US set for sharp downturn, recession: IMF research

[Naveed Yaseen]

WASHINGTON (October 04 2008): The United States is set for a sharp economic downturn or recession judging by the impact of similar banking crises around the globe over the past 30 years, the International Monetary Fund said on Thursday. In new research, the IMF said the risk of a recession is higher when financial turmoil is preceded by rising house prices and rapid expansion of credit, which was the case in the United States.

"The patterns of asset prices, aggregate credit and house borrowing in the United States during the current episode of financial stress appear similar to those of previous episodes that were followed by recessions," IMF research found.

After several years of a housing boom, the US economy has been shaken by a banking crisis that began with a spike in defaults among the riskiest mortgages and spread to Wall Street, marking the worst financial crisis since the Great Depression.

"It is now all too clear we are seeing the most dangerous shock to mature financial markets since the 1930s, posing a major threat to global growth," Charles Collyns, deputy director in the IMF's research department, told reporters.

He said so far the US economy has slowed but not entered into recession - at least through the second quarter - but risks identified in the research showed it could still. The research, published in chapters of the IMF's bi-annual World Economic Outlook report, was compiled from 113 periods of financial stress in 17 advanced economies over three decades.

The IMF compared the US turmoil to six banking-related crises that affected Finland, Norway, Sweden, Britain and the US in the early 1990s, and Japan throughout that decade. Half of these crises involved the banking sector and the remainder were in securities or foreign exchange markets.

"Based on this metric, the current episode of financial stress ranks as one of the most intense for the United States and one of the most widespread affecting virtually all countries in the sample," the IMF said.

BANKING STRESSES: It said when a slowdown or recession follows a period of financial stress, and especially when the stress is in the banking sector, typically it is more severe. "Economies like the United States, with more arms-length or market-based financial systems, seem to be particularly vulnerable to sharp contractions in activity in the face of financial stress," Collyns said.

"The is because leverage tends to be more pro-cyclical in these economies, which means that when a shock hits the financial system, the process of deleveraging can be more severe, and the risks of a credit crunch are greater," he added.

In particular, slowdowns or recessions preceded by bank-related stress tend to involve two to three times greater cumulative output losses and tend to last two to four times as long, the IMF said.

Recapitalizing banks and responding quickly to the crisis were critical to alleviating such downturns. "To limit the fallout on the real economy it is therefore paramount that the damage to the banking systems in the United States and Europe is swiftly contained by far-reaching and comprehensive measures," Collyns said, welcoming actions by central banks to pump capital into the financial system.

Still, the IMF said the severity of a US downturn could be cushioned by the strong corporate balance sheets at the outset of the crisis and aggressive interest rate cuts by the Federal Reserve soon after the turbulence began a year ago.

"One area of support, until now, has been the quite strong position of the non-financial corporate sector." Collyns said. "That has been one of the factors that have helped buttress the US economy over the past year," he said. In Europe, relatively strong household balance sheets offer some protection against a sharp downturn, the report added.

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