UK and world facing the biggest financial shock since the Great Depression. says IMF

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Calm down: Alistair Darling moved to allay fears over the economy

In its most startling report of modern times the IMF says that the meltdown on financial markets "has inflicted heavy damage on markets and the financial institutions at the core of the financial system."

For the first time the IMF predicts that the American economy is heading for recession and will shrink by 0.7pc this year sending shock waves across the globe.

Despite healthy growth in the Far East it now believes that there is a 25pc chance that the whole world could follow the Americans into recession.

"The financial markets crisis that erupted in August 2007 has developed into the largest financial shock since the Great Depression," the report says.

It estimates that the financial losses from the collapse of America's toxic mortgages will eventually reach $945bn (£500) more than twice previous estimates.

The US housing collapse is far from over with the Fund economists expecting a further 10pc decline in 2008 on top of similar fall in prices in the previous years. Such declines it believes are way beyond anything seen in the previous American experience.

The apocalyptic language used by the Fund is highly unusual and reflects an unprecedented concern about the impact of the credit crunch which has prevented banks from borrowing in the wholesale money markets making it all but impossible to fund new mortgage lending on both sides of the Atlantic.

In Britain the IMF warns that the "housing correction will continue to impact on consumers" and "be a drag on the economy."

The Fund's top economist Charles Collyns was sceptical about the chances of Alistair Darling meeting his growth forecast for Britain of 2pc this year, as set out in his March budget.

He said that the IMF's own forecast of 1.6pc output expansion "was in line with the consensus."

Speaking ahead of his arrival in Washington for his meeting with the world's top financial leaders, the Chancellor stood by his budget forecasts.

He said there "are grounds for optimism despite the unprecedented shock for the economy."

Britain, he claimed, "has a strong economy that has been remarkably resilient."

In contrast the top IMF economist said: "The housing market will be a drag on the economy," he said and also warned that Britain was extremely vulnerable to the cold winds blowing out of the United States and Europe, with the German economy also slowing rapidly.

"In the UK there are a number of factors both domestically and externally holding back the economy.

"We do see house prices softening and we see potential for that correction to it will continue, with an impact on consumption.

"We also see the UK affected by the tightening in financial constraints related to the turmoil in financial market.

"It will also be affected by the slowdown in the US and the euro area," Collyns cautioned.

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The IMF has warned that home repossessions could double as borrowers struggle with rate increases

Britain in the view of the IMF is much less well placed to deal with the downturn, including the Americans, than our counterparts because of the UK's soaring budget deficit which is expected to hit £38bn this year.

He also noted that Britain's national debt, the accumulated sum of the nation's borrowing over past years, was perilously close to 40pc of national output - the self-imposed limit under Prime Minister Gordon Brown's fiscal rules.

"There has been an upward drift in the fiscal deficit in the UK", Collyns said.

"Nevertheless there will be some fiscal space created by letting the automatic stabilisers work, though the government would have to be careful that in the short term fiscal policy is constrained within its rules - about meeting the 40pc rule," he added.

The automatic stabilisers, referred to by the IMF, is the rise in unemployment benefits and welfare payments to people feeling hardship which push up government spending in hard times and assist in preventing an unrelenting downward spiral for the economy.

Any hope that pressure on the American economy, the key to our own economic health, will improve in 2009 - when there is a new President in the White House - was brushed aside by the IMF.

"Downside risks especially for 2009 remain a concern," it cautioned.

"This is a result of a combination of financial strains, a deep housing market correction and the deteriorating financial position of US consumers."

A house price collapse in the US, beyond the 14pc to 20pc, built into the IMF's forecasts "could have serious repercussions."

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Fears: The IMF has warned that home repossessions could double as borrowers struggle with rate increases

It could affect other economies - including those of Britain, France, Germany and Switzerland - because of the exposure of high street banks to the toxic debts originating in the US. An end was in sight for Britain's housing boom with "a sharp deceleration in house prices."

It noted that in the past house price falls, of the kind now emerging in the UK, have been a "significant factor" on the road to recession.

Meanwhile, banks around the world could face losses approaching £500billion because of the credit crisis.

The analysis will add to fears that the economic crisis triggered by America's sub-prime property collapse could fall out of control.

The Bank of England has warned that the current cash squeeze in the banking system is the worst since the Second World War.

The housing market, one of the key drivers of growth in the UK, has come under increasing pressure due to problems in the mortgage sector.

Figures from the Council of Mortgage Lenders (CML), released yesterday, showed that the number of mortgages taken out fell for the fourth month in a row during February to just 49,000.

Also, the number of mortgages available continued to fall, with Abbey striking a further blow for hard-pressed first-time buyers with the announcement that it is pulling out of the 100% mortgage market.

Mr Darling said: "I think we can do more, working with the industry, to try and reopen the mortgage market.

"The basic problem you have got at the moment is the banks and the building societies have found funding harder to raise because if what is happening in the financial markets generally."

Richard Lambert, director general of the Confederation of British Industry (CBI), said he expected the Bank of England to relax its rules on lending to inject extra liquidity into the financial market.

He told Today: "The Bank is thinking about other steps, which means basically lending money to banks on longer terms than it normally does and against the security of a wider range of assets than it would normally accept as collateral.

"It is fiendishly difficult for it to do, because it has to get the money in the right place, in the right hands, but that is what it is working on."

He supported the moves, adding: "The system is blocked, it needs unblocking."

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