(For more on Europe’s debt crisis, click on {EXT4}.)

Jan. 24 (Bloomberg) -- The International Monetary Fund cut its forecast for the global economy as Europe slips into a recession and growth cools in China and India.

The world economy will expand 3.3 percent this year and 3.9 percent in 2013, compared with September forecasts of 4 percent and 4.5 percent, the IMF said. The euro area may enter a “mild recession” this year and contract 0.5 percent compared with a previous estimate of a 1.1 percent expansion. The U.S. outlook was held at 1.8 percent growth.

“The near-term outlook has noticeably deteriorated,” the IMF said in an update of its World Economic Outlook report. “The global recovery is threatened by intensifying strains in the euro area and fragilities elsewhere.”

The forecasts hinge on increased efforts in the 17-country euro area to fight the financial turmoil, which the IMF calls the “most immediate policy challenge.” The report called on European policy makers to increase the size of the region’s rescue fund and for the European Central Bank to continue its support of the region to limit contagion to other countries.

“We need a larger firewall,” IMF Managing Director Christine Lagarde said in Berlin yesterday. “Without it, countries like Italy and Spain, that are fundamentally able to repay their debts, could potentially be forced into a solvency crisis by abnormal financing costs.”

Europe Confidence

Confidence in Europe’s strategy for coping with the crisis was dealt a setback late yesterday in Brussels when European finance ministers pushed bondholders to provide greater debt relief for Greece.

Euro governments sought to fill a deeper-than-expected hole in Greece’s finances by saddling investors with a lower interest rate on exchanged bonds, setting up a confrontation in the runup to a Jan. 30 European Union summit. At the same time, efforts to shore up Greece were flanked by headway on a German-inspired deficit-reduction treaty and indications that a cap on rescue lending might be boosted.

To avoid a 1930s-style worldwide depression, the IMF’s Lagarde yesterday also called on other countries to play their part. The IMF, which co-finances loans to Greece, Ireland and Portugal, identified a potential global financing need of $1 trillion in coming years and is seeking $500 billion in new lending resources from its member countries to address potential loan demand.

Developing Economies

The IMF predicts growth of 5.4 percent in developing economies this year, down from 6.1 percent forecast in September, reflecting “the deterioration in the external environment, as well as the slowdown in domestic demand in key emerging economies,” according to the report.

China’s estimated expansion was cut to 8.2 percent from 9 percent. India is expected to grow 7 percent in 2012, 0.5 percentage point less than in September forecasts.

Richer nations will expand 1.2 percent this year instead of 1.9 percent, the IMF said. Japan is seen growing 1.7 percent, 0.6 percentage point lower than four months ago.

The estimated expansion compares with world growth of 3.8 percent in 2011 and 5.2 percent in 2010. Economists surveyed by Bloomberg News from Jan. 6 to Jan. 11 forecast global expansion of 3.4 percent this year and 4 percent in 2013, according to the median of 72 forecasts.

Italy, Spain

Italy and Spain’s outlooks had the steepest cuts among large developed economies. Italian gross domestic product will contract 2.2 percent this year compared with a prior forecast for 0.3 percent growth, while Spanish GDP will shrink 1.7 percent compared with a previously estimated 1.1 percent expansion, the fund predicted.

Greek and Italian bonds had their worst years on record in 2011 as Europe’s financial woes intensified, also halting a two- year rally in equities. The Stoxx Europe 600 Index tumbled 11 percent last year and the MSCI All-Country World Index slid 9.4 percent.

More recently, investor demand for short-term sovereign debt such as Spanish and Italian two-year notes has rallied across the euro area since the ECB issued 489 billion euros ($637 billion) in unlimited three-year loans to euro-region banks last month.

The Frankfurt-based ECB also has bought 217 billion euros of bonds from distressed member countries since May 2010. It kept its benchmark interest rate at 1 percent this month following two straight reductions.

ECB Liquidity

“The ECB should continue to provide liquidity and stay fully engaged in securities purchases to help maintain confidence in the euro,” the IMF said in the report.

It also recommended “additional and timely monetary easing” in Europe while more broadly calling for supportive monetary policy in advanced economies.

The IMF cautioned countries that have fiscal room to maneuver, including in the euro area, against “overdoing fiscal adjustment in the short term” because it may damp growth further and damage market confidence.

That’s also a risk in the U.S., where the IMF sees “political paralysis” potentially leading to an abrupt unwinding of stimulus spending. Still, the U.S. and Japan need to spell out their plans to reduce debt in the medium term because “neither country can take for granted its status as a safe haven.”

Advanced Economies

In advanced economies, “continued adjustment is necessary for medium-term debt sustainability, but should ideally occur at a pace that supports adequate growth in output and employment,” the IMF said in its separate Fiscal Monitor report released today.

The IMF based its forecasts on oil at $99 a barrel, close to current trading prices, and sees non-oil commodities prices falling by 14 percent this year. Emerging economies need to focus on responding to weakening domestic demand and slowing external demand, the IMF said.

Developing economies where inflation is under control and that have surpluses, such as China, should boost spending for the poorest, it said. Countries with less fiscal room including “many” in Latin America should stop raising interest rates.

--With assistance by Alex Tanzi in Washington, Michael Regan in New York, Daniel Tilles in London, Brendan Murray in Sydney, James G. Neuger and Rainer Buergin in Brussels. Editors: Gail DeGeorge, Kevin Costelloe

To contact the reporter on this story: Sandrine Rastello in Washington at srastello@bloomberg.net

To contact the editor responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net

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