The IMF sounded the alarm in a world economic report that sharply lowered the IMF’s growth projections for the 17-nation eurozone to 1.6 percent in 2011 and 1.1 percent in 2012, down from 2.0 percent and 1.7 percent in a June forecast.
“Should the periphery’s debt crisis continue to propagate to core euro area economies, there could be significant disruption to global financial stability,” the IMF said in its “World Economic Outlook.”
European banks are “heavily exposed” to countries facing rising borrowing costs and lenders should make efforts to increase their capital following holes revealed by recent “stress tests” on the sector, the IMF said.
“A concern is that capitalisation of euro area banks is relatively low, and they rely heavily on wholesale funding, which is prone to freezing during financial turmoil,” the report said.
“Trouble in a few sovereigns could thus quickly spread across Europe. From there it could move to the United States — by way of US institutional investors’ holdings of European assets — and to the rest of the world.”
After previously rebuffing IMF calls for a recapitalisation of Europe’s banks, the European Commission admitted on Tuesday that the sector may need more capital and would extend measures allowing states to rescue their banks.
“Sadly, as the sovereign debt worsens, more banks may need to be recapitalised, on top of the nine signalled in the July stress tests,” Almunia said in a speech, referring to tests that most European banks passed.
With European banks struggling to raise dollars from US lenders wary of their exposure to the debt crisis, the world’s top central banks leapt into action last week to inject dollars into the sector.
The eurozone has battled for nearly two years against a debt crisis that is threatening to spread further, with Italy the latest country hit by a credit downgrade by ratings agency Standard & Poor’s on Tuesday amid persistent fears of a devastating Greek debt default.
The European Commission last week also forecast growth of 1.6 percent in 2011, warning that the economy would grind to a “virtual standstill” at the end of the year as a result of the debt crisis and turmoil on financial markets.
But eurozone states are divided over a new Greek rescue deal aimed at resolving the crisis. The IMF called for “speedy implementation” of the agreement that was reached at a July summit.
The package would expand the powers of the eurozone’s crisis fund, enabling it to buy bonds of distressed nations as well as support bank capitalisation.
The IMF, a participant in debt bailouts of Greece, Portugal and Ireland, said the European Central Bank should continue its extraordinary policy of buying bonds of weak states until the eurozone implements the July measures.
The ECB should also be ready to lower its interest rate if “downside risks to growth and inflation persist.”
Amid rising calls for the eurozone to take a leap towards a federal system, the IMF said Europe’s “greatest hope” against future financial shocks was deeper fiscal integration.
“Crucially, increased sharing of risk will need to be accompanied by increased sharing of responsibility for macroeconomic and financial policies. Countries must stand ready to sacrifice some policy autonomy for the common European good,” the IMF said.