The International Monetary Fund has slashed its global growth forecast for this year and exhorted the European Central Bank to boost liquidity to stave off a deeper eurozone crisis.
"The global recovery is threatened by the growing tensions in the euro area," the Fund said, according to a leaked draft of its World Economic Outlook which is due to be published next week.
Global GDP growth is to be cut from 4pc to 3.3pc, with drastic revisions for an arc of countries in Southern Europe.
Italy's economy will contract by 2.2pc and Spain's by 1.7pc as fiscal austerity measures bite harder and banks curtail lending, playing havoc with debt dynamics.
The eurozone as a whole will shrink by 0.5pc, down from growth of 1.1pc in the Fund's last forecast in September, an even grimmer outlook for the region than growth revisions released by the World Bank earlier this week.
The new figures are an admission that the IMF has been caught badly off guard by fast-moving events. It appears to misjudged the gravity of the crisis in Southern Europe. The new forecasts explain why the Fund is requesting a $600bn (£388bn) boost to its firepower.
Britain will muddle through with growth of 0.6pc, marginally below the 0.7pc forecast of the Office for Budget Responsibility. It will rebound to 2pc next year.
The US and China will remain the two main growth blocs in the world economy. The Fund predicts the US will grow at an unchanged rate of 1.8pc, and China will motor ahead at 8.2pc, down from 9pc.
"The most immediate political challenge is to re-establish confidence and put an end to the euro area crisis, supporting growth," said the draft, obtained by the Italian news agency ANSA. The text is subject to last-minute changes.
The IMF encouraged the ECB to continue moving to a "more accommodative monetary policy" to prevent a credit squeeze as European banks shrink their balance sheets to meet tougher capital ratios by June.
The ECB said its January Bulletin that loan growth had slowed but there is no sign yet of a "sizeable curtailment of credit".
In Brussels, an early draft of the EU's new treaty stipulates that no country will be able to tap the permanent bail-out fund or European Stability Mechanism unless they sign the pact committing them to near-balanced budgets, with little leeway for deficits even after an economic shock.
The text is aimed squarely at Ireland, which may have to hold a referendum on the new treaty. If the Irish vote 'No' – as thought likely in the current fractious mood – it would block aid disbursements under Ireland's EU-IMF loan package once the new bail-out fund is up and running.
Critics say the move is a pressure tactic to induce Dublin to pass the treaty through secondary legislation without a vote.
Elsewhere in Europe, there was little progress in the crucial talks between Greece and its private creditors over them taking voluntary losses on their holdings of the country's debt.
Horst Reichenbach, head of the European Commission's special task force to help rebuild the Greek economy, said the talks were "moving ahead slowly" but warned not to "expect any miracles." He told a German radio station: "We must be more generous as far as time-frames go when it comes to Greece's reforms."
Insiders said bondholders, represented by the Institute of International Finance (IIF), were offered 3.5pc coupon on new Greek debt but turned it down, arguing that it was too low given that Italian debt trades at over 6pc.
On Friday, finance minister Evangelos Venizelos is due to update officials from the troika – the IMF, ECB, and EU – on the country's finances as Greek tries to secure a €130bn bail-out.
The extent of financial chaos in Italy was again laid bare by a report that claimed the country missed out of €119bn of revenues in 2009 because of tax evasion.
The figure, which included income tax evasion and failed VAT collection and produced by newspaper La Repubblica, adds up to 28pc of Italy's total tax revenue and is nearly four times the value of Mr Monti's tough austerity package.
Ed Parker, a director of Fitch, added to Italy's woes by warning that the rating agency was likely to impose a one or two-notch downgrade on country alongside Spain, Ireland, Belgium, Cyprus and Slovenia.
As the countdown starts for the next European leaders' summit, Joerg Asmussen, board member of the ECB, warned that the central bank's bond-buying programme cannot be used to support sinner states indefinitely. "It is an important mandate but it is also a mandate with limits," he said. "And that's why that one should not overburden monetary policy."
Fresh data showed Italian banks had tapped the ECB for €50bn when the central bank opened its doors offering cheap three-year money in December, handing out a total of €489bn in loans.
However European stockmarkets rose as France and Spain conducted successful bond auctions. France raised €9.5bn of debt in its first big test since being stripped of its AAA rating by Standard & Poor's. Spain sold €6.6bn of 10-year bonds – far more than the €4.45bn target – on a yield of 5.403pc.
The CAC rose 2pc, Germany's Dax was up 1pc. In London the FTSE 100 rose 0.7pc.
Sentiment was also boosted by data that showed overnight deposits at the ECB fell to €395.3bn on Wednesday night, compared to the €528.2bn record the night before.
The figures signalled an easing of concern as banks are beginning to become more comfortable parking money with other lenders, instead of turning to the central bank for safety. Source