World growth slows,credit crunch clouds outlook-IMF

By Lesley Wroughton

WASHINGTON, Oct 17 (Reuters) - The world economy is solid but will lose a step next year as growth slows in the United States and Europe, the International Monetary Fund said on Wednesday, warning that disarray in global credit markets had clouded near-term economic prospects.

The IMF maintained its previous forecast, made in July, for 2007 global economic growth of 5.2 percent, but lowered the forecast for 2008 by 0.4 percentage point to 4.8 percent.

"While underlying fundamentals supporting growth are sound and the strong momentum in increasingly important emerging markets is intact, downside risks from the financial markets and domestic demand in the United States and western Europe have increased," the IMF said in its semi-annual World Economic Outlook.

The IMF said the global expansion was now firmly led by China, whose economy is expected to grow by 11.5 percent in 2007 and slow slightly to 10 percent next year.

The IMF's largest downward revisions in its growth forecasts were in the United States and in countries affected by the troubles in the U.S. subprime mortgage market, especially Canada, Mexico and some Asian economies. It said the U.S. economy was set to grow just 1.9 percent next year, a sharp downward revision from the 2.8 percent forecast in July.

The problems in the U.S. subprime mortgage market, which has seen a wave of foreclosures, spread quickly worldwide because the loans were packaged into complex financial securities and resold to investors.

The turmoil triggered a tightening of credit conditions in August, prompting central banks around the world to respond with massive injections of liquidity to ensure the global financial system did not feeze up. The U.S. Federal Reserve cut interest rates sharply in an attempt to limit economic damage from the credit crunch and market turbulence.

U.S. RATES COULD MOVE LOWER

The IMF said signs that U.S. growth was likely to continue below trend would justify further interest rate cuts, provided inflation was contained. Meanwhile, rates should be held on hold in the euro zone rates and in Japan, where authorities should wait for clear signs of rising inflation, it added.

The IMF said its baseline forecast for global growth was based on the assumption that market liquidity would be gradually restored in the next few months and that interbank lending would revert to more normal conditions.

Still, the IMF said there was a distinct possibility that market turbulence may continue for some time, further dampening growth, particularly through the effect on housing markets in the United States and some European countries.

Countries in eastern Europe and former Soviet states with large current account deficits could be affected should capital inflows weaken, it added.

The immediate task for policy-makers was to restore market conditions and to safeguard the global expansion, the fund said, citing uncertainties over the scale of losses that investment banks were suffering because of the credit turmoil.

It said rising oil prices, which hit a record above $88 a barrel on Tuesday, were an additional risk to the global outlook, adding that further spikes in prices could not be ruled out amid limited spare production capacity.

Risks from persistent global economic imbalances -- large trade deficits in the United States and massive surpluses in China and oil-producing countries -- also weighed, although inflation worries had generally eased, the IMF said.

U.S. DOLLAR OVERVALUED

The IMF repeated its view that the U.S. dollar was overvalued, despite recent declines to record lows, and needed to depreciate further. It also said the yen was undervalued, considering medium-term fundamentals.

"In the IMF staff's view, the dollar remains overvalued relative to medium-term fundamentals," the IMF said.

It said the euro, which has recently chalked record highs against the dollar in recent weeks, continued to trade in a range broadly consistent with medium-term fundamentals.

The euro's strength has prompted anguished calls from some European politicians for U.S. action to strengthen its currency, but the IMF said the euro did not look particularly expensive.

The fund said the Canadian dollar, which also has strengthened, was in line with fundamentals, but the British pound was overvalued.

The IMF repeated that more flexibility in China's currency was needed to help unwind global financial imbalances and boost domestic consumption.

The Chinese yuan has gained a further 7.8 percent against the dollar since it was revalued by 2.1 percent in July 2005 and cut free from a dollar peg to float within tightly managed bands.

But the United States and other trade partners say the currency remains far too cheap, given China's record $1.434 trillion stockpile of foreign exchange reserves.