IMF Sees Reason for Hope, Caution in World Economy

The world economy has “turned the corner” toward recovery, but substantial regulatory reform is needed to prevent a return to the edge of the abyss, the International Monetary Fund said Wednesday in its semi-annual report on global financial stability.

In the five months since the IMF’s last stability report, “financial markets have rebounded, emerging market risks have eased, banks have raised capital and wholesale funding markets have reopened,” the report reads.

The IMF report came on a day of mixed signals about the U.S. economy as it closed the third quarter. The nation’s second-quarter gross domestic product was revised upward by the Commerce Department, while a separate report found that unemployment in the private sector rose more than expected in September. U.S. stocks slipped in Wednesday trading, but the Dow Jones industrial average ended the quarter with a three-month gain of 15 percent — its best quarterly performance since 1998. Jos? Vi?als, IMF director of monetary and capital markets, said the economic situation has stabilized in both mature and emerging economies.

“Overall, the situation has improved, and we have gone from the verge of the financial meltdown to a situation of stability,” Vi?als said in an interview on the IMF Web site.

Still, credit is tight and the economic recovery is likely to be slow, the report says.

“The financial system is still not on safe grounds,” Vi?als said. “It still depends a lot on economic support — public policy measures — to function. So this means that we need to continue to address some basic problems that still are important.”

Chief among those problems is undercapitalized banks, which need to raise more money, through either private or public means, the IMF report says. The question is how.

“European banks are hoping that they can earn their way to stronger balance sheets, but I think some will take advantage of the healthier capital markets to raise money,” said Peter Boockvar, equity strategist at Miller Tabak. “Plenty of banks have raised money via stock offerings, and the current rally has provided a nice window of opportunity for some to do more.”

The IMF estimates that banks will be forced into $3.4 trillion worth of write-downs thanks to the crisis, but that figure is $600 billion less than it forecast in its April global financial stability report. Also, the IMF said, businesses and households need to reduce their debt levels.

Americans have already begun to pare back debt, according to government reports. Consumer credit decreased at an annual rate of 10.4 percent in July, while the personal savings rate rose to 5 percent in the second quarter of this year, the highest rate of this decade.

On Thursday, the IMF is set to release its global economic outlook for 2010. Most forecasters expect the IMF to increase its global growth forecast for next year from 2.5 percent to 3 percent. On Wednesday, the Commerce Department said the U.S. economy shrank 0.7 percent in the second quarter, an improvement from the preliminary report of a 1 percent contraction.

Jobs are a key element of any economic recovery, and the IMF stability report had tough news for workers.

In the United States, the official unemployment rate stands at 9.7 percent and is expected to climb to 9.8 percent Friday, when September’s numbers come out. The White House and many economists predict that U.S. unemployment will crest at 10 percent next year.

In Europe, however, unemployment is expected to top off at 12 percent next year, the IMF report says, and the high rate will continue to produce adverse side effects: “European delinquencies and defaults are also rising, though from lower levels,” the report reads, “and are likely to accelerate as unemployment allowances and other social safety nets that only offer temporary protection are exhausted.”

Wednesday’s IMF stability report hits at the central problem for governments in managing the recovery from this recession, which began in December 2007: knowing when to pull back hundreds of billions of dollars in stimulus and let the private sector start to work again.

“While the time is not ripe for a full-fledged disengagement from all the unconventional policies undertaken — indeed in some countries additional public resources may still be needed — it is time for policymakers to consider and articulate how and in what sequence policies may be unwound,” the report says.

On oversight of the financial system, the IMF report describes a term economists call macroprudential regulation — the act of trying to identify bubbles as they are forming and taking steps to prevent them from bursting. In the United States, such a process could take the shape of a super-regulator, possibly a Federal Reserve imbued with greater powers, that would be look for systemic problems among interconnected institutions. It would also be given the authority to wind down troubled financial institutions — such as insurance giant American International Group — in a similar fashion to the way the Federal Deposit Insurance Corp. takes over failed banks.

“The priority should be to reform the regulatory environment so that the probability of a recurrence of a systemic crisis is significantly reduced,” the IMF report says. “This includes not only defining the extent to which capital, provisions, and liquidity buffers are to rise, but also how market discipline is to be reestablished following extensive public sector support of systemic institutions in many countries.”