The International Monetary Fund cut its global growth forecasts and now projects a second year of contraction in the euro region as progress in battling Europe’s debt crisis fails to produce an economic recovery.

The world economy will expand 3.5 percent this year, less than the 3.6 percent forecast in October, the Washington-based IMF said today in an update of its World Economic Outlook report. It expects the 17-country euro area to shrink 0.2 percent in 2013, instead of growing 0.2 percent as forecast in October, as Spain leads the contraction and Germany slows.

“Is Europe on the mend? I think the answer is yes and no,” IMF Chief Economist Olivier Blanchard said in a video released with the report. “Something has to happen to start growth.”

While measures to stem the debt turmoil last year helped boost financial markets around the world and decrease sovereign bond yields from Spain to Greece, European officials now still face a recession and unemployment at a record 11.8 percent. The IMF warned that the region still poses a “large” risk to the rest of the world if efforts under way to strengthen its economies and work on a banking union slip.

The forecast for a second year of economic contraction reflects “delays in the transmission of lower sovereign spreads and improved bank liquidity to private sector borrowing conditions,” as uncertainty remains over ending the turmoil that has engulfed nations from Ireland to Cyprus, according to the report.

2014 Outlook

The fund expects the region’s outlook to improve, forecasting a return to 1 percent growth in 2014. It sees the world economy expanding 4.1 percent next year, 0.1 percentage point less than in October.

In the U.S., “ underlying economic conditions remain on track,” the IMF said as it cut its forecast for the world’s largest economy to 2 percent from 2.1 percent in 2013 and raised it 0.1 percentage point to 3 percent next year.

The priority is for Congress to avoid too much deficit reduction too soon, reach an agreement between Republicans and Democrats to raise the debt ceiling and craft a plan to reduce debt over the medium term, according to the report.

While the forecast for Japan was left unchanged at 1.2 percent this year amid fiscal and monetary plans to stimulate its economy, the fund cut the 2014 prediction by 0.4 percentage point to 0.7 percent.

Japan’s Debt

Fiscal expansion is “going to help growth in the short run, no question,” Blanchard said. At the same time “when you start with such a level of debt and without a medium term credible fiscal consolidation plan, increasing the fiscal deficit in the short run is a very risky thing to do.”

Commodities exporters will feel the pinch of falling prices, with oil now seen slipping 5.1 percent instead of 1 percent, according to the report. While supportive policies have help buoy growth in some emerging market countries in recent months, there’s less space for such action now, it said.

Growth forecasts for Brazil were cut to 3.5 percent this year from 4 percent and to 4 percent from 4.2 percent in 2014. India was lowered 0.1 percentage point to 5.9 percent this year and was left unchanged at 6.4 percent in 2014.

The IMF didn’t change its forecast for China, seen growing 8.2 percent this year and 8.5 percent in 2014.

“It’s not the rates that we saw before the crisis, but these rates are long gone,” Blanchard said of emerging countries. “Things in general are fine.”

In Europe, German growth was cut by 0.3 percentage point to 0.6 percent in 2013 and is seen accelerating to 1.4 percent next year, from 1.3 percent.

Spain will contract 1.5 percent this year, compared with 1.3 percent in October and is seen growing 0.8 percent in 2014, 0.2 percentage point less than before.

Italy will shrink 1 percent in 2013 rather than 0.7 percent seen in October, and expand 0.5 percent in 2014, unchanged from three months ago, according to the IMF report released today.

While most developed economies need steady fiscal consolidation, and continued reform of their financial sector, recommendations for developing counterparts vary depending on their circumstances, the IMF said.

Bloomberg