IMF Special Report: Averting Another ‘Lehman Moment’

Three years ago, with banks tottering following the collapse of Lehman Brothers Holdings, Christine Lagarde, then France’s Finance minister, appeared before a gathering of bankers and policymakers during the International Monetary Fund’s annual meeting and promised that Western governments would do what was necessary to save the banking system. Days later, the United States and European governments injected capital into banks and guaranteed their liabilities, moves that ultimately stemmed the panic.

As global financial leaders prepare to gather in Washington later this week for another installment of the IMF and World Bank annual meetings, circumstances are eerily familiar. A new standoff between Greece and its European and IMF overlords on fiscal and economic reform is raising fears that Europe could be approaching its own Lehman moment, involving a Greek government default. European Union Finance ministers did nothing to dispel those worries last week, failing to make any progress toward a long-term resolution at a meeting in Poland and clashing with U.S. Treasury Secretary Timothy Geithner, who was invited to the meeting, over ways to deal with the crisis.

Lagarde, who succeeded Dominique Strauss-Kahn as the IMF’s managing director two months ago, once again finds herself in the thick of things, with even greater visibility than three years ago but arguably with less power to influence events. Lagarde’s call late last month for European banks to raise more capital to protect against the region’s debt crisis drew quick criticism from EU leaders, who regard any hint of undercapitalization as an admission that some European sovereign debt can never be repaid. The EU backlash frustrates officials in Washington, both at the IMF and at the U.S. Treasury, who believe the EU needs to take bolder action to get ahead of the debt problem and prevent contagion from spreading to countries like Spain and Italy.

“Europe’s problems are manageable, but they have to be managed,” says one IMF official. “If they’re not managed, they will fester. And if they fester long enough, they will become unmanageable.”

Speculation is growing in financial markets that Greece will default. Laurence Boone, European economist at Bank of America Merrill Lynch, says it is “increasingly likely” that Greece will default later this year after EU countries approve an expanded role for the €440 billion ($600 billion) European Financial Stability Facility. EU leaders will be able to draw on the revamped EFSF to recapitalize banks, which would make a controlled default easier to contemplate. Boone says a Greek default would probably involve a 50 percent writedown of its debts.

The concern in European is that any hint of more-drastic action might lessen the political pressure on the Greek government to pare its deficit further and enact economic reforms. IMF officials say Athens stalled on its reform efforts after the EU struck a deal in July on a debt exchange that would effectively writedown some of the country’s debts. They want to see a fresh commitment to deficit reduction when fund and EU officials hold a conference call with the finance minister Evangelos Venizelos later Monday. The prime minister George Papandreou had been scheduled to come to Washington on Tuesday to appeal personally for the next €8 billion tranche of bailout aid, but he cancelled the trip over the weekend. Fund officials must judge Greece in compliance with the terms of the three-year bailout program by early October in order for aid to be released and default averted. “There’s still a big chasm in trusting whether these guys can deliver,” says the fund official.

Greece, and Europe, ultimately need stronger growth to resolve their debt problems, but the news out of Washington this week is unlikely to be encouraging. The IMF is expected to lower its growth forecasts for Europe and the United States yet again when it releases its World Economic Outlook on Tuesday. Fund officials, like many in the financial markets, have very modest expectations that any further easing from the Federal Reserve Board, whose policy-making committee meetings Tuesday and Wednesday, will boost growth by much. On Wednesday, the IMF will release its Global Financial Stability Report, which will include the fund’s much-anticipated estimate of the amount of additional capital European banks need.

Expectations are similarly subdued for the wider policy discussion at Friday’s G-20 meeting, which combines the developed West with emerging economic powers such as Brazil, China, India and South Africa. Earlier this month the IMF released a series of so-called spillover reports that aim to show how economic or policy changes in the United States, say, will affect Europe, Japan and China. The reports are the latest effort by the fund to encourage global policy coordination, involving a familiar cocktail of medium-term deficit reduction in the United States and Europe with measures to spur consumer demand in China. But most of the parties are too preoccupied with domestic politics – the debt crisis in Europe and the aftermath of the debt-ceiling debate in Washington – to do much in the way of coordinating.

The atmosphere is not as dire as three years ago, when the financial system appeared on the verge of collapse, but today’s myriad problems resist any simple solution. Lagarde will have to muster all of her political skills and diplomatic charm to generate confidence at this year’s meetings.