by Steve Schifferes BBC Economics reporter at the OECD in Paris

The OECD does not want to see interest rates rise for the eurozone

Europe is set to suffer most from the unwinding of global economic imbalances if market turmoil continues, the OECD has warned.

OECD chief economist Jean-Phillippe Cotis said that a decline in the value of the dollar could damage Europe's prospects for recovery.

"A brutal unfolding of such imbalances would hurt the world economy, with perhaps the largest output losses concentrated in the least resilient regions, not least the euro area," he said.

But in his comments to accompany the OECD's semi-annual economic forecast, he added that much of the recent market turmoil could be a useful adjustment to unrealistic expectations about risk.

"If the market prices risk more realistically, this should not be a source of worry," he told reporters in Paris.

The OECD's central predication is that the broad-based recovery in the world economy will continue, with growth slowing slightly in the US and Japan but accelerating in Europe.

If anything, the risks have increased OECD

But Mr Cotis acknowledged that signs of recovery were still fragile in Europe, and urged the European Central Bank to hold off from further rate hikes until the autumn when it would become clear whether economic growth was on track.

However, the ECB has already signalled that it is likely to raise interest rates in June because of inflationary worries.

Mr Cotis said that a rapid depreciation of the dollar could cut into Europe's export-led growth.

The big budget deficits in most EU countries meant it would be difficult to spend more money to stimulate the economy, while interest rates were already at a low level and probably could not drop further.

Buoyant - but vulnerable

Overall, the OECD says that the world economy is still buoyant but "vulnerable" to a number of risks.

And it warns that "if anything, the risks have increased" as regards current account imbalances, long-term interests rates, and houses.

The biggest problem for the world economy are global trade imbalances. The OECD forecasts that the US deficit will increase to 7.5% of GDP by 2007, while China and Japan will both have trade surpluses to 6% of GDP.

It says that the longer such balances go on uncorrected, the bigger the risk of an "accident" that would lead to a sudden fall in the dollar.

"It seems unlikely that these balances would continue indefinitely without prompting market-driven adjustment, which could prove unpleasant," the OECD warns.

GROWTH FORECAST US: 3.1% (2006), 2.9% (2007) Japan: 2.8% (2006), 2.3% (2007) Euro area: 2.2% (2006), 2.1% (2007) Source: OECD

In the long run, it estimates that the dollar may have to fall by a third for a global correction in trade flows to take place.

And it points out that although a collapse of the dollar could lead to higher interest rates in the US, for the US economy this would be balanced by increased exports, as the cheaper dollar made American goods more competitive on world markets.

House price fears

The OECD also warned that the risks to financial and economic stability from "high and in some places inflated house prices" should not be overlooked.

If long-term interest rates rose by 2%, it said, sharp downturns in house prices were likely in the US, France, and Spain, although some correction had already occurred in the UK and Australia.

This could slow any recovery, by making consumers feel less wealthy and lose confidence.

Another risk comes from further rises in oil prices, given the inability of the oil market to increase supply in the short-term, and the likelihood of more geo-political instability.

This, the organisation warned, could give a further boost to world inflation and force banks to raise interest rates, hurting growth.

But the OECD pointed out that global trade flows - especially cheap imported goods from China - are exercising a strong downwards pressure on inflation.

Debt problems

It is not only current account deficits that are worrying the OECD.

Mr Cotis also said that the failure of most OECD countries to cut their big budget deficits, even during the recovery phase of the economic cycle, was storing up trouble for the future.

He was"greatly troubled" by this, especially in the light of the higher costs that governments would face in the future in paying for retirement and health care costs of the growing number of elderly people.

And he warned that if governments do not put aside some money during the upturn, they will not be able to stimulate their economies in the future if another downturn occurs.

Nevertheless, the OECD is forecasting that the US budget deficit will be stuck at around 4% of GDP, despite promises by the Bush administration that it will come down, and warns that reductions in the eurozone deficit will be slow and painful despite the "courageous" action by Germany in raising taxes.