By Anna Yukhananov
TOKYO (Reuters) - The International Monetary Fund urged European policymakers to deepen the financial and fiscal ties within the euro area with some urgency to restore sagging confidence in the global financial system.
In its semi-annual check on the world's financial health, the Fund said the euro area's debt crisis was the main threat and the risks to global financial stability had risen in the last six months, leaving confidence "very fragile".
The euro area's plodding progress means European banks are likely to offload $2.8 trillion in assets over two years to cut their risk exposure, an increase of $200 billion from a prediction six months ago, the IMF estimated. That could shrink credit supply in the periphery by 9 percent by the end of 2013, crimping economic growth.
"Despite many important steps already taken by policymakers, this agenda remains critically incomplete, exposing the euro area to a downward spiral of capital flight, breakup fears and economic decline," the IMF said in its Global Financial Stability Report (GFSR) released on Wednesday.
Jose Vinals, director of the IMF's monetary and capital markets department and the main author of the financial stability report, said Europe's troubles should serve as a lesson to the heavily indebted United States and Japan that delaying the necessary policy adjustments until markets force their hands would lead to "harsher economic outcomes."
"We should not let the current market conditions, which have improved, lead to a false sense of security," Vinals said in a press briefing.
The report adds to the gloomy backdrop ahead of the IMF's semi-annual meeting to be held in Tokyo later this week. On Tuesday, the Fund said the global economic slowdown was worsening as it cut its growth forecasts for the second time since April and warned U.S. and European policymakers that failure to fix their economic ills would prolong the slump.
Last week, Canada's Finance Minister Jim Flaherty expressed his latest sign of frustration over progress in resolving Europe's debt crisis by saying it represented a "clear and present danger".
In September, the European Central Bank agreed to buy the bonds of debt-strained governments once they have signed up for a euro zone bailout programme, restoring some market confidence and narrowing the spread between core and peripheral debt in the region.
But private investors still lack confidence in peripheral European markets and the difference between the yields on peripheral and core debt from banks and companies remains high, threatening any recovery, the IMF said.
Under current policies, the IMF estimated European banks will shed $2.8 trillion in assets between the third quarter of 2011 and the end of 2013, higher than the $2.6 trillion it had predicted in April, further squeezing credit availability.
And if European policymakers do not fulfill promises to establish a common bank supervisor, and peripheral countries do not follow through with adjustment programmes, the costs could be even higher, with $4.5 trillion in lost assets, and additional impacts on employment and investment. Supply of credit in the periphery could tumble by 18 percent.
Risks from the euro zone could also spill into emerging markets, where growth is already slowing. Countries in central and eastern Europe are the most vulnerable to financial shocks, given their exposure to the euro zone and their own entrenched external debts, the report said.
And while the United States and Japan have benefited from safe-haven flows away from the euro zone, the IMF said both countries need to do more to reduce their fiscal burdens in the medium term.
The U.S. faces a so-called "fiscal cliff" -- government spending cuts and tax rises due to take effect early in 2013. Japan is carrying the biggest public debt burden among leading industrialised nations at twice the size of its $5 trillion economy at a time when its social welfare spending is under constant pressure from a rapidly ageing population.
"The choice today is between making the necessary but tough policy and political decisions or delaying them - once more - in the false hope that time is on our side," Vinals said.
"It is not."
(Additional reporting by Lesley Wroughton and Kaori Kaneko, editing by Neil Fullick and Emily Kaiser)