April 12 (Bloomberg) -- The U.S. is set to have the largest budget deficit of major developed economies this year and should narrow it now rather than face tough adjustments in the next two years, the International Monetary Fund said.
The U.S. shortfall will reach 10.8 percent of its gross domestic product this year, ahead of Japan and the U.K., the Washington-based IMF said in a report released today. It estimates that President Barack Obama will need to cut the deficit by 5 percentage points of GDP in the next two fiscal years, the largest adjustment in “at least half a century,” to meet his pledge of halving it by the end of his four-year term.
“Market concerns about sustainability remain subdued in the U.S., but a further delay of action could be fiscally costly, with deficit increases exacerbated by rising yields,” the IMF wrote in its Fiscal Monitor report, published several times a year to analyze public finance development.
The IMF recommended “a down payment” in the form of deficit reduction this year that would make the government goal “compatible with a less abrupt withdrawal of stimulus later.”
Obama is expected to announce long-term proposals for cutting the federal deficit tomorrow, following a budget deal he reached with congressional leaders last week that averted a government shutdown. In May, the government may be forced to increase the $14.3 trillion federal debt ceiling to ensure the U.S. will meet its financial obligations.
The U.S. delayed its fiscal tightening with the adoption of a package extending tax cuts in December, the IMF said. It estimates that the stimulus measures, which also include emergency unemployment benefits, will have a small impact on growth relative to fiscal costs.
The IMF also called for a U.S. commitment to a medium-term debt target “as an anchor for fiscal policy.” China is the biggest foreign holder of U.S. Treasuries with a portfolio of $1.15 trillion in January, according to U.S. government data. Japan is the second-largest with $885.9 billion.
In Japan, where the government is planning additional spending for reconstruction after the March 11 earthquake and tsunami, the deficit is expected to reach 10 percent of GDP this year, the IMF said.
The country’s authorities will need to incorporate such costs into a medium-term fiscal adjustment plan “backed up by measures more clearly identified than in the past,” according to the IMF report.
A few days after Europe’s Greek-born debt crisis forced Portugal to seek financial aid from the European Union and the IMF, the fund said it is “essential” for all advanced economies to start bringing their debt to “prudent levels” in the medium term.
It forecast that the average gross domestic debt ratio in advanced economies will breach the threshold of 100 percent of GDP for the first time since the years after World War II. Debt will peak at 107 percent of GDP in 2016, 34 percentage points above levels before the global financial crisis, the report said.
The IMF estimates that financing needs in the richest nations will continue to rise this year after surging in 2010, and will remain high in 2012.
Japan has the highest financing requirements for its deficit and its maturing debt this year, with the total amounting for 56 percent of its GDP. The U.S. is second, with needs at 29 percent of GDP, followed by Greece, Italy, Belgium, Portugal and France, which all have needs above 20 percent of their GDP, according to the IMF report.
In the euro region, “market conditions remain tense in several smaller countries, in part due to ongoing concerns about possible feedback between the financial sector and the sovereign,” it said.
As the region narrows its deficit, investors are “discriminating in favor of countries with credible policy frameworks,” according to the IMF.
In the U.S., the stronger economic outlook “has been reflected in higher real yields, leading towards more normal interest rate levels,” the report said. At the same time, the Federal Reserve’s latest bond purchase program is likely to have lowered them, it said.
Yields on U.S. 10-year notes were little changed yesterday at 3.59 percent in New York, according to Bloomberg Bond Trader prices. They will increase to 3.90 percent by year end, according to the weighted-average forecast of 71 economists in a Bloomberg News survey.
“Rollover problems for the largest advanced economies remain a tail risk, but one that would entail huge costs for them and the rest of the world,” the IMF said.
By contrast, investors perceive emerging-market risks as “benign,” according to the report. Deficits in such countries are narrowing amid fast growth and higher commodity prices, it said. The deficit in emerging economies will narrow to 2.6 percent of GDP this year, compared with 7.1 percent in their developed counterparts, the IMF forecasts.
Still, the pace of fiscal tightening is short of what is needed and these nations should refrain from increasing spending in the near term and rebuild fiscal space, the IMF said.
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