A Happier Ending for IMF Reform?

Mohamed A. El-Erian

FEB 3, 2014
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Newsart for A Happier Ending for IMF Reform?


NEWPORT BEACHDespite an elegant solution that involved no new commitments of resources, the US Congress has refused to take up a long-delayed funding proposal for the International Monetary Fund. In the process, it derailed a multilateral agreement that was hammered out back in 2010ironically, in the eyes of the rest of the world, with US President Barack Obama’s administration taking a leading role. And it did so at a time when financial disruption in emerging economies is reminding the world of the importance of a strong stabilizing anchor at the core of the international monetary system.

After the initial disappointment, many are hoping that Congress will again take up the Obama administration’s IMF request after a short interlude. It will certainly have several opportunities to do so while working on other financial legislation. But, with Congressional elections due later this year, few are confident that lawmakers will be in any mood to change course until 2015 at the earliest.

This is an unfortunate and regrettable outcome for both the IMF and the international community as a whole. Congressional obstinacy is forcing the Fund to miss out on an opportunity to strengthen its finances at a time when most other countries have already approved the initiative. It is also being held back from addressing, albeit modestly, governance and representation deficits that have steadily eroded the integrity, credibility, and effectiveness of this important multilateral institution.

Meanwhile, global developments confirm that the recent period of financial tranquility remains a tentative one. Rather than being anchored by fundamental and durable reforms, the current calm has been secured through prolonged reliance on central banks’ experimental monetary policies, especially in the United States, Europe, and Japan.

These policies have improved domestic prospects in advanced countries, but they have accentuated the policy dilemmas facing many emerging economies. In some cases, they have overwhelmed policymaking capability and added to internal political instability all of this at a time when no one knows the full range of side effects and unintended consequences of the West’s unconventional measures.

Yes, this is an important lost opportunity for all who value global growth and financial stability. That is undoubtedly bad news. But there is also a silver lining, because last month’s disappointment can be turned into an opportunity.

The 2010 agreement was, after all, a compromisealbeit a hard-fought one – that advanced only marginally the cause of long-delayed IMF reforms. Moreover, there were insufficient assurances that the limited changes would end up providing a springboard for more meaningful reforms down the road. Indeed, rather than modernizing economic multilateralism and revamping its governance, what many would have regarded as an unsatisfactory yet final partial compromise could have played into the hands of those who advocate regional arrangements as a substitute for multilateralism, not a compliment to it.

But this new opportunity, born of disappointment, will not be seized if the international community’s approach is simply to wait for the US president to submit the same set of limited reforms to Congress again and again. Instead, leaders need to come together and support the initiation of discussions on a more comprehensive set of reforms.

Such reforms could start by targeting a more aggressive, and much-needed, realignment of voting power and representation at the IMFone that reflects the world of today and tomorrow, rather than that of decades ago. This could be achieved by pursuing three specific initiatives.

· Leaders should target a much bigger shift in favor of emerging economies and away from Europe – in voting power, representation on the IMF’s Executive Board, and funding obligations.

· The outmoded relic of a system that de facto reserves the position of Managing Director for European citizens should be eliminated once and for all.

· Third, policymakers should build on recent progress to ensure a more level operational playing field for the implementation of Fund surveillance.

There is no better time than now to start working on these three initiatives. The last twofurther improving the procedures governing the election of the next Managing Director, and more even-handed surveillance – could be pursued rather quickly and without having to secure parliamentary approval. What is required is stronger political will by governments and, in the case of Europe, greater humility.

The first initiative, pertaining to voting power and representation, would inevitably take longer and be much more complicated to implement. In many countries, governments would need to obtain parliamentary approval. 

And the process of getting there is bound to require difficult negotiations and hard compromises. To adapt a concept that the columnist Thomas Friedman recently used for the Middle East, the key is to recognize that, at the national level, it is aboutno victor, no vanquished.” This is not about individual countries, but rather about the well-being of an international system that can better serve and protect individual countries’ interests over the longer-term.

Acting through its 24 representatives on the IMF’s Executive Board, the international community would be well advised to move quickly to empower the Managing Director to appoint an independent committee of outside experts to devise detailed proposals in each area, including by drawing on work that has already been undertaken. Indeed, the emerging world’s recent bouts of instability, and the risk that they may spillover to advanced countries where growth has yet to achieveescape velocity,” are a timely reminder of the danger of reform paralysis.

Anyone who wishes to see a strong IMF at the center of a fluid international monetary system – and most economists see great merit in this – would agree that such a multi-speed outcome is far superior to doing more of the limited same.


Mohamed A. El-Erian is CEO and co-Chief Investment Officer of the global investment company PIMCO, with approximately $2 trillion in assets under management. He previously worked at the International Monetary Fund and the Harvard Management Company, the entity that manages Harvard University's endowment. He was named one of Foreign Policy's Top 100 Global Thinkers in 2009, 2010, 2011, and 2012. His book When Markets Collide was the Financial Times/Goldman Sachs Book of the Year and was named a best book of 2008 by The Economist.


