The international Monetary Fund (IMF) sharply cut its forecasts for global economic growth on Tuesday, warning about multiple challenges as financial stability in danger, growth prospects have dimmed, and downside risks have escalated.

Global growth decelerates?

The IMF downgraded its projection for global economic growth this year to 3.3 percent, and marked down its estimate for next year to 3.9 percent. The euro zone economy would contract 0.5 percent this year before returning to meager growth of 0.8 percent in 2013. Growth in developing economies was also expected to moderate due to "the worsening external environment and a weakening of internal demand."

"The global recovery is threatened by intensifying strains in the euro area and fragilities elsewhere." the IMF said in an update of its World Economic Outlook (WEO) report, one of the three staff reports released on Tuesday.

"The epicenter of danger is Europe, but the rest of the world is increasingly affected," Olivier Blanchard, IMF chief economist, said on Tuesday at a news conference in Washington.

IMF Managing Director Christine Lagarde on Monday urged Europe to boost growth and build a larger firewall to insulate the world economy from a possible 1930s-style crisis. She laid out the core elements of a policy path forward and called for collective efforts to avoid bad scenario.

"The most immediate policy challenge is to restore confidence and put an end to the crisis in the euro area by supporting growth, while sustaining adjustment, containing deleveraging, and providing more liquidity and monetary accommodation," according to the updated report.

In other major advanced economies, the key policy requirements were to address medium-term fiscal imbalances and to repair and reform financial systems, while sustaining the recovery. In developing economies, near-term policy should focus on responding to moderating domestic growth and to slowing external demand from advanced economies, cautioned the IMF.

Financial risks escalate

The IMF said in its Global Financial Stability Report that financial stability is deeply in danger zone as risks have increased and debt crisis in the euro zone continued to weigh on government and the balance sheets of banks.

It noted the sharp rise in the sovereign bond yields and said the trend had spilled from the periphery into the core of Euro zone. "Sovereign strains also spilled into the euro zone banking system" and resulted in deleveraging of banks, which would "ignite an adverse feedback loop to euro area economies," said the fund.

The report said both emerging and advanced countries are susceptible to a range of shocks from the euro zone. Potential spillovers could include direct exposures to euro area banks, or deteriorating macroeconomic prospects.

"Global financial system remains fragile," Jose Vinals, IMF financial counselor said at the news conference, adding that it was not too late to take actions.

"Restoring sovereign access to funding at sustainable yields is a key challenge," the IMF stressed. It pointed out additional policy actions for policymakers, such as increasing the size and flexibility of the bailout funds in Europe "at the earliest possible opportunity" to make the firewall against high funding costs for sovereigns and banks "sufficiently large and convincingly built."

The Washington-based lender proposed last week to extend its lending capacity by as much as 500 billion dollars as it estimated a global potential financing need of 1 trillion in the coming years.

Fiscal consolidation challenge

The IMF noted in its updated Fiscal Monitor Report that deficits in many advanced economies fell "significantly" during 2011, but warned too rapid consolidation during 2012 could exacerbate downside risks given the weak economic environment and increasing market concerns.

In advanced economies, fiscal deficits fell in 2011 by about 1 percent of GDP overall, said the report. The headline deficit fell by 2 percent of GDP in the euro zone. However, the public debt in advanced economies continued to accumulate rapidly in 2011 to 103. 5 percent of GDP, and the ratio is expected to reach 107.6 in 2012.

The public debt in the euro area rose by 3.1 percent to 88.4 percent of GDP in 2011. Among euro countries, only Germany experienced a contracting trend. "Continued adjustment is necessary for medium-term debt sustainability, but should ideally occur at a pace that supports adequate growth in output and employment," the fund pointed out.

"Fiscal policy has to walk a narrow path and should not amplify shocks that may affect GDP growth," said Carlo Cottarelli, director of fiscal affairs department in IMF. "If growth decelerates, countries should allow the automatic stabilizer to operate," which means allowing deficit to increase temporarily, he added.