The economic recovery under way has been proceeding broadly as expected, but downside risks remain elevated and the global financial system is the Achilles' heel of this recovery, according to the International Monetary Fund (IMF).

In releasing two key documents on the state of the global economy — the October 2010 World Economic Outlook (WEO) and the Global Financial Stability Report (GFSR) — the IMF provided a cautious outlook that comprised both gradual improvements in economic conditions and significant uncertainty in Western economies.

In doing so, the Fund, however, made a distinction between the growth trajectories of developed economies on the one hand and emerging markets such as India and China on the other. In the WEO, it noted that most advanced economies still faced “large adjustments,” that their recoveries were advancing at a sluggish pace, and that high unemployment still posed major social challenges.

However, in contrast, the WEO noted that many emerging and developing economies were again witnessing “strong growth,” because they did not experience major financial excesses immediately before the recession of 2009.

In what might be a reference to the ongoing controversy over China's currency value and its role in creating a trade surplus for the country the IMF said that the recovery would require external rebalancing, with “an increase in net exports in deficit countries, such as the U.S., and a decrease in net exports in surplus countries, notably emerging Asia.”

The WEO also made reference to the effectiveness of the overhaul of financial regulation in European countries and the U.S., arguing that “the repair and reform of the financial sector need to accelerate to allow a resumption of healthy credit growth.”

In terms of the financial system itself, the Fund stuck a note of concern in the GFSR, which pointed out that progress toward global financial stability experienced a setback since April, and the recent turmoil in sovereign debt markets in Europe had highlighted “increased vulnerabilities of bank and sovereign balance sheets arising from the crisis.”

The GFSR further noted that while the financial situation has subsequently improved, owing to the “forceful response by policymakers which helped to stabilise funding markets and reduce tail risk,” substantial market uncertainties persisted.

Touching on emerging markets in particular the IMF said in the WEO that many of them had successfully concluded first-generation reforms that improved macroeconomic policy frameworks, strengthening their resilience to macroeconomic shocks.

However, it cautioned, in order to sustain or further raise potential growth and employment, it would be necessary to simplify product and services market regulation, raise human capital, and build critical infrastructure.

The Fund argued that such reforms would help absorb growing capital inflows in a productive manner, “which would accelerate global income convergence and external rebalancing.”

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