Double-dip recession unlikely as strains ease

Dubai: Playing down the possibility of a double-dip recessionary scenario, the International Monetary Fund said yesterday that the "overarching policy challenge globally" is to restore financial market confidence without choking the nascent economic recovery.

This is particularly true for the euro area, where well-coordinated policies are required to rebuild confidence, according to the update of the World Economic Outlook (WEO) released by the IMF.

In a companion update of its Global Financial Stability Report, the IMF said acute market strains have "receded somewhat over the last month or so", but market confidence remains fragile.

"The world economy expanded at an annualised rate of over five per cent in the first quarter of 2010. Growth was stronger than expected in most countries, including the United States, Europe, Japan, Brazil, and India," said IMF chief economist Olivier Blanchard.

"In most cases, it has reflected stronger private demand, a good sign for the future. The most recent indicators suggest some slowdown of demand, but it is too early to assess how significant this slowdown may be."

Contagion

The clouds started building over Greece, but quickly extended to Europe, and are threatening to cover the entire global economy, Blanchard said.

"Worries about fiscal solvency in Greece turned into worries about fiscal solvency elsewhere. Worries about fiscal solvency have triggered worries about the solvency of banks. These in turn have led to financial turbulence, disruptions in market financing and a freeze in the interbank market in Europe, he added.

According to the IMF document, further decisive follow-up is needed to the significant national and supranational policy responses that have been taken in order to strengthen confidence in the financial system and ensure continuation of the economic recovery.

Spillovers between sovereigns and the banking system has increased market and liquidity risks. Banks again have become less willing to lend to one another, except at the shortest maturities, especially to banks in euro area countries perceived to be facing greater policy challenges.

Moreover, financial asset price volatility has increased and investor risk appetite has declined.

"Such financial risks have raised the chances of re-establishing an adverse feedback loop to the economy, though to date there is little evidence of this," the WEO said. The announcement of the European Financial Stability Facility and the programme by the European Central Bank (ECB) to buy securities helped to ease some of the more severe euro area bond market pressures.

After the announcement of the securities purchase programme in early May, spreads over German sovereign bonds on Greek, Portuguese, and Irish debt narrowed. "Recently, however, the effect has been wearing off, and market liquidity in this debt has remained poor," the IMF said.

With the heightened uncertainty about the health of some banks, average bank credit default swap (CDS) spreads are increasing in the UK, US, and euro area.

"In part, the pressure on banks has been exacerbated by the legacy of unfinished cleansing of bank balance sheets over the last three years, a process that has been slower in the euro area than in the UK and US," it said.