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IMF warns of 'severe shock' if U.S. debt cap not lifted

International Monetary Fund acting managing director John Lipsky

Mark Wilson/Getty Images

The International Monetary Fund has warned of a "severe shock" to global financial markets if the U.S. does not move quickly to increase its borrowing authority, adding pressure on Congress and the White House to clinch a deal on fiscal policy.

In its annual report on U.S. economic policy, the IMF cited "unfavourable fiscal outcomes" as one of the key dangers to the country's economic outlook.

"These could take the form of a sudden increase in interest rates and/or a sovereign downgrade if an agreement on consolidation does not materialize or the debt ceiling is not raised soon enough," the IMF said.

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It added: "These risks would also have significant global repercussions, given the central role of U.S. Treasury bonds in world financial markets."

The U.S. Treasury Department has said that if Congress does not raise the debt limit - currently at $14.3-trillion (U.S.) - the U.S. would run out of cash to pay its obligations and could default as early as Aug. 2. But Republicans and Democrats in Congress and the White House have so far been unable to break the political impasse surrounding fiscal policy, as they spar over spending levels and taxation. Republicans have been resisting an increase in the debt ceiling to extract deeper spending cuts and fiscal reforms, while opposing any tax increases.

After the IMF statement on the U.S. was released, John Lipsky, acting managing director, said he was "confident that the participants are well aware of the potential risks of a debt default in the U.S. and will avoid those dangers".

Mr. Lipsky added: "It should be self-evident a debt default by the U.S. government . . . would have very serious, far-reaching, dramatic repercussions and that's why we're confident that it will be avoided."

With the heat rising over the debt ceiling, Tim Geithner, U.S. Treasury Secretary, sent a letter to a group of Republicans in the Senate arguing that there was no leeway for the Obama administration to prevent a default by simply prioritizing interest payments over the federal government's other payments.

Some Republicans have accused the White House of "scare tactics" over the debt ceiling, suggesting that even if no deal is reached by early August, the impact would be more like a partial government shutdown than a true default because of the Treasury Department's discretion to make certain payments ahead of others.

"This 'prioritization' proposal advocates a radical and deeply irresponsible departure from commitments by presidents of both parties, throughout American history, to honour all of the commitments the nation has made," Mr. Geithner said. "It is unwise, unworkable, unacceptably risky and unfair to the American people. There is no alternative to enactment of a timely increase in the debt limit," he told senators, including Mitch McConnell, the minority leader.

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In its report, the IMF said striking the right balance on fiscal policy represented the main challenge facing U.S. economic officials. The fund said fiscal consolidation needed to proceed and losing fiscal credibility could be very damaging, and is recommending that deficit reduction should begin next year - with the overall effort to include both spending cuts and tax increases through the elimination of special incentives and deductions.

But on the other hand, the IMF cautioned against deep and immediate savings, saying that "an excessively large upfront fiscal adjustment could also significantly weaken domestic demand." The IMF is expecting the U.S. economy to grow at a rate of 2.5 per cent this year, accelerating to 2.7 per cent in 2012 and 2013.

Among the other risks to the outlook besides fiscal policy, the IMF cited the weak housing market, the potential for a commodity price shock, tight credit supply and the European sovereign debt woes.

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