ATHENS (Reuters) - International lenders told Greece on Monday it must shrink its public sector to avoid running out of money within weeks, as investors spooked by political setbacks in Europe dumped risky euro zone assets.
Adding to concerns, Standard & Poor's cut its ratings on Italy in a major surprise that threatens to stoke fears of contagion in the debt-stressed euro zone.
Greece is near a deal to continue receiving bailout funds, a Greek finance ministry official said after a conference call with lenders, though "some work still needs to be done."
U.S. stocks recovered some of their losses on the news.
Greek Finance Minister Evangelos Venizelos held what Greece termed "productive and substantive" talks by telephone with senior officials of the European Union and International Monetary Fund after promising as much austerity as necessary to win a vital next installment of aid.
The talks will resume on Tuesday evening after experts meet through the day. Earlier, the IMF's representative in Greece spelled out steps Athens must take to secure the 8 billion-euro loan it needs to pay salaries and pensions next month.
"The ball is in the Greek court. Implementation is of the essence," Bob Traa told an economic conference.
Additional savings measures were required to cut the public deficit to a sustainable level and reduce the public sector's claim on resources -- code for axing jobs and cutting pay and pensions -- while improving tax collection rather than adding further taxes, Traa said.
Venizelos said Greece would do what was needed to get more funds but would not be made a scapegoat by euro zone policymakers who had failed to tackle the region's debt woes.
European stocks and the euro fell sharply on fears of a Greek default, compounded by the failure of EU finance ministers to agree new steps to resolve Europe's debt crisis at weekend talks, and another regional election defeat for German Chancellor Angela Merkel.
The euro fell about 0.5 percent in early Asian trade on Tuesday after S&P cut its rating on Italy, citing weakening economic growth prospects and a fragile ruling coalition.
In a sign of mounting stress, yields on Italian and Spanish bonds rose further above 5 percent despite six weeks of European Central Bank buying to stabilize them. The cost of insuring peripheral debt against default also rose.
"There will be additional volatility in the global financial markets heading into the end of the month as the pressure to get Greece and others to enact their reforms will be white-hot intense," said Andrew Busch, global currency strategist at BMO Capital Markets in Chicago.
The euro zone debt crisis is now dominating the thoughts of policymakers worldwide with the United States, in particular, pushing for more dramatic action from Europe's leaders.
President Barack Obama and Germany's Merkel spoke by telephone on Monday -- the latest of several calls between the two leaders -- and agreed that "concerted action" would be needed in the coming months to address it.
Emerging economies are also worried about being hurt by a deepening of the crisis in Europe.
A Brazilian official said Brazil will propose this week that it and other large emerging economies make new funds available to the IMF to help ease the crisis in the euro zone.
"A new and larger risk looms. The drop in markets and confidence could prompt slippage in developing countries' investment and a pull back by their consumers too," World Bank chief Robert Zoellick said ahead of Group of 20 talks and an IMF/World Bank meeting in Washington later in the week.
Without its next loan tranche, Athens says it will run out of cash in mid-October.
A default would threaten contagion to larger euro zone economies such as Italy and hammer European banks with heavy exposure to Greece.
Prime Minister George Papandreou canceled a planned trip to Washington and the United Nations at the last minute and returned home in response to the crisis.
A senior Greek government official told Reuters the EU/IMF inspectors expect a new property tax unveiled last week to yield just half the two billion euros targeted this year.
Greek media published a list of 15 austerity measures it said the troika was demanding the Socialist government implement to receive the next tranche of aid.
They included firing another 20,000 state workers, cutting or freezing state salaries and pensions, increasing heating oil tax, shutting down loss-making state organizations, cutting health spending and speeding up privatizations.
The European Commission said it was not asking Athens to adopt any additional austerity steps on top of what had already been agreed in the Greek reform program.
The IMF's Traa acknowledged that the IMF/EU bailout plan lacked public support and said there was plenty of goodwill to give Greece more time for its adjustment program in a weaker-than-expected economy.
He said the economy was set to contract by 5.5 percent this year and 2.5 percent in 2012.
Asked whether Greece would get the next loan tranche, finance minister Venizelos told Reuters: "Yes, of course."
Even if it does, many economists and investors believe Athens will default on its debt mountain -- more than 150 percent of gross national product -- perhaps within months.
Former IMF chief Dominique Strauss-Kahn joined the chorus on Sunday, saying Greece's debt must be cut and government and private creditors should take losses now. "(EU) governments are not solving things, they are kicking the problem down the road, and the snowball is growing...," he told French television.
Uncertainty over Greece was compounded by another political shock in Germany at the weekend.
The sixth regional election defeat this year for Merkel's center-right coalition on Sunday raised questions about the stability of her government and her ability to push through more euro zone rescue measures.
Her Free Democratic (FDR) junior coalition partners crashed out of Berlin's regional assembly with 1.8 percent of the vote, raising pressure from some party activists for a more Euroskeptical line.
Leaders of both the Bavarian Christian Social Union (CSU) and the FDR have raised the prospect of Greece defaulting and possibly having to leave the 17-nation single currency area, ignoring rebukes from the chancellor for alarming markets.
Merkel said on Monday it would send a disastrous political message if euro zone members could be thrown out of the bloc because they faced difficulties. Instead, she advocated tougher rules to force euro states to obey budget discipline.
German lawmakers are due to vote on September 29 on reforms agreed by euro zone leaders in July to allow the European Financial Stability Facility to buy government bonds in the secondary market, give states precautionary loans and lend to recapitalize banks.
Merkel insisted she would win the vote.
In another illustration of the pressures on her, German central bank chief Jens Weidmann told parliament that planned measures to beef up the euro zone's rescue fund would not encourage countries to put their budgets in order.
Last week Treasury Secretary Timothy Geithner pressed euro zone finance ministers apparently in vain to take stronger action to stop the sovereign debt crisis spreading.
One of his predecessors, Lawrence Summers, said in a Reuters column that all nations should pressure Europe to go beyond "grudging incrementalism" to recapitalize banks, and revive economic growth.
Additional reporting by Brian Rohan in Berlin, Catherine Bremer in Paris, William James and Natsuko Waki in London, Harry Papachristou in Athens, Kristina Cooke in New York; Brian Winter in Sao Paulo; Caren Bohan in Washington; Writing by Paul Taylor; editing by Janet McBride/Mike Peacock, Kenneth Barry/Andrew Hay