Markets Insight

February 4, 2014 8:49 am

Barrage of bad news drives EM outflows

Nervous EM money will find a home in developed market stocks


An emerging market, according to the old joke, is one that you cannot emerge from in an emergency.

Whether recent events constitute an emergency or just a drama, it is clear that a great deal of emerging has been going on. According to the Institute of International Finance (IIF) net outflows of equity investment in 2013 amounted to $393bn while inflows were just $84bn.

Last week alone saw an exodus of $6.3bn from equity funds on the estimate of data provider EPFR. What we saw in January was an old-fashioned flight to qualitywitness the fall in 10- and 30-year US Treasury yields last week – and a return to the knee-jerk world of risk-on/risk-off trading. Who is to blame for this dismal start to the market year?

All fingers point to the Federal Reserve, which last Wednesday acted to further reduce its bond purchasing programme. Yet the Fed’s announcement of more tapering was widely expected.

The underlying problem was surely that there was a near-consensus on January 1 that 2014 was going to be a good year for global equities despite their considerable run up last year. The market was overblown and vulnerable, with Japan being the most extreme case in point. After the 57 per cent stock market rise last year, Japanese equities have shown by far the worst performance among the major markets in January.

The difficulty for emerging market equities, which are down considerably more than those in the developed world, is that they ran into a barrage of specific bad news: a weak purchasing managers’ report from China; strikes in South Africa; political crises of varying degrees of severity in Ukraine, Turkey and Thailand; Argentina retreating into yet another devaluation, and so forth. Against the background of Fed tapering, which means that global liquidity conditions are tightening, those countries with current account deficits and large external financing requirements are inevitably feeling the strain.

How long will it take for emerging markets to stabilise? In the latest of its regular research notes on capital flows to emerging markets IIF is relatively upbeat. While acknowledging that investors have become more sensitive to country risks, it argues that there will not be a sustained pullback from emerging markets. Its prognosis is for a gradual rebound in capital flows in 2014 and 2015, although at a much lower level relative to gross domestic product than from 2010 to 2012, on the back of a sustained pick-up in global growth and a gradual Fed exit from bond buying.

I am not so sure, however. The markets’ negative response to central bank tightening last week in Turkey, South Africa and India suggests that investors may feel that the level of real interest rates in the developing world are simply too low and that the risks are higher than previously thought. If rates are going to rise significantly, that will eat into the emerging markets’ growth story. Investors are also increasingly wary about currency risk, which is bound to be tricky to manage while the Fed tapers and eventually starts to raise rates. There is a question, too, about whether the emerging market asset category is due for a more general reassessment.

The past 12 months have served as a potent reminder that political risks in the developing world are too readily underestimated. The speed with which Turkey has gone from being an exemplary democracy to one where governance is increasingly wayward has been an object lesson on how political risk can take investors by surprise. Much of the economic and financial case for emerging markets has also come adrift as a result of the global flood of liquidity unleashed by developed world central banks.

After the Asian financial crisis many emerging market countries responded by accumulating mountainous quantities of foreign exchange reserves and reducing reliance on foreign currency debt. National balance sheets were tidied up and good housekeeping prevailed. Yet the tidal wave of capital inflows led in some countries to renewed current account deficits, rising inflation and a return to foreign currency borrowing.

At the same time China is no longer helping the developing world’s commodity producers as it slows down and tries to shift the balance of its economy away from investment towards consumption. And as we saw again last week, the movement of share prices across the world tends to become more closely correlated when markets become twitchy, so emerging markets are not offering the portfolio diversification that investors looked to them to deliver.

No doubt there are bargains to be had, but a more general recovery is not yet, I suspect, in the offing. My guess is that the flight to US Treasuries will be temporary and that this nervous money will soon find a home in developed world equities.


Copyright The Financial Times Limited 2014


Gold Is Rewriting The Textbooks; Likely Headed Lower, Will Test Critical $1,200 Level

by: Robert Wagner

Feb. 3, 2014 10:49 PM ET


One of my favorite investment themes is biodiesel. The EPA has implemented a relatively new program called the RFS2 which has all sorts of market distorting regulations that alter the prospects for the industry

Congress then piles on with something called a "blender's tax credit," and there is simply too many variables for the market to accurately discount all the possible outcomes. When I read research reports from the Wall Street brokerages on this industry it becomes apparent that many on Wall Street haven't figured out the RFS2 yet. If Wall Street doesn't understand the RFS2, it is likely that they are making the wrong recommendations and errors in their earnings estimates. If they are making the wrong recommendations and earnings estimates, it creates an opportunity to profit from their errors because the market has discounted their errors.

Another favorite subject is Yahoo's (YHOO) holding of Alibaba. When I first wrote about that issue a year ago it was relatively unknown. Now it is very well known the stock is up over 100% from when I first wrote about it. The markets hadn't fully discounted the relatively unknown holdings of Alibaba, but I was pretty confident they would once the market started to pay attention to them.

