International Monetary Fund warns on borrowing risk

MASSIVE government borrowing programs threaten to choke a still-fragile global economic recovery by pushing interest rates higher and reducing available credit for the private sector, the International Monetary Fund has warned.

The fund's latest review of global financial stability says that although the extreme risks of a year ago have abated, the world's banks are still facing huge bad debts that could yet cause a "double-dip" global recession.

The fund is concerned that weakened banks, which have $US1.5 trillion ($1.71 trillion) in bad debts to write off, will be unable to provide business and households with the credit needed when governments are mopping up so much available funds. "Since all credit providers can buy sovereign debt, sovereign issuance will effectively compete with - and possibly crowd out - private sector credit needs," the fund said.

The IMF's findings echo comments by Reserve Bank governor Glenn StevensGlenn Stevens earlier this week that long-term interest rates are at risk because of the heavy borrowing requirement of the major advanced countries.

"The thing which is most likely to crowd out Australian businesses and other businesses by pushing up the long-term global interest rate - it is not going to be the Australian government's contribution to borrowing, unless it is a lot bigger than it looks like being - it will be the huge run-up in public debt in the major countries, which are quantitatively so much larger."

In the five years before the crash, the major advanced countries borrowed an average of $US1trillion a year. This doubled last year and will reach $US3.2trillion this year and $US2.2 trillion next year.

The IMF said that over the next two years, the total borrowing needs of government and the private sector would be greater than the ability of the finance sector to supply funds by 2.4 per cent of GDP in the US, 3 per cent in Europe and 15 per cent in Britain.

The result was that despite the continuing depressed state of their economies, long-term rates could be pushed higher. "Financing increases in the budget deficit of 5 to 6 per cent of GDP may well raise long-term interest rates by 150 to 200 basis points with very adverse growth consequences."

Mr Stevens said on Monday there was so far no evidence of long-term rates being pushed higher, but he said the size of the deficits in the US, Europe and Britain created a potential problem. Long-term interest rates are set in world capital markets, which is why the level of Australian government debt has no influence.

The IMF said the focus of the crisis was now shifting from the private sector banks to governments. The margin that private sector banks have to pay above official cash rates is now smaller than it was before Lehman Bros crashed a year ago. So, too, is the premium that major corporations have to pay when they raise debt.

However, the spreads that governments have to pay are now greater than they were a year ago.

"This is consistent with the transfer of private sector risks to sovereign balance sheets," the IMF said. Its biggest concern with the private banking sector is the continued weakening of commercial property markets.

Small commercial banks in the US have half their loans secured by commercial property.

"A further deterioration in bank balance sheets could intensify the global recession in a feedback loop with the financial system," the fund said, adding that the fragile state of the world's financial system meant there was a case for retaining banking guarantees, even though more banks are now able to raise funds on world capital markets on their own.

"An early exit by countries keen to demonstrate their banks' strength could put pressure on countries with weaker banks," it said. "Given the global nature of the crisis and the types of unconventional policies used, attention must be paid to the cross-border impact of unwinding, and co-ordination may be helpful, notably with regard to the withdrawal of guarantees for bank debt across countries where potential arbitrage opportunities can arise."

The fund said it was critical for governments to be clear in the way they communicated their withdrawal strategy, saying it would be better to publish the indicators of market conditions that would guide a decision.

"Given that this is uncharted territory for policy-makers, some experimentation may be appropriate to test market conditions."