* Zimbabwe yet to agree with lenders on arrears, reforms
* IMF says domestic borrowing unsustainable, inflationary
* Zimbabwe owes more than $1.75 billion in foreign arrears
By MacDonald Dzirutwe
HARARE, July 7 (Reuters) - Zimbabwe is yet to reach a deal with the World Bank and other foreign lenders over clearing arrears and reforms, the International Monetary Fund said, warning that reliance on central bank finance could fan inflationary pressures.
President Robert Mugabe's government has not received foreign funding since it started defaulting on its external debt in 1999 and the country is relying on domestic borrowing and taxes to fund its national budget.
The IMF said in a statement on Friday after a meeting of its executive board this week that although Harare cleared its arrears with the fund last year, talks with the World Bank and other multilateral lenders faced delays.
"It (Zimbabwe) is yet to reach agreement with the World Bank and other multilateral institutions on the settlement of arrears, and undertake reforms that would facilitate resolution of arrears with bilateral creditors," the IMF said.
The IMF also said Zimbabwe should not seek to clear its $1.75 billion arrears through agreements that would worsen its debt situation. Zimbabwe's foreign debt stands at more than $7 billion, more than half of its GDP.
On April 27, Zimbabwean Finance Minister Patrick Chinamasa said the southern African nation had met all conditions to clear arrears to the World Bank and African Development Bank, paving the way for possible future funding from the IMF.
But the IMF warned that Zimbabwe's borrowings from its central bank and domestic banks to plug its budget deficit was unsustainable and had "significant potential for generating inflationary pressures."
The World Bank has forecast a 3.2 percent annual inflation rate in Zimbabwe at the end of this year, before accelerating sharply to 9.6 percent at the end of 2018.
The government's domestic borrowing stands at more than $4 billion and is seen growing as the government struggles to raise money to finance everything from salaries to agriculture.
"The marked increase in public debt is crowding out private sector activity, aggravating liquidity shortages, and exacerbating debt distress," the IMF said.
Zimbabwe has been facing shortages of cash and foreign currency since last year, forcing banks to limit daily withdrawals while importers, including mining companies, have struggled to pay for their goods abroad. (Editing by Alexander Smith)