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WASHINGTON (Reuters) - Euro zone policymakers must lay out a clear path toward fiscal union and supervise their banks centrally if they are to restore market confidence in monetary union and achieve lasting financial stability, the International Monetary Fund said on Wednesday.
Although the European Union and the European Central Bank have taken major steps that have eased tensions in financial markets over euro-zone sovereign debt problems, they need to break the vicious cycle of market attacks, the IMF said in its Global Financial Stability report.
"European authorities need to provide investors with a clear vision of where monetary union is going, because the answer to this is more and better Europe, not less Europe," said Jose Vinals, IMF financial counsellor in releasing the report.
"None of these policies are easy and some are politically difficult. But I believe they are within reach. Let's not miss the opportunity," Vinals said.
Risks to global financial stability remain elevated and have not abated over the past six months, due to festering problems in Europe and its banking system, the IMF said.
The IMF estimated that bank deleveraging will cause European bank assets to shrink by $2.6 trillion over two years, squeezing credit availability. Italy, Spain and other periphery economies in the euro zone will be especially hard hit and emerging Europe will suffer too, Vinals said.
If economic conditions worsen, EU banks could shed an additional $1.2 trillion in assets by the end of 2013, causing credit to contract by a further 4.4 percent and GDP to decline by 1.4 percent, it said in recommending that the EU help recapitalize banks.
European bank credit is tightening, bond markets are fragile and financial conditions have worsened, underscoring the importance of finding a lasting solution to Europe's problems, which easily could spill over to the rest of the world, it said.
Although the EU has agreed on a fiscal compact that tightens budgetary rules and has set up an emergency bailout fund for troubled countries, and the ECB has cut interest rates and bought sovereign bonds aggressively, the IMF said those measures are not enough.
It recommended that the euro zone pool sovereign risk, something that already has begun through the ECB's purchase of government bonds to support the region's debt markets and through the issuance of common debt for its bailout funds, the European Stability Mechanism and the European Financial Stability Facility.
But creating these mechanisms in an emergency is inefficient and costly, the IMF said. Sending a clear message that the euro zone has laid out a path toward economic integration would help stabilize financial conditions, it added.
"The crisis has shown that fiscal disciplining mechanisms failed, that economic integration remains limited and that financial integration causes difficulties if national authorities remain ultimately responsible for their financial systems," the report said.
The IMF also recommended that European Union policymakers integrate regulation and supervision of EU banks, including setting up a common system of bank deposit insurance and a plan for closing down failed banks. It said the EU should consider capital injections into banks from public funds.
Reporting By Stella Dawson; Antonella Ciancio; Lesley Wroughton; Editing by Andrea Ricci