IMF: Global economic recovery fragile and risk of relapse high

Disorderly default and exit by eurozone member could spark market panic and cause bigger crisis than after Lehman collapse, IMF says in World Economic Outlook report

Larry Elliott in Washington

guardian.co.uk, Tuesday 17 April 2012 12.04 EDT

http://www.guardian.co.uk/business/2012/apr/17/global-economic-recovery-fragile-imf

The International Monetary Fund warned today that the European debt crisis could flare up again at any time and send the global economy back into deep recession.

Olivier Blanchard, the Fund's chief economist, said there was currently "an uneasy calm" following the tensions in financial markets at the end of 2011, with hopes of a gradual recovery dependent on keeping the single currency in one piece.

The IMF also gave the Bank of England the all-clear to add to its £325bn programme of quantitative easing if the UK economy struggles to recover from its longest and deepest recession of the post-war era. The Fund said that there was a risk of a 1930's style slump. "In the current environment of limited policy room, there is also the possibility that several adverse shocks could interact to produce a major slump reminiscent of the 1930s."

Asked about the risks that a country would leave the euro, Blanchard said: "We are doing everything possible so that this does not happen."

The IMF's chief economist said membership of the single currency made it harder for countries to become more competitive, but added: "For the moment there is no plan B. The costs of one country leaving the euro unilaterally would be very big and would lead to a very large drop in output."

Blanchard said there would be contagion risks if one country departed from the single currency, and said this would be one of the circumstances in which the firewalls would be needed. There would be knock-on pressure on the sovereign bonds of other nations, he said.

At a press conference to mark the publication of the IMF's flagship World Economic Outlook, Blanchard, said: "In the fall, a simmering European crisis became acute, threatening another Lehman size event, and the end of the recovery.

"Strong policy measures were taken, new governments came to power in Italy and Spain, the European Union adopted a tough fiscal pact, and the European Central Bank injected badly needed liquidity. Things have quieted down since, but an uneasy calm remains. At any time, things could get bad again."

He added: "The main risk remains that of another acute crisis in Europe. The building of the 'firewalls', when it is completed, will represent major progress. By themselves, however, firewalls cannot solve the difficult fiscal, competitiveness, and growth issues that some of these countries face. Bad news on the macroeconomic or political front still carries the risk of triggering the type of dynamics we saw last fall."

"Further measures must be taken to decrease the links between sovereigns and banks, from common deposit insurance, to common regulation and supervision. Now that the fiscal pact has been introduced, Euro countries should also explore the scope for issuing common sovereign bonds."

In the absence of a euro meltdown, the IMF predicted that weak recovery was likely to resume in developed countries — including the UK — and to remain relatively solid in emerging nations.

Global growth was projected to drop from 3.9% in 2011 to 3.5% before rebounding to 4.1% in 2013. At the turn of the year, the Fund had feared a more pronounced drop in global growth as a result of the debt crisis in the eurozone but has now revised up its forecasts modestly for all regions.

The IMF said it expected growth in the UK to be 0.8%, little changed on the 0.7% recorded in 2011 but slightly higher than the 0.6% the Fund had pencilled in for 2012 three months ago. It left the 2013 forecast unchanged at 2%.

Noting that Britain's financial sector had been hard hit by the financial crisis, the Fund said activity would be weak in early 2012 before recovering. The Office for National Statistics will next week publish its first estimate for gross domestic product in the first quarter of 2012, with the City forecasting a small increase in activity.

"In the United Kingdom, with inflation expected to fall below the 2% target amid weaker growth and commodity prices, the Bank of England can further ease its monetary policy stance," the Fund said.

The eurozone is still expected to suffer a mild recession in 2012, with output falling by 0.3% and the outlook for Spain – the current cause for concern in financial markets - is now thought to be worse than it was three months ago.

"Because of the problems in Europe, activity will continue to disappoint in the advanced economies as a group", the WEO said, "expanding by only about 1.5% in 2012 and by 2% in 2013.

"Job creation in these economies will likely remain sluggish, and the unemployed will need further income support and help with skills, retraining, and job searching."

The IMF said the most immediate concern was a further escalation of the euro area crisis leading to a "generalised flight from risk".

This, the Fund added could see output in the euro area fall by 3.5% over two years, with knock-on consequences for the world economy, which would see activity decline by 2% over the same period.

With most eurozone countries now subject to tough deficit-reduction plans, the IMF warned: "Austerity alone cannot treat the economic malaise in the major advanced economies."

It added that "sufficient fiscal consolidation" was taking place in Europe and said plans should be structured "to avoid an excessive decline in demand in the near term."

The US, Canada and Japan are expected to be the fastest growing of the leading G7 industrial nations this year, with growth of around 2%. China's growth rate, which dropped from 10.2% in 2010 to 9.2% last year is expected to ease further to 8.2% in 2012. Sub-Saharan Africa is forecast to keep up its recent 5%-plus growth rate.

The Fund said the low levels of domestic inflation meant there was scope for further action by central banks and said policy makers should guard against overplaying the risks related to unconventional monetary support.

"While unconventional policies cannot substitute for fundamental reform, they can limit the risk of another major economy falling into a debt-deflation trap, which could seriously hurt prospects for better policies and higher global growth".