My other favorite theme to write about is gold. I have written many bearish articles on gold, detailing the counter intuitive theory that gold is not an inflation hedge... at least not now. The fifth article I wrote for Seeking Alpha detailed how gold was behaving like a leveraged bond fund. The reason that is significant is because if gold was an inflation hedge, it would be performing like a leveraged inverse bond fund. If gold was an inflation hedge it would be directly correlated with interest rates and inversely correlated with bonds.

The fact that gold was correlating with bonds defies every economic and financial textbook ever written, or at least that I've ever studied. Gold is the classic inflation hedge. Ask anyone what is the most popular inflation hedge and the number one will be gold. Ironically, during a period of disinflation and near deflation, all the gold commercials still tout gold as an inflation hedge. The reason they do that is because they know the markets think of gold as an inflation hedge. Problem is the markets are wrong, and if the markets are wrong, money can be made from their error.

The theory goes that printing money causes inflation and inflation drives the price of gold higher. Almost everyone has been taught that. I was taught that; textbooks teach that to this day. Problem is they are wrong, or at least not right in all circumstances. What the markets failed to understand is the context in which that theory was developed. That theory is consistent with late business cycle inflation, or hyperinflation situations like the Waimar Republic where newly printed money was immediately used to take things off the shelves of a store. 

Yes, printing money can cause inflation, but it doesn't always result in inflation. Printing money that simply goes and sits in a back as reserve requirements isn't inflationary. For money to be inflationary it has to be put into circulation buying things

Banks are loaning, people aren't buying, there is no mechanism for the new money to cause inflation is it just sits in a bank. That is what the market doesn't, or at least didn't, get. The market reaction of gold even confused Janet Yellen and Ben Bernanke, who claim they don't understand its behavior, and don't believe anyone else does either:
At her Senate confirmation hearing in November, Janet Yellen said, "I don't think anybody has a very good model of what makes gold prices go up or down." Ben Bernanke also said last year that "nobody really understands gold prices, and I don't pretend to understand them either."

That is understandable; gold has been performing in a counterintuitive manner contrary to what is taught in our finance and economic courses. It is not surprising then that many of my articles were just viciously attacked. The gold bugs are legendary for their vitriol, and my articles brought out the worst of them. It takes a whole lot for people to change their thinking, especially when it has been drummed into them year after year after year. Old habits die hard, and I knew the belief that gold wasn't an inflation hedge would take a long time for the markets to accept. Therefore, I knew there was going to be many many many opportunities to make money shorting gold. That belief resulted in many articles highlighting that the gold rallies were nothing but dead cat bounces and pointing out how gold uber bulls were certain to be wrong.

Fortunately, I do not stand alone with this counterintuitive theory. Thanks to a comment on my recent article, it was brought to my attention that Pimco is promoting the exact same theory that I have been outlining over the last year. They even produced a nice graph to demonstrate it.



Where is Gold Going?


In mid-December 2013 gold tested key support of $1,200/oz, and the support held. After support held, gold rallied to reach a peak of $1,275 on January 26, 2014.


(click to enlarge)

Since that time a crisis in Turkey, a global stock market correction and falling interest rates after the Fed's "Taper" announcement has failed to provide support for gold. Those kinds of events usually provide support for gold, but this time, owners of gold have used the opportunity to exit their positions, not add to them. Gold appears to be losing its safe haven appeal.

To make matters worse for gold, its close cousin silver has retraced more than 100% of its post December 19th advance.


(click to enlarge)

Running a comparative chart of the gold and silver ETFs highlights the divergence.

(click to enlarge)

While gold and silver don't always trend together, they do so more often that not. With the most recent events failing to drive gold higher, and silver giving up 100% of its most recent rally, I would expect the odds favor gold retesting $1,200/oz over reversing from here and exceeding its previous peak of $1,275. If gold significantly breaks the $1,200/oz support, I would expect gold to rally back up to $1,200/oz, which would then become a resistance level. If gold fails to retake the $1,200/oz level, then there is little to stop it from dropping to $1,100 and beyond.

(click to enlarge)


In conclusion, following the classic relationship of gold and inflation will not work in this current market environment. Gold is not acting as an inflation hedge, it is acting as a fear gauge - a fear of financial collapse

As the economy strengthens, and inflation and interest rates return to normal, gold will sell off, not rally. Gold is likely to continue through an extended bear market until we get late into the business cycle when capacity constraints and a tight labor market generate the kind of inflation that will drive gold higher. That, however, is a long way away, and gold will go a lot lower before it finds a bottom from which it will rally due to eventual inflation.

I expect that gold is headed towards a critical support level. $1,200 has been tested multiple times over the last decade, and each time it has proven to be either a significant support or resistance level. Given that gold tested $1,200/oz just last month, and is already looking like it will be tested again soon, with silver already breaking its support level, I would place odds that gold will break $1,200 this time, and $1,100 will become the next likely price target.