* European banks to offload $2.8 trln under current policies
* Euro agenda 'critically incomplete', risk of capitalflight
* Looming risk to safe-haven flows to U.S., Japan * IMF tone in contrast to more upbeat mood in Europe * IMF says global financial confidence "very fragile"
(Adds response to IMF report from a European Commissionspokesman)
By Anna Yukhananov
TOKYO, Oct 10 (Reuters) - The International Monetary Fundurged European policymakers to deepen the financial and fiscalties within the euro area with some urgency to restore saggingconfidence in the global financial system.
The IMF's stark tone on the euro area debt crisis in itssemi-annual checkup of the world's financial health was inmarked contrast to the mood in Europe, where a European CentralBank decision to buy bonds of countries that accept anassistance programme has removed immediate concerns about thesurvival of the euro.
"Despite many important steps already taken by policymakers,this agenda remains critically incomplete, exposing the euroarea to a downward spiral of capital flight, breakup fears andeconomic decline," the IMF said in its Global FinancialStability Report (GFSR) released on Wednesday.
It said the euro area's debt crisis was the main threat toglobal financial stability, which had weakened in the last sixmonths to leave confidence "very fragile".
The euro area's plodding progress means European banks arelikely to offload $2.8 trillion in assets over two years to cuttheir risk exposure, an increase of $200 billion from aprediction six months ago, the IMF estimated. That could shrinkcredit supply in the periphery by 9 percent by the end of 2013,crimping economic growth.
The report adds to a gloomy backdrop ahead of the IMF'ssemi-annual meeting to be held in Tokyo later this week, whichwill gather the world's financial leaders.
On Tuesday, the Fund said the global economic slowdown wasworsening as it cut its growth forecasts for the second timesince April and warned U.S. and European policymakers thatfailure to fix their economic ills would prolong the slump.
GRAPHIC: EU debt crisisGRAPHIC: Cost of funding
IMF warns global economic slowdown steepens
HIGHLIGHTS of comments in Tokyo
A scenario where Europe muddles through, addressinghaphazardly each new flare-up in the protracted crisis ratherthan adopting a comprehensive plan, would prove costly, JoseVinals, director of the IMF's monetary and capital marketsdepartment and the main author of the financial stabilityreport, said.
"The more time that goes by without a complete solution, themore are the eventual costs for everybody of resolving thecrisis," he told Reuters in an interview.
Europe's troubles should also serve as a lesson to theheavily indebted United States and Japan that delaying thenecessary policy adjustments until markets force their handswould lead to "harsher economic outcomes", Vinals told abriefing.
"We should not let the current market conditions, which haveimproved, lead to a false sense of security," he said.
Still, ECB Vice-President Vitor Constancio said his messageto the IMF and World Bank gatherings is that Europe has mademuch progress in recent months.
"That should be encouraging for the world economy," he toldReuters in Tokyo.
Measures carried out by Europe included an unprecedentedstrengthening of economic governance and deep structuralreforms, said Simon O'Connor, the European Commission'sspokesman on economic and monetary affairs.
"No one should underestimate how far Europe has come sincethe start of the crisis," he said in reaction to the IMF report.
SHRINKING BALANCE SHEETS
A German finance ministry source said in Berlin that theEU's most powerful member would strive to ensure that the debtcrisis was not the sole focus of the IMF meeting.
Last week, Canada's Finance Minister Jim Flaherty expressedhis latest sign of frustration over progress in resolving thecrisis by saying it represented a "clear and present danger".
U.S. Treasury Secretary Timothy Geithner said on Tuesdaythat resolving the euro area's debt problems would take time.
"Even if one is optimistic about the will and capacity tomanage through this, you are still likely to see a very, verychallenging growth environment in Europe for a long period oftime," Geithner said during a visit to New Delhi.
On Tuesday, ECB President Mario Draghi said the bond buyingprogramme, although not yet in operation, provided a "fullyeffective backstop" for the euro zone to avoid destructivescenarios and had already helped calm market fears.
The IMF acknowledged that the ECB's bond buying agreementhad restored some market confidence and narrowed the spreadbetween core and peripheral debt in the region.
But private investors still lacked confidence in peripheralEuropean markets and the difference between the yields onperipheral and core debt from banks and companies remained high,threatening any recovery, it said.
Under current policies, the IMF estimated European bankswill shed $2.8 trillion in assets between the third quarter of2011 and the end of 2013, higher than the $2.6 trillion it hadpredicted in April, further squeezing credit availability.
And if European policymakers do not fulfill promises toestablish a common bank supervisor, and peripheral countries donot follow through with adjustment programmes, the costs couldbe even higher, with $4.5 trillion in lost assets, andadditional impacts on employment and investment. Supply ofcredit in the periphery could tumble by 18 percent.
The IMF said risks from the euro zone could also spill intoemerging markets, where growth is already slowing. Countries incentral and eastern Europe are the most vulnerable to financialshocks, given their exposure to the euro zone and their ownentrenched external debts, the report said.
And while the United States and Japan have benefited fromsafe-haven flows away from the euro zone, the IMF said bothcountries need to do more to reduce their fiscal burdens in themedium term.
The U.S. faces a so-called "fiscal cliff" -- governmentspending cuts and tax rises due to take effect early in 2013.Japan is carrying the biggest public debt burden among leadingindustrialised nations at twice the size of its $5 trillioneconomy at a time when its social welfare spending is underconstant pressure from a rapidly ageing population.
"The choice today is between making the necessary but toughpolicy and political decisions or delaying them - once more - inthe false hope that time is on our side," Vinals said. "It isnot."
(Additional reporting by Lesley Wroughton, Kaori Kaneko, andTomasz Janowski in TOKYO and Luke Baker in BRUSSELS:; Editing byNeil Fullick and Emily Kaiser)
Keywords: IMF FINANCIAL/