The IMF slashed its global growth forecast and warned things could get much worse if the eurozone crisis is not quelled and Washington fails to reverse the looming "fiscal cliff" austerity plan.
Unrelenting market turbulence and budget-cutting in developed countries has spun worries about risks across the globe, slowing trade and investment, the International Monetary Fund said in a report released Tuesday in Tokyo.
The Fund cut its growth forecast for this year to 3.3 percent, from its July estimate of 3.5 percent, with Asia still leading the pack of expanding regions while Europe contracts an expected 0.4 percent this year.
Growth will only hit 3.6 percent next year -- lower than the 3.9 percent predicted in July -- as even powerful emerging economies like China, India and Brazil hit the brakes, the Fund said.
But it warned that its assumptions are based on Europe's leaders getting ahead of their crisis soon and US politicians reversing course from the harsh spending cuts and tax hikes slated for January 2013 in a poison-pill deficit deal cemented last year but never intended for implementation.
"Failure to act on either issue would make growth prospects far worse," the Fund said in its World Economic Outlook.
Whether the world's economy can achieve even the lowered forecasts, the Fund said, "depends on whether European and US policymakers deal pro-actively with their major short-term economic challenges."
"The most immediate downside risk -- that delayed or insufficient policy action will further escalate the euro area crisis -- remains in place."
"In the United States, it is imperative to avoid excessive fiscal consolidation (the fiscal cliff) in 2013, to raise the debt ceiling promptly, and to agree on a credible medium-term fiscal consolidation plan."
The IMF said the main forces pulling down growth in advanced economies are pressure to close budget deficits, by cutting spending and hiking taxes, as well as frail banking systems.
In its twice-yearly Fiscal Monitor report, the Fund said about half of economies measured were on target to bring their budget deficits under pre-financial crisis levels by next year.
"Despite substantial progress in restoring the sustainability of public finances, fiscal vulnerabilities remain elevated," the report said.
"Public debt rollover requirements are still very high and expose countries to the vagaries of financial markets," it added.
But, the Fund cautioned, economic managers have to tread a very fine line.
"While this consolidation is needed, there is no question that this is weighing on demand," IMF chief economist Olivier Blanchard told reporters in Tokyo, adding it was a long-term process. "This is a marathon not a sprint."
The effect is to add to homegrown weaknesses in developing countries by generating uncertainty among investors and slowing trade overall.
In the report, Blanchard credited the aggressive monetary easing by the world's leading central banks with keeping the global economy going.
"The main force pulling growth up is accommodative monetary policy. Central banks continue not only to maintain very low policy rates, but also to experiment with programmes aimed at decreasing rates in particular markets, at helping particular categories of borrowers."
The report noted concerns that central bank stimulus efforts, like the US Federal Reserve's quantitative easing bond buying programme, aimed at forcing long-term interest rates lower, are not benefiting the intended sectors.
"However, large differences in financing conditions do not mean that monetary policy is not working. The actions taken by central banks have forestalled worse outcomes," it said, pointing to France and Italy.
"More generally, liquidity provision has prevented a collapse of the banking systems in the (eurozone) periphery economies."
Blanchard emphasised the negative impact of the persistent atmosphere of uncertainty on growth that comes mainly from the problems in the eurozone and United States.
"Alternative risk-off and risk-on episodes, triggered by progress and regress on policy action, especially in the euro area, are triggering volatile capital flows," he said.
"If uncertainty could be decreased, the recovery could well turn out to be stronger than currently forecast."
In Europe, he said, most of the pieces of the solution "are falling into place".
"If the complex puzzle can be rapidly completed, one can reasonably hope that the worst might be behind us."
