January 24, 2012 3:06 pm

Warning over world economic outlook

World economic growth is set to be significantly weaker than previously thought, the International Monetary Fund said on Tuesday, as it urged the eurozone to break the vicious circle of retrenching banks and governments, falling lending and recession.

Despite more benign market conditions and better economic data, including improved business activity indicators in January, the fund predicts weak momentum from the sovereign crisis of late 2011 will push eurozone economies into recession even if a new crisis is averted.

PMI graphic

PMI graphic

The IMF joined the World Bank in warning that a failure of the euro would prompt another global recession on the scale of that which followed the collapse of Lehman Brothers in 2008

“The current environment – characterised by fragile financial systems, high public deficits and debt, and interest rates close to zero – provides fertile ground for self-perpetuating pessimism,” the fund concluded in its updated World Economic Outlook.

To avoid an escalation of the crisis, the fund has gone further than before in prescribing its vision of a solution to the eurozone’s woes, one that is not likely to find favour with the European Central Bank, Germany or other creditor nations.

Calling for fiscal “risk sharing across euro area members”, the fund has for the first time put its weight behind the idea of eurobonds, something still an anathema to Germany, although to stop countries freeriding on cheap finance, it also advocates “stronger fiscal discipline or centralisation”.

It also called on the ECB to loosen monetary policy further and to continue to buy sovereign debt of peripheral countries in its securities markets programme, which has now purchased €219bn, although additional purchases have slowed to a crawl in recent weeks.

For the medium term, it called on peripheral eurozone economies to push ahead with structural reforms and austerity drives. But it also urged Europe to agree to “substantial” additional money to operate a firefighting fund, going further than simply running the European Financial Stability Facility and its successor, the European Stability Mechanism, in parallel.

It is most likely to succeed with the last recommendation as Germany opened the door to such a move on Monday.

The fund’s Global Financial Stability Report adds to the IMF’s gloomy prognosis, stating that much of the eurozone has failed to develop a mechanism to stop a vicious circle operating between weak sovereign positions undermining bank balance sheets and therefore putting an even greater strain on sovereign debt.

In addition, it warned that the European demand for banks to improve their capital ratios has led to a fire sale of bank assets and a credit crunch that threatens to establish a second vicious circle of falling asset prices, weaker bank balance sheets, deleveraging and recession.

The financial stability report recommended a pan-European facility to help weak banks in peripheral countries.

With so much scope for damaging economic trends, the IMF has significantly downgraded its economic forecasts. It now expects the global economy to grow by 3.3 per cent in 2012, 0.7 percentage points lower than its September forecast.

Most of the downgrade stems from a 1.6 percentage point fall in the growth forecast for the eurozone. The fund now expects the eurozone to shrink by 0.5 per cent in 2012 with much larger contractions of 2.2 per cent and 1.7 per cent in Italy and Spain, respectively, as austerity, a credit crunch and higher sovereign debt costs hit hard.

The IMF forecasts for the rest of the world have also been revised lower, although the US is expected to be relatively immune from the eurozone’s difficulties so long as a disorderly break-up is avoided. In those circumstances, the IMF believes eurozone growth would be 4 percentage points lower than the already bad baseline and economic growth in the rest of the world would fall by 2 per cent compared with the current forecasts.

The fund has maintained its nuanced advice on fiscal policy, encouraging a relatively loose stance in the short term with credible medium term deficit reduction. It has urged Germany to slow its budget deficit reduction and other countries able to borrow cheaply in markets – the US and UK – to allow tax revenues to fall as their economies slow more than expected this year.

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