The European Central Bank may have to cut interest rates and launch a fresh round of unconventional monetary easing to help boost the euro zone economy, which is still weighed down by spending cuts, the IMF said on Thursday.
While recent purchasing managers' surveys on the euro zone have suggested that business activity is picking up, offering a glimmer of hope that the currency bloc can return to growth soon, the IMF does not see a recovery until 2014.
In an assessment of the economy of the 17 countries sharing the euro, the Washington-based organisation said efforts to shore up public finances could cut growth by up to 1.25 percentage points this year.
As a result, it forecast the euro zone would remain in recession for the second year in a row, contracting another 0.6 percent before a return to 0.9 percent growth in 2014.
"For the area as a whole, the negative growth impact of consolidation could reach as much as 1-1.25 percentage point this year," the IMF said. "Fiscal adjustment should be paced to avoid an excessive drag on growth."
With a risk of stagnation in the euro zone, and inflationary pressure very weak, the ECB should act to help growth with measures to reduce financial market "fragmentation" - a code word for highly disparate credit rates for companies in the north and the south of the euro zone.
"Additional unconventional monetary support could help reverse fragmentation," the IMF said.
"Taking its current approach forward, the ECB should ensure term funding needs for weak but solvent banks through an additional LTRO of sufficient tenor," the report said, referring to the bank's ultra cheap loans to banks, called Long-Term Refinancing Operations (LTRO).
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"This would be most effective if accompanied by lower collateral haircuts, particularly on small and medium-sized enterprise loans," the report said.
"To tackle fragmentation and repair monetary transmission more decisively, the ECB should consider further unconventional policies, including through a targeted LTRO (linked to new SME lending), or direct purchase of select private assets," it said.
The report praised the extra time that European Union finance ministers gave several euro zone countries to reduce their budget deficits as a way to support demand, but said even longer deadlines for some governments may be needed.
"Given weak growth prospects, these deadlines may still prove to be overly ambitious in some cases, and even more flexibility may be useful, particularly if countries use that fiscal space to implement ambitious structural reforms, or to recapitalize viable banks," the IMF said.
"In this context, the small projected loosening of the fiscal stance in Germany is appropriate. If downside risks materialize, countries that are not under market pressure would benefit from a slower pace of fiscal adjustment," it said.
To help stem the growing risk of stagnation, individual euro zone governments must continue with reforms and the euro zone as a whole must go ahead with its plans to create a banking union.
The banking union is particularly important because it will finally help identify which of the 200 larger banks still have problems and hidden losses, recapitalise them and in this way get credit going again to small and medium-sized firms.
The clean-up of the banking sector would be a result of a bank asset quality review done by the ECB next year and a test of what would happen to the value of those assets under various adverse economic scenarios that would follow.
Three such stress tests have already been done over the last three years by the European Banking Authority (EBA), but badly failed to show the full extent of the sector's problems.
"Independent third-party involvement (preferably from the private sector), along with the ECB, the EBA and national authorities, would be essential to ensure full credibility and transparency of the exercise," the IMF said.
"In the absence of such involvement, prospects for raising private capital would be jeopardized," the IMF said in the report.