The euro zone should have a bigger rescue fund for member states in trouble, and the European Central Bank should boost its bond buying to prevent the sovereign debt crisis from derailing economic recovery, an IMF report obtained by Reuters said.
International Monetary Fund chief Dominique Strauss-Kahn will present the report on the economy of the 16 countries using the euro at a meeting of euro zone finance ministers and European Central Bank President Jean-Claude Trichet on Monday.
The recovery could still stay the course, but this scenario could now easily be derailed by the renewed financial market turmoil, the IMF report said. The sovereign and financial market storm affecting the periphery (of the euro zone) constitutes a severe downside risk.
The IMF will tell the ministers that while last week's 85 billion euro ($114.1 billion) joint EU/IMF rescue package for Ireland and a permanent mechanism for crisis resolution including the private sector are welcome, they are not enough.
National structural reforms plans, fiscal consolidation and bank sector repair were still the first line of defense against market turmoil, but more should be done, the IMF said.
The document said euro zone rescue funds should be deployed for countries undertaking strong adjustment but remaining under market pressure, using sufficient liquidity support to cope with uncertain market responses so as to minimize costs from market risks and contagion.
It was not clear from the document if this meant the IMF was advocating euro zone help to Portugal, whose borrowing costs have risen sharply on market concern over its high debt and low growth, but which has passed an austerity budget for 2011.
There is also a strong case for increasing the resources available for this safety net and making their use more flexible, including for the purpose of providing more effective support to banking systems, the report said.
The euro zone, together with the IMF, now has a fund totaling 750 billion euros to help governments cut off from being able to borrow on financial markets, in exchange for fiscal austerity and reforms.
But economists and some policymakers believe that should more euro zone countries, like Portugal, Spain or even Italy, be forced to seek EU financial help, the fund would be too small.
To prevent borrowing costs of countries like Portugal or Spain from rising too high, the ECB has been buying their bonds on the secondary market, but the purchases have been moderate compared, for example, to similar moves in the United States.
The ECB's extraordinary liquidity provision and its securities market program, as well as the EU's extended state aid framework for bank support, would need to remain in place and indeed be expanded until systemic uncertainty receded, the IMF said. Eventually they should be removed gradually to avoid the return of unexpected market pressures, it said.
To raise market confidence in the euro zone banking sector, the IMF called for more probing and stringent national and EU-wide stress tests of banks, which would include liquidity tests with more transparency about exposures to various assets.
It is now urgent to address remaining banking weaknesses and follow up with individual action to restructure, recapitalize, or resolve weak institutions, the report said.
The IMF report will be discussed at length at the euro zone finance ministers' meeting on Monday, a euro zone source said, along with the current situation on debt markets.
European Union finance ministers, who will join their euro zone colleagues on Tuesday, will formally approve the aid package for Ireland and discuss progress in detailing the reform of EU budget rules, the outline of which was agreed in October.
EU sources said they expected a tough debate on whether the revised EU budget rules should allow countries to deduct pension reform costs from the deficit.
Nine EU countries want the costs to be excluded from deficit accounting, but Germany is against it.
The budget rule reform has been watered down by France and Germany to insert more political discretion into disciplinary action against euro zone countries that do not abide by the Stability and Growth Pact -- the EU fiscal rulebook.
The executive European Commission and the ECB have signaled to the European Parliament, which will have a say in the final agreement, that deputies should make the rules stricter again.
The IMF also called for that, saying that a crisis resolution mechanism envisaged for after mid-2013 was a good idea, but crisis prevention was better than crisis resolution.
The IMF would like to see sanctions imposed on euro zone countries which do not plan budgets for the following year in line with EU guidelines and which allow macroeconomic imbalances to grow, despite warnings from fellow euro zone countries.
It also opposes the increased political discretion introduced by France and Germany in deciding on sanctions for rule-breakers, saying in the document that it believes the process should be depoliticized.
(Editing by Mark Trevelyan)