UPDATE 2-IMF says Cyprus must act fast to avoid crisis

* IMF says Cyprus fiscal situation is very serious

* Sees 2011 growth at a standstill, contraction in 2012

* Govt has opportunity to avert problem getting worse

NICOSIA, Oct 12 (Reuters) - Cyprus needs to take urgent action to shore up its economy, the IMF warned on Wednesday, saying the island needed to intensify efforts to avoid fiscal slippage caused in part by its exposure to Greece.

An existing austerity drive by authorities to contain pensions costs and better target social benefits was the minimum that could be done to get the situation in order, said assistant director in the European Department Erik Jan de Vrijer.

"We think the situation at the moment is very serious. The fact that the government cannot access the capital markets is very serious and the risks to the banking sector compound that," he said. "The first priority for Cyprus is to do all it can to avoid that these problems get out of hand."

Worries have grown since a July munitions explosion that crippled its largest power plant that Cyprus's tiny economy could be the fourth in the euro zone to need a bailout.

Asked about the IMF's evaluation of the risk Cyprus may require a bailout, De Vrijer said: "I think that there is time, and there is opportunity for the government to take decisive action to avert the possibility of these problems getting worse and worse."

"We are saying the situation is serious and it demands a strong policy response," said De Vrijer, who was on an IMF consultation mission to Cyprus.

Cyprus's credit ratings have been cut this year as a result of the exposure of its banking sector to Greek debt and fiscal slippage domestically, pushing up its cost of borrowing on financial markets.

Last week, the island's cabinet said it had given the finance minister the go-ahead to take a 2.5 billion euro loan from Russia to refinance maturing debt.

BANK EXPOSURE

IMF mission leader Wes McGrew said on Wednesday that the unsettled external environment meant vigilance and careful contingency planning was required for Cypriot banks, which have a large exposure to Greece.

"(Authorities) should undertake rigorous stress tests to identify potential capital and liquidity shortfalls under adverse scenarios, and require banks to strengthen buffers accordingly where needed," he said.

Cooperative credit institutions, which have a sizeable market share in Cyprus, also require careful oversight and should be subject to stress testing and planning similar to banks, the IMF said in a preliminary report.

Co-ops are not under the supervision of the Cypriot central bank and have their own authority.

FISCAL SHORTFALL

De Vrijer said the best way authorities for restore confidence would be to make a "large upfront reduction" in the country's fiscal deficit next year.

The IMF expects a deficit of 4.0 percent of GDP in 2012, compared with a government target of 2.3 percent. Authorities have trimmed public sector salaries and plan to cut spending on child benefits and student grants.

Measures to achieve fiscal savings should focus mostly on expenditure reductions, which experience has shown provide more durable savings than tax increases, the IMF said.

The Fund expected "little if any growth" this year, and to register a small contraction in 2012, it said.

In February, the IMF had issued a markedly more upbeat scenario of growth of between 1.5 and 2.0 percent for this year.

Asked what had prompted the radical revision, De Vrijer said the July 11 munitions blast which destroyed Cyprus's largest power station had an impact.

"But far the most important one is the financial turbulence in Europe and the diminished growth prospects in North America and Europe (which) are having an impact on Cyprus," he said.