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* IMF says fiscal overperformance must be avoided
* Germany must continue re-balancing economy
* Should show leadership in financial sector initiatives
By Sarah Marsh
BERLIN, Aug 6 (Reuters) - The IMF warned Germany on Tuesday against being overly ambitious in consolidating its budget given risks to growth in Europe's largest economy, which has not decoupled from the rest of the crisis-hit euro zone.
The International Monetary Fund, which kept its forecast for 0.3 percent German growth this year, said it welcomed Berlin's modest loosening of fiscal policy to boost domestic demand. That is seen driving expansion in the traditionally export-led economy.
However, it also said proactive fiscal policies "would be needed" if growth prospects soured. Some IMF directors already saw scope for more stimulus.
"It will be important to avoid continued fiscal overperformance as this may imply a contractionary fiscal stance," the IMF wrote in a regular review of the German economy. "Macroeconomic policy settings now need to be appropriately supportive of growth in Germany given the substantial downside risks."
Berlin must be prepared to invoke "the escape clause under the debt brake rule" - a legal commitment to cut its structural deficit to no more than 0.35 percent of gross domestic product - in the case of a large shock to the economy, the IMF said.
"The outlook for the remainder of 2013 and next year is heavily dependent on a gradual recovery in the rest of the euro area and a sustained reduction in uncertainty."
Growth should return to potential in 2014, although it will probably only reach 1.3 percent, according to the IMF.
While the German economy propped up growth in the euro zone during the early years of the region's debt crisis, it faltered at the end of last year and only narrowly avoided a recession at the start of 2013.
Recent data, such as Tuesday's figures showing industry orders surging at the fastest pace since October, suggest the economy is gaining traction albeit tentatively.
The IMF said the German banking system was now more stable, but vulnerabilities remain, in part because the regulatory landscape is still unsettled.
"Directors looked forward to German leadership in articulating a clear, coherent roadmap towards achieving European financial sector initiatives," the Fund said.
Germany must also continue with reforms, for example improving the productivity of the services sector, to raise its growth potential and achieve a more balanced economy no longer so heavily reliant on exports.
"Given the size of Germany's economy and its large external imbalances, stronger and more balanced growth in Germany is critical to a lasting recovery in the euro area and global rebalancing," the IMF said. (Additional reporting by Gernot Heller; Editing by Susan Fenton)