By Brai Odion-Esene

WASHINGTON (MNI) – Having taken on the challenge of directly
addressing how major economies pose risks to each other and their
smaller neighbors, the IMF Thursday said Europe needs “urgent” and far
reaching policy changes, the U.S. should fix its fiscal policy, China
must brace for any slowdown, Japan should speed up its escape from
deflation and the UK should rebuild confidence in its financial
institutions.

The International Monetary Fund’s 2012 Spillover Report described a
world that is “ripe” for spillovers, but argued that a coordinated
reaction, going beyond the bounds of standard policy, could attentuate
the effects.

The spillover reports examine the external effects of domestic
policies in five economies seen to be systemic, the so-called S5 —
China, the Euro Area, Japan, the United Kingdom, and the United States.

The report aims to provide an added perspective to the policy line
developed in the Article IV discussions with these entities and an input
into the Fund’s broader multilateral surveillance.

The IMF said topics for this report were chosen based on
consultations with officials from the S5 and selected emerging markets
— Brazil, the Czech Republic, India, Korea, Mexico, Poland, Russia,
Saudi Arabia, Singapore, South Africa, and Turkey. It said this report
focuses on the forward-looking issues raised by partners and on S5
officials’ reactions.

“High asset price correlations, shocks to financial risk premia,
and limited policy space all combine to intensify cross-border
spillovers from systemic country policies and developments. Together
with the deteriorating outlook, this explains the heightened concern
expressed this year about spillovers,” the IMF said.

The list of concerns raised by officials consulted for this report
is not surprising, revolving around the issues that currently pose the
greatest threat to the global economy:

–The eurozone’s struggles. “The sense is that not enough has been
done to stop the spread of stresses and attenuate fiscal-growth-banking
feedback loops,” the IMF said.

–U.S. fiscal policy and the worry of a “too sharp” fiscal
contraction in 2013 and, not enough — “or ill defined” — adjustment in
the medium term, both with potential to disrupt economic activity and
financial markets.

–Monetary policy in the U.S. and other advanced economies.
“Officials from emerging market economies thought the easing of monetary
policy in advanced economies had the side effect of pushing up the
prices of emerging market currencies, assets, and commodities,” the IMF
said.

–China growth and rebalancing. There is surprisingly little
mention of China’s foreign exchange policy in this report beyond an
acknowledgment of progress on the currency front and in reducing the
current account surplus.

“However, with the adjustment investment-led in an economy with
already high investment rates, an abrupt reversion could yield negative
spillovers,” the report said.

–Japan fiscal risks and ballooning debt burden makes the cut.
“High public debt, the highest in the S5, makes it vulnerable to an
abrupt shift in market sentiment,” the IMF said.

There was also concern expressed with regards to financial reform,
with some elements of it viewed as “problematic,” the IMF said. For
example, “the prohibition of proprietary trading in other countries’
sovereign debt under the Volcker rule, thus raising liquidity premia and
bond yields.”

The IMF report said while most of these shocks that could give rise
to spillovers will hopefully be prevented from materializing, this
cannot be taken for granted.

“The foregoing points to the need for stronger steps to prevent the
shocks that generate global spillovers,” it said. “But were one to
materialize, a coordinated reaction, going beyond standard policy
bounds, could attenuate the effects.”

“The spillovers from policy inaction or mistakes would be severe
without global responses and still significant with responses,” it
added.

Still, the report said a simulation by IMF staff showed that, in
the case of intensified euro area stress, the use of automatic fiscal
stabilizers by other systemic advanced economies reduces their output
losses by 15% to 25%, adding that the mitigation is close to one half
across China and other economies if they also react with conventional
monetary policy easing.

But it does not see conventional policies as the only option.

“Responses such as quantitative easing can prevent asset prices
from collapsing, greatly attenuating spillovers through bond markets,
and perhaps more importantly, stock prices,” the IMF said. “Previous
staff work has shown that coordinated policy reaction is usually more
effective, even ignoring the confidence effects it induces.”

The report concluded by putting forward suggestions, already raised
in direct consultations with the countries in question, that could
prevent these shocks.

In the Euro Area, the situation calls for “a policy game changer,”
the IMF said, with “urgent” steps towards a banking union, fiscal
integration, phased fiscal consolidation and monetary accommodation.

“Structural reforms must raise growth across — and fix
competitiveness problems within — the euro area,” it added.

It can be assumed then that, from an IMF point of view, the
European Central Bank’s decision Thursday not to announce any detailed
new measures to support the eurozone and its struggling members, looks
like a missed opportunity.

In the United States, the IMF said the priority must be to remove
the threat of the fiscal cliff, and adopt a credible plan for
medium-term adjustment. In addition, it said the recovery can be
supported with action on housing and monetary accommodation, while
financial reform should be mindful of potential adverse effects on
others.

The report urged China, to be prepared to adapt macro policies to
“any unexpected weakening in global prospects,” and take steps to
rebalance domestic demand gradually from investment to consumption.

“In Japan, the medium-term fiscal adjustment plan now under
consideration in the Diet should be doubled to 10% of GDP,” the report
said, “supported by reforms to raise growth and by monetary easing to
escape deflation.”

It said further steps are needed in the United Kingdom to fortify
the financial system and to underpin confidence in the banks and market
institutions “that render it a global platform.”

** MNI Washington Bureau: 202-371-2121 **

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