Europe presents main threat to global recovery, IMF says

By Howard Schneider
Washington Post Staff Writer
Thursday, July 8, 2010

Europe's weakened economy is now the central threat to global recovery, as its countries struggle with heavy debt, banks face a reckoning over their lack of capital and growth is slowing, the International Monetary Fund said Wednesday in its first assessment of the world economy since a crisis over government borrowing in Greece.

While the agency estimated that growth in the United States and emerging Asian and Latin American countries remains on track, it scaled back projections for Europe and outlined a series of issues there that could -- unless controlled -- spark problems rivaling those that caused the 2008 collapse of Lehman Bros.

"Downside risks have risen sharply" in recent months, the IMF said. "The ultimate effect could be substantially lower global demand."

In updating its World Economic Outlook, the IMF slightly raised its overall forecast for global growth, to 4.6 percent for the year, compared with 4.2 percent in its April report. The improvement was based on a stronger than expected performance in the first months of the year, particularly in Asia. The IMF said it also expected the United States to grow slightly faster than earlier predicted -- about 3.3 percent this year and 2.9 percent next year, less than forecast by the U.S. Federal Reserve.

But the outlook for Europe was reduced, as the combined impact of government spending cuts, continued concern over national debt and uncertainty about the banking sector undermines an economy already lagging behind the rest of the world. The IMF projected that the 16 countries that share the euro as a currency will grow just 1 percent this year and 1.3 percent in 2011.

The report and an accompanying analysis of world economic stability emphasized how a problem that was considered limited in scope when it surfaced in Greece last fall eventually expanded to other European countries and is now one of the main issues facing the global economy. Governments across Europe are cutting spending and overhauling social programs in an effort to curb record levels of debt, and the Obama administration is studying similar U.S. measures.

Although no other country has reached the crisis point hit by Greece -- where borrowing costs skyrocketed until a joint European Union-IMF bailout provided emergency funding -- the IMF noted that European countries and the United States will be competing this year to refinance some $4 trillion in government bonds maturing in the second half of the year. With the United States and nations such as Germany considered classic havens, there has been pressure felt in Britain, and in weaker euro-zone economies such as Portugal and Spain, to make a convincing effort to control deficits to keep the favor of bond investors and analysts.

While Europe, in conjunction with the IMF, established a fund to guarantee the repayment of euro-zone government debt, the IMF noted that thecalming effect of that program is "wearing off." The interest rates paid by countries such as Spain and Italy -- and even some, such as Belgium, considered at the heart of "core Europe" -- have been rising again in comparison to those paid by Germany, the continent's top economic performer.

"On the heels of Greece's fiscal troubles, investors are now re-pricing these risks across the region," the IMF said.

In addition, European and other economic analysts are awaiting the result of financial stress tests that will give a sense of how European banks fared during the recent financial crisis and recession, whether they could withstand another downturn, and how much capital they might need to raise to be considered healthy.

Stress tests in the United States helped restore confidence in the banking system. But IMF and other analysts say that European banks have been slow to write off bad loans and raise new capital and, until now, have been protected by national governments from a full accounting of their problems.

The issues of government debt and the health of the banks are related: European banks own tens of billions of dollars in Greek, Spanish and other government bonds, and the stress tests will assess how those holdings affect each company's overall financial health.

The European banking system is plagued by a "legacy of unfinished cleansing," the IMF said, which has left "pockets of vulnerability, overcapacity, and poor profitability." Banks have become hesitant to lend to each other -- much as happened during the U.S. financial crisis -- and are relying on an ultimately unhealthy mix of short-term loans from the European Central Bank to ensure they have enough cash.

"Recent global stability gains are threatened by a confluence of sovereign and banking risks in the euro area that, without continued and concerted attention, could spill over," the agency said.

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