Merkel's IMF pressure points

The International Monetary Fund has cranked up the pressure on German Chancellor Angela Merkel to water down her demands for tough new austerity measures in the eurozone, warning that these could cause the region to contract sharply.

In its latest report, the IMF has slashed its growth projection for the eurozone from its previous forecast only four months earlier. It now predicts that the eurozone will experience a mild recession in 2012 as a result of rising government bond yields, a reduction in lending by the banks and extra austerity measures that eurozone governments have introduced.

The IMF has slashed the growth outlook for the peripheral eurozone countries. It now expects Italy's economy to shrink by 2.2 per cent this year, while the Spanish economy will contract by 1.7 per cent. At the same time, it has downgraded the growth outlook for the eurozone's two largest economies, Germany and France. The German economy will likely experience a sluggish 0.3 per cent growth rate this year, while French economic growth will be 0.2 per cent.

According to the IMF, the situation could be much worse if eurozone leaders fail to find a way to stop borrowing costs from rising, and to cushion the growing squeeze on bank lending. In that case, the eurozone economy could shrink by 4 per cent on average in the next two years.

One danger, it says, is that eurozone countries tighten their budgets even further in response to slower growth. Overdoing fiscal adjustment, it says, "will further undercut activity, diminish popular support for adjustment, and undermine market confidence.”

The latest IMF report will strengthen the hand of Italian Prime Minister Mario Monti who is increasingly challenging Merkel's demand that debt-strapped eurozone countries be forced to adopt ever more rigorous belt-tightening measures.

And Monti is already having some success in curbing Berlin's powers. Merkel had wanted all eurozone countries to follow Germany's example and introduce balanced budget amendments (known as "debt brakes” in Germany) into their constitutions.

But last week Monti, with the backing of France, was able to frustrate Berlin's demand. As a result, in the latest draft of the proposal, eurozone countries are now only required to adopt debt brakes that are "preferably constitutional”.

Monti – again with the backing of other debt-strapped eurozone countries – is also warning Berlin that its focus on budgetary tightening will only snuff out growth in the eurozone. Instead, he's pushing Merkel to agree to policies that bolster economic activity.

His position is supported by many leading economists who argue that unless Italy can find a way to bolster economic growth, the country will face difficulty meeting its borrowing costs in coming years. And, they say, the situation is even worse for Portugal. Unless Portuguese growth picks up, lenders may be forced to write-down more than half of their loans – more than €170 billion.

But pro-growth policies are unlikely to find favour in Berlin. Merkel has promised German voters that she will force eurozone countries to adopt tough budgetary policies in exchange for additional German support.

Already, Jens Weidmann, the head of the powerful Bundesbank, has pointed out that Berlin's efforts to ensure tougher budgetary rules are falling short. "The cornerstone for a genuine fiscal union has yet to be laid," he complained last week.