(Recasts lead, adds details from news conference)
By Lesley Wroughton
WASHINGTON, Jan 28 (Reuters) - The world economy will slow to a virtual standstill this year, the International Monetary Fund said on Wednesday, emphasizing that removing toxic assets from the banking system is critical to restoring growth.
In a grim assessment of the world economy, the IMF slashed its 2009 forecast to a slight 0.5 percent, the weakest since World War Two, from a November estimate of 2.2 percent.
IMF chief economist Olivier Blanchard said the world economy had taken a turn for the worst in the past three months, with global output and trade falling dramatically.
He urged countries to work more closely and to take decisive policy actions to restore the collapse in confidence and revive the global financial system.
"Despite wide-ranging policy actions, financial strains remain acute, pulling down the real economy," the IMF said. "A sustained economic recovery will not be possible until the financial sector's functionality is restored and credit markets are unclogged."
The IMF's outlook was particularly bleak for advanced countries such as the United States and the euro area, whose economies are seen contracting by 1.6 percent and 2 percent, respectively.
The sharpest decline will be in Britain, whose economy is likely to contract by 2.8 percent this year, the IMF said. Japan's economy is expected to shrink by 2.6 percent in 2009.
CLEANING BALANCE SHEETS
Jaime Caruana, the IMF's financial counsellor, said it was critical to clean bank balance sheets to revive lending activity but acknowledged it will be hard to put a value on the bad assets held by global banks.
"It is more easier said than done," Caruana told a news conference. "This crisis is more complex, we recognize that ... but at the end, this assessment needs to be done, the losses need to be recognized."
Efforts to remove bad assets should be done bank-by-bank, Caruana said, "because the balance sheets are not clean," a situation that must change in order to restore confidence among borrowers and lenders.
Caruana said declared losses on U.S. loans and securitized assets were likely to reach $2.2. trillion, up from an October estimate of $1.4 trillion.
The IMF said European and U.S. banks will likely need at least half a trillion dollar capital input to handle expected write-downs in 2009 and 2010.
"This implies that for U.S. and European banks taken together such an amount in new capital is necessary just to prevent their capital position from deteriorating further," the IMF said.
EMERGING ECONOMIES ONLY GROWTH SPOTS
The IMF said emerging market economies would be the only source of growth, expanding 3.3 percent in 2009 and 5 percent next year, but those forecasts were also below projections made less than three months ago.
It revised down Chinese growth to 6.7 percent this year, half of what it was just two years, but saw a recovery next year to 8 percent.
Blanchard addressed concerns about China's foreign exchange policy but said this was not the right time to push China on its yuan currency.
"It is probably not the right time to focus on the Chinese exchange rate given that it is not a central element of the world crisis," he said. "There are many other things we should be thinking about," he said.
Still, he said in the long run it would be best for China and the rest of the world if the yuan's value was increased.
The IMF said the risks of deflation were heightened because of a housing slump in many key economies and the global financial crisis but said the world will likely escape a sustained bout of falling prices, as it did after the last scare in 2002-2003.
It said inflation in advanced economies was set to decline to a record low 1/4 percent in 2009 from 3.5 percent in 2008, edging up to 3/4 percent next year. (Additional reporting by Glenn Somerville and Emily Kaiser; Editing by Leslie Adler)