In its new forecast for the world economy, the International Monetary Funds singles out the normalization of financial markets as a key upside and downside risk to its gloomy outlook.

The IMF says that more needs to be done to ensure the downside risks don’t materialize, and that fiscal policy must be employed to spur growth.

The organization adds that policy efforts have addressed the immediate threats to financial stability (through liquidity support, deposit insurance, and recapitalization schemes), “but they have done little to resolve the uncertainty about the long-term solvency of financial institutions.”

The process of loss recognition and restructuring of bad loans is still incomplete, it observes. “Therefore, financial sector policies should focus on advancing this process by forcing credible and coordinated loan loss recognition and by providing public support to the viable financial institutions,” the group counsels. “Such policies should be supported by measures to resolve insolvent banks and set up public agencies to dispose of the bad debts, including possibly through a ‘bad bank’ approach, while safeguarding public resources.”

Monetary policy also remains an important lever, it notes, although it says that the effectiveness of interest rate cuts to support activity is likely to be constrained as long as financial conditions remain disrupted. “With interest rates approaching zero in several major countries, central banks are exploring alternative policy approaches that rely on using their balance sheets to ease monetary conditions further. The focus should be on unlocking key (high-spread, low-liquidity) credit markets,” it says.

The IMF also says that the timely implementation of fiscal stimulus must provide a key support to world growth, as its new, gloomier forecasts are predicated on strong and coordinated policy actions, “any delays will likely worsen growth prospects, it warns.

“Countries that have policy room should make a firm commitment to do more if the situation deteriorates further,” the IMF says. “Fiscal stimulus packages should rely primarily on temporary measures and be formulated within medium-term fiscal frameworks that ensure that the envisaged buildup in fiscal deficits can be reversed as economies recover and that fiscal sustainability can be attained in the face of demographic pressure.”

Countries that have more limited fiscal space should focus their efforts on supporting the financial sector and credit flows, it adds, “while ensuring that budgets adjust to less favorable external conditions. However, it will be important to avoid cutbacks in foreign aid in response to tightening budget constraints, lest hard-won economic gains in developing countries are lost.”

IE