Europe's stability fund needs more firepower - IMF

JOHANNESBURG, Jan 25 (Reuters) - The effective size of Europe’s financial rescue fund should be increased and its banks need rigorous stress-testing to help restore market confidence, the IMF said in a report released on Tuesday.

The link between weak balance sheets of European banks and governments was a primary reason why the International Monetary Fund said global financial stability was still at risk nearly four years after the financial crisis struck.

In an update to its Global Financial Stability Report, the IMF also cautioned emerging markets to be on the lookout for asset price bubbles or excessive credit stemming from heavy capital flows, spurred on in part by easy-money policies in advanced economies.

“While progress has been made and most financial sectors are on the mend, risks to global financial stability remain,” the IMF wrote in the report released in Johannesburg.

“Problems in Greece, and now Ireland, have reignited questions about sovereign debt sustainability and banking sector health in a broader set of euro-area countries and possibly beyond,” it said.

The Fund recommended the effective size of the European Financial Stability Facility be increased and said it should have a “more flexible mandate” to ensure access to funding.

The European fund has a headline value of 440 billion euros but an effective lending capacity estimated at just 225 billion euros because of the need to secure a triple-A credit rating.

The worry is that the fund could be wiped out if a larger European economy needed rescuing, and if that happened the fallout may not remain contained within Europe.

The EU has discussed ways to beef up the fund, but there been resistance -- particularly from Germany -- to increasing the total value.

The IMF also said the European Central Bank would need to continue supplying liquidity to banks that need it, and keep active its Securities Markets Programme for buying public and private debt securities.

Europe’s banks required further “rigorous and credible” stress-testing to ensure they could withstand a shock, and authorities should require that banks found to need more capital obtain the funding within a set timeframe, the IMF said. Non-viable banks should be closed, it said.

In the United States, the IMF said it was important to move ahead with an overhaul of the housing finance system, and said government-sponsored enterprises -- Fannie Mae and Freddie Mac -- could either be privatized or converted to public utilities with an explicit guarantee.

“The authorities should not delay efforts to create an action plan for the future,” the IMF said.

For emerging markets, heavy capital flows posed a stability risk, and the IMF said countries with undervalued exchange rates should allow their currencies to rise to help offset inflow pressures.

“So far, evidence of asset price bubbles and credit booms is still isolated to a few countries in a few sectors, but equity inflows and carry-trade activity are generally quite strong and these flows have to be watched carefully, particularly where leverage may be involved,” the IMF said. (Writing by Emily Kaiser in Washington; Editing by Alex Richardson)