The world economy will expand 3.7 percent in 2008, the slowest pace since 2002, according to a document titled “IMF Background Paper on the Update of the Global and Regional Outlook” obtained by Bloomberg News at a meeting of Southeast Asian deputy finance ministers and central bankers in Da Nang, Vietnam. In January the fund projected growth of 4.1 percent.

It’s the third time the Washington-based institution has cut its forecast for 2008 after downplaying the threat of a U.S. credit squeeze to the world economy last July, when it predicted a 5.2 percent expansion this year. Central banks will need to conduct policy “as flexibly” as the circumstances warrant, the statement said, adding that the European Central Bank has room to lower borrowing costs.

“The financial shock that originated in the U.S. subprime mortgage market in August 2007 has spread quickly, and in unanticipated ways, to inflict extensive damage on markets and institutions at the core of the financial system,” the statement said. “The global expansion is losing momentum in the face of what has become the largest financial crisis in the United States since the Great Depression.”

The IMF gave a 25 percent chance that global growth will drop to 3 percent or less in 2008 and 2009, a pace the fund described as equivalent to a world recession.

The fund lowered its forecast for U.S. economic growth to 0.5 percent this year, according to the document, below a 1.5 percent prediction made in January. The world’s biggest economy will expand 0.6 percent in 2009, it said.

The euro region will expand 1.3 percent in 2008, the document said, down from the fund’s 1.6 percent projection in January.

“Growth in the U.S. and Europe is slowing sharply,” the IMF document said. “The ECB can now afford some easing of the policy stance.”

The ECB has left its benchmark rate at a six-year high of 4 percent as inflation runs at 3.5 percent, above its goal of 2 percent and almost the fastest pace in 16 years.

“The greatest risk comes from the still-unfolding events in financial markets, particularly the potential that deep losses on structured credits related to the U.S. subprime mortgage market and other sectors would seriously impair financial-system capital and initiate a global de-leveraging that would turn the current credit squeeze into a full-blown credit crunch,” the statement said.

Japan’s economy, the world’s second largest, will grow 1.4 percent in 2008, less than the 1.5 percent the IMF predicted in January, according to the statement. China will grow 9.3 percent this year, slower than the 10 percent projection made in January, the statement said.

“The divergence between advanced and emerging economies is expected to continue, with growth in advanced economies generally expected to fall well below potential,” the IMF document said.

The IMF statement said world inflation would remain elevated in the first half of 2008.

The U.S. dollar is strong relative to fundamentals and China’s yuan remains “substantially undervalued,” the document said.

“The main counterpart of the dollar’s depreciation since August has been the appreciation of freely floating currencies, notably the Canadian dollar and the euro, with the latter now being on the strong side relative to fundamentals,” the statement said.

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