The IMF will urge euro zone governments on Monday to boost the size of their rescue fund and recommend the European Central Bank buy more bonds to prevent the bloc's debt crisis from derailing economic recovery.
According to a report that IMF chief Dominique Strauss-Kahn will present to euro zone finance ministers at a meeting in Brussels, the turmoil hitting countries in the currency area's southern periphery constitutes a severe downside risk and more action from member states is needed.
Together with the IMF, the EU set up a 750 billion euro ($1 trillion) rescue facility in May, but it now faces pressure to increase it after last week's rescue of Ireland failed to ease fears of contagion to Portugal, Spain and other high-deficit countries.
The IMF report, a copy of which was obtained by Reuters, says there is 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 also says extraordinary ECB measures to combat the crisis, including its bond purchasing program, should be expanded until systemic uncertainties recede.
Government debt purchases by the ECB calmed markets toward the end of last week, pushing down the borrowing costs of vulnerable countries on the euro zone's southern periphery.
But ECB President Jean-Claude Trichet has made clear that Europe's politicians should not count on the central bank alone to solve the bloc's woes and urged them to take decisive new steps to prevent contagion.
Belgian Finance Minister Didier Reynders, speaking at a conference in Brussels on Saturday, echoed the IMF in urging his euro partners to think about boosting the rescue facility, which would be stretched if Portugal and Spain required bailouts.
Chancellor Angela Merkel's government, worried German taxpayers could rebel against paying for more euro zone bailouts, has said it sees no reason to increase the facility.
Berlin would face intense pressure to drop its objections if the 12-year-old currency bloc came under renewed attack on Monday from investors spooked by economic and fiscal divergences within the euro zone aggravated by the global financial crisis.
PRESSURE FOR MORE AUSTERITY
In a bid to ease market concerns about Spanish finances, the government of Prime Minister Jose Luis Rodriguez Zapatero unveiled new measures last week, saying it would bring forward pension reforms, raise tobacco tax and cut wind power subsidies.
Its plans to sell off a 49 percent stake in state-owned airports authority AENA provoked a 24-hour wildcat strike by air traffic controllers that paralyzed airports and forced the government to declare a state of emergency.
The disruption, which may cost the airline and tourism sectors hundreds of millions of euros, underscored the difficult balancing act euro zone governments face as they seek to appease markets without provoking a public backlash that could end up denting investor confidence even more.
Portugal, widely seen as the next euro zone domino at risk of a bailout, has resisted announcing new measures on top of a tough 2011 budget approved last month.
Greece, struggling to meet tough deficit targets agreed as part of its 110 billion euro EU/IMF rescue, is also under pressure to do more. In a Sunday newspaper interview, its central bank governor urged the government to step up the pace of reform, saying Athens should be striving to beat the fiscal goals set for it.
Meanwhile, opposition parties have vowed to renegotiate the terms of Ireland's bailout after an election early next year. Prime Minister Brian Cowen's deeply unpopular government faces a crucial vote on its 2011 budget on Tuesday.
GERMANY REJECTS EURO BREAKUP
German Finance Minister Wolfgang Schaeuble urged vulnerable countries on the euro periphery to press ahead with painful economic reforms, telling the Bild newspaper that German fiscal discipline should serve as a model for the whole bloc.
He rejected suggestions that Germany might be better off if the 16-nation currency area split up. The Guardian newspaper reported on Saturday that Merkel had warned fellow EU leaders at a summit in October that Germany might leave the euro, a story vehemently denied by the government in Berlin.
The costs of that would be far higher than all the measures we are taking now to defend the euro, Schaeuble told Bild. The economy would suffer and many jobs would be lost.
Luxembourg's Prime Minister Jean-Claude Juncker and Italian Finance Minister Giulio Tremonti also called for the issuance of joint European sovereign bonds -- or E-bonds -- to assert the irreversibility of the euro.
The pair, in a column published in Monday's Financial Times, said the creation of a European Debt Agency that could issue such bonds would be possible as early as this month if the body that represents member states endorsed it.
Germany has rejected calls by Spain to create a fiscal union in the euro zone to ease market concerns about the imbalances in the bloc. It also opposes the idea of issuing common euro zone bonds that would reduce the borrowing costs of weaker euro states, any idea pushed by Jean-Claude Juncker, the head of the Eurogroup forum of euro zone finance ministers.
(Reporting by Paul Day in Madrid, Justyna Pawlak in Brussels, Dave Graham in Berlin and Michel Rose in London; Editing by Michael Roddy)