certain shareholders from selling, and encourages retail investors to trade on margin using their apartments as collateral? Is this the same China that, not even a month after accepting the honor of being included in the SDR, devalued the renminbi by nearly 4%, a move that further amplified global financial instability? Is this the same China that would jail writers like all of us here on Seeking Alpha for promoting "antisocial behavior" or "political dissidence"?

Regardless of China's size, the IMF made a grave error in including it in the SDR, but unfortunately, the deliberalization process of the IMF has been going on for some time. Through new lending facilities introduced in 2009, such as the Flexible Credit Line, Precautionary and Liquidity Line Rapid Financing Instrument, and Rapid Credit Facility, the IMF needn't rely on the traditional conditionality principle but on "ex-ante" conditionality - in other words, it can lend in the hope that the country will adopt its recommended macro policies at some point in the future.

Conclusion

Despite my criticisms, the IMF has acted as a critically important player in financial crises of the past century, such as the Greek Debt Crisis. Its role has no doubt been positive in mitigating financial contagions from spreading and in providing liquidity and a mode for cooperation where, in some cases, there might have been none. Unfortunately, I see the IMF acquiescing to political influence and allowing its liberal economic conditionality principle to fall by the wayside, and we see the consequences of this action in national investment policy and capital flows today.

Relevant Equities: iShares Core Total U.S. Bond Market ETF (NYSEARCA:AGG), SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA), iShares Russell 2000 ETF (NYSEARCA:IWM), PowerShares QQQ Trust ETF (NASDAQ:QQQ)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.