Risks to the global financial system have increased as capital flight threatens to tear the eurozone apart, the International Monetary Fund has warned.
In its latest assessment of global financial stability, the IMF (Other OTC: IMFAF.PK - news) warned that the eurozone still poses the biggest risk as investor confidence in the world financial system has become "very fragile" since the fund's last report in April.
The IMF praised "significant and continuing efforts" by the eurozone, including proposals for a "banking union", the creation of a €500bn (£403bn) bail out fund, and a European Central Bank pledge "to do whatever it takes" to protect the single currency.
But, in an important message to EU leaders ahead of a Brussels summit on deepening fiscal integration, banking union and bank recapitalisation next week, the IMF issued a stark warning that the lack of decisive action by European governments and institutions risked tipping the global economy into deeper crisis.
"Incremental policy making has been insufficient to fully allay market tensions, despite the recent market rally since end July," the report said. "Merely muddling through imposes increasingly higher costs, as the unchecked forces of fragmentation continue to gather speed and undermine the very foundations of the union a common monetary policy, and economic and financial integration."
The IMF is pressuring the EU not to back away from reforms to rapidly create a powerful new eurozone bank supervisor under the auspices of the ECB, including controversial proposals, opposed by Germany, for a European deposit insurance scheme.
"The existing strains in the markets require a leap to better policies if the euro area is to stabilise funding markets and reduce spreads, arrest capital flight, and begin to reintegrate financially," the report said.
The IMF has identified an "increase in macroeconomic risks" as investors flee southern European countries and move investments to the North or outside the eurozone, creating a new economic divide in Europe (Chicago Options: ^REURUSD - news) .
"Within the euro area, capital has continued to move out of the periphery, both to the core and to countries outside the euro area altogether, as official measures to safeguard integration have so far proved insufficient to offset strong private sector forces for fragmentation," said the report.
In signs that progress could be difficult, EU finance ministers meeting in Luxembourg failed to make progress on plans for banking union or proposals to use the euro's bail out fund to recapitalise banks.
Timothy Geithner, US Treasury Secretary, said Europe was "unlikely to be a support for the global economy for some years to come". He said the eurozone was on "a more promising path", but there was "a very hard road ahead".