In its latest Global Financial Stability Report released in Washington on Wednesday, the IMF stated that risks to the global financial system had risen since its last report in October because market turmoil could easily recur and intensify if no action was taken to clean up bank balance sheets, particularly in China and Europe.

"If the growth and inflation outlooks degrade further, the risk of a loss of confidence would rise. In such circumstances, recurrent bouts of financial volatility could interact with balance sheet vulnerabilities," the IMF said in the report.

"Risk premiums could rise and financial conditions could tighten, creating a pernicious feedback loop of weak growth, low inflation and rising debt burdens," it added.

The report came as finance ministers and central bankers from around the world are convening in Washington this week for the spring meetings of the IMF, the World Bank and Group of 20 finance ministers and central bank governors.

The report complements the IMF's gloomy World Economic Outlook publication released on Tuesday, in which the crisis lender cut its growth forecasts for the fourth time in the past year.

China bank worries

In its stability report, the IMF came to the conclusion that the recent turmoil in global financial markets - which hit especially Chinese stocks at the beginning of this year - was caused by investors' concerns for the growth slowdown in the world's second largest economy.

China's struggling state enterprise sector was straining bank balance sheets to the point that some $1.3 trillion (1.14 trillion euros) were at risk of default - translating into potential bank losses of approximately seven percent of the country's gross domestic product (GDP).

"This may seem like a large number, but it is manageable given China's bank and policy buffers and continued strong growth in the economy," said Jose Vinals, head of the IMF's Monetary and Capital Markets Department.

Debt overhang stifles growth

What worries the IMF more are current levels of public debt in advanced economies, and to a lesser extent in emerging nations.

It calculated that average public debt in industrialized nations has risen to over 107 percent of gross domestic product, with Japan's debt standing at almost 250 percent. Emerging market economies are better off at just under 50 percent of GDP, but their financial needs are also rising, with many of them facing sharply higher fiscal deficits than the advanced economies.

High and rising debt levels would make it harder for governments to boost spending in support of growth, the IMF said, especially in many European countries and Japan which remained mired in economic weakness.

As a result, more countries are approaching the World Bank and the IMF for financial support. According to the World Bank loan requests have surged to levels only seen during financial crises. And most recently, the IMF was approached by Angola whose financial position has been devastated by the crash in oil prices.

Therefore, the organization urged countries with some fiscal space to spend more, while others needed to focus spending on "anything that will accelerate growth" such as infrastructure, education, business creation and research and development.

"A lasting solution to the debt overhang problem is not possible without higher medium-term growth," the IMF said.

Negative interest rates crucial

In a somewhat surprising note, the IMF's report praised recent monetary policies adopted notably by the European Central Bank(ECB) and the Bank of Japan (BoJ). The two central banks have launched massive asset-buying programs and introduced negative interest rates, effectively punishing commercial banks that park money with them instead of lending it out to businesses.

The IMF stability report said negative interest rate policies were "crucial" to boosting economic growth, although they had reduced bank profit margins. Commercial banks would ultimately benefit from stronger growth and the ability to cut non-deposit funding costs, it added.

Under the IMF's worst-case scenario, global economic growth is estimated to plunge by 3.7 percent over the next five years - effectively the loss of nearly a year's worth of growth at current levels.

Therefore, it called for action by global leaders to reduce liquidity risks, clean up non-performing loan problems and reduce vulnerabilities in emerging market banks. If those risks were effectively addressed, annual growth could add 1.7 percent to baseline growth by 2018, it concluded.

uhe/kd (dpa, Reuters, AFP)