The International Monetary Fund on Thursday urged the United States to quickly reach an agreement on a permanent fix to avoid automatic tax hikes and spending cuts early next year, saying a stop-gap solution could be harmful to the global economy.
Many analysts believe Washington will come up with a deal that would temporarily stave off what has become known as the fiscal cliff, although doubts persist as to whether Congress can agree on a timely compromise.
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In a report prepared for the Group of 20 finance ministers' meeting in Mexico on November 4-5 and published on Thursday, the IMF warned that the euro zone crisis and the threat of a political impasse in Washington over the looming fiscal cliff posed the biggest risks to the world economy.
The Fund said, however, there were signs that financial stress and global economic conditions "may be stabilizing" due to recent steps by major central banks to cut interest rates to spur growth, although economic activity remains sluggish.
The combined U.S. government spending cuts and tax rises to be implemented under existing law at the start of 2013 are seen by many as threatening to tip the economy back into recession.
The IMF has estimated that the tax increases and spending cuts amount to $700 billion in 2013. Unless avoided, this could contract U.S. gross domestic product by around 4.5 percent.
"A last-minute deal that relies on suboptimal fixes or largely 'kicks the can down the road' may ultimately prove harmful," the IMF said in the report.
It also said a temporary U.S. fiscal cliff was a "medium-term probability event," and said that even if the cuts were quickly unwound, damage to the economy would be "substantial" because businesses and consumers would be unsure about tax and spending policies.
"The severity of the economic effects would partly depend on the duration of the cliff - here, staff sees a temporary cliff, before measures or extensions could be implemented, as a medium-probability event," the IMF said.
Dealing with the fiscal cliff is the biggest near-term challenge facing the Obama administration. It is also one of the biggest concerns for international policymakers, with Canada warning this week it could fall into recession if Washington does not reach a deal to avoid the cliff.
The IMF said the U.S. economy could fall back into recession if Congress fails to avert the package of tax hikes and spending cuts.
The IMF also urged Washington to agree on a credible plan to reduce government debt, warning that failing to do so could "exacerbate uncertainty," and could "lead to a gradual erosion of the reserve currency status of the U.S. dollar and put upward pressure on Treasury bond yields."
While some progress has been made to address the euro zone crisis, the IMF urged Europe to present a road map for banking union, followed quickly by implementation.
It also said euro zone countries facing high borrowing costs should implement fiscal adjustment plans and, if needed, request financial support from European emergency funds.
Spain is considering whether to ask for aid from the euro zone. Promises of help from the EU and the European Central Bank have brought Spain's borrowing costs down from unsustainable levels in the past few months.
The IMF said austerity in the euro zone's periphery countries risks becoming politically and socially untenable because fiscal and economic reforms will take years to complete. Countries like Greece, Portugal and Ireland are implementing IMF-EU supervised austerity packages in return for international aid.
(Reporting By Lesley Wroughton; Editing by Chizu Nomiyama, Leslie Adler and Philip Barbara)