The world prays for an economic miracle

(AFP/ GETTY IMAGES)

After an incredibly volatile day on world markets, the head of the International Monetary Fund, Christine Lagarde, warned of a looming "collapse in global demand" which threatens to push economies around the world into a new recession.

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"Dark clouds over Europe and huge uncertainty in the United States" mean that "the challenge could not be more urgent", she told politicians and leading economists in Washington, who are meeting there in an attempt to tackle the world's economic woes.

Calling for immediate action to support global growth and stabilise the international financial sector, Ms Lagarde said: "The actions I am calling for today are not for the coming years – they are for the coming months."

The stark warning followed the failure of the G20 group of leading economies to convince investors that they would avert a new global banking crisis. A communiqué from G20 finance ministers and central bank governors pledging to "take all necessary action to preserve the stability of banking systems and financial markets" failed to deliver a significant lift to investor sentiment. Stock markets in Europe and the US picked up slightly by the close of trading yesterday, but generally failed to recover the large losses experienced earlier in the week.

The Chancellor, George Osborne, who is in Washington for the IMF summit, attempted to ratchet up the pressure on his European counterparts, warning that they had six weeks to agree on radical measures to address the eurozone sovereign debt crisis before the next G20 meeting in November in Cannes. "There is now a quite clear deadline set which is the Cannes summit," he said. "The eurozone has six weeks to resolve this political crisis." The Chancellor claimed that European finance ministers are finally waking up to the fact that they must act faster to resolve the Continental debt crisis, saying that the "leading lights of the eurozone are aware of the fact that time [is] running out for them".

The G20 communiqué had sought to reassure financial markets that prompt action would be taken to ensure that all banks have sufficient capital buffers to absorb any economic shocks.

It said: "We will ensure that banks are adequately capitalised and have sufficient access to funding to deal with current risks."

But no new plan to inject capital into the Continent's fragile financial sector was announced. The IMF claimed this week that there is a potential €200bn-hole in the balance sheets of European banks as a consequence of strains in the European sovereign debt market.

And Ms Lagarde repeated her call for European leaders to act quickly to strengthen the balance sheets of their banks. A move by the credit rating agency Moody's to further downgrade eight Greek banks underlined the stresses in the Continent's financial sector.

The G20 communiqué also promised that the powers of the eurozone's emergency stabilisation fund, the EFSF, will be significantly boosted by the time of the Cannes meeting, enabling it to recapitalise banks and increase emergency lending to troubled states.

But that is dependent on national parliaments sanctioning an increase in the EFSF's powers. The German Bundestag will vote on the measures on 29 September. The German Chancellor, Angela Merkel, is facing problems convincing her Christian Democrat Party and her coalition partners, the Free Democrats, to back the legislation.

Despite instructing European leaders to take radical action in the face of the looming economic emergency, Mr Osborne refused to budge from his own radical deficit-reduction strategy. The Chancellor rejected claims he is contributing to the deficiency of global demand with his determination to wipe out the bulk of the UK's budget deficit by the end of this parliament. "This is a debt crisis. You can't separate debt and demand," he said. "They are intricately linked. Unless you deal with debt you can't deal with demand."

The Chancellor also stressed that, despite his opposition to the UK ever joining the single currency, it is in Britain's national interest for the eurozone to survive the present crisis: "I'm very clear that a break-up of the euro is bad for Britain ... It is in Britain's interest that the euro works, that it's stable."

Although Britain is not in the eurozone, the British banking sector is significantly exposed to turmoil in the currency bloc. A stress test of Europe's banks in July by the European Banking Authority showed that the Royal Bank of Scotland, Barclays and HSBC have extended loans amounting to €204bn to governments and companies in troubled eurozone nations.

If the single currency were to collapse, British banks would register large losses on those loans. Despite rising fears about the health of European banks, Mr Osborne yesterday insisted that British banks are perfectly safe: "UK banks are well capitalised and liquid."