German Chancellor Angela Merkel.JESSICA RINALDI/Reuters
The International Monetary Fund says potentially destructive and unpredictable contagion risks spreading to the global economy if Europe's leaders don't quickly contain the euro debt crisis.
The ominous warning comes as German Chancellor Angela Merkel worked to downplay expectations of a quick fix when euro zone leaders meet at an emergency summit Thursday.
"Further steps will be necessary and not just one spectacular event which solves everything," Ms. Merkel told reporters Tuesday in Hanover, where she was hosting visiting Russian President Dmitry Medvedev.
Germany, Europe's wealthy powerhouse, is the euro-zone member most uneasy about writing another blank cheque for Greece, which is quickly burning through the €110-billion bailout it got last year and needs more cash.
The crisis is no longer just about Greece as investors punish Italy and Spain - the euro zone's third and fourth largest economies - by demanding sharply higher interest rates on the countries' bonds. Irish and Portuguese government bonds were downgraded to junk status last week by major rating agencies, virtually freezing them out of debt markets.
IMF officials said any further delays in bolstering a regional bailout fund would put Europe's "core" - Germany and France - and the rest of the global economy at risk. And contagion could happen, even without a default by Greece.
"It would be very costly not just for the euro zone but for the global economy to delay tackling the sovereign crisis," IMF official Luc Everaert explained as he presented an IMF staff report on the crisis.
"We need more Europe, not less," he said.
The IMF warned in its report that dragging out debate on saving the so-called periphery of Europe - Greece, Ireland and Portugal - would only make it worse for everyone else. "Serious trouble in the periphery spilling over into the core" would have a "very unpredictable outcome and significantly larger spillover effects," the Washington-based lender said.
The IMF called for a larger and more flexible bailout fund, a clearer role for private bond holders and measures to shore up weak banks.
Euro-zone officials are coming to the meeting with a plan for a possible tax on banks to help pay for a second Greek bailout, according to a confidential euro-zone paper drafted for the 17-nation summit and obtained by Reuters. A small levy on banks could raise as much as much as €10-billion a year - a solution that would mollify Germany's demand that the private sector share the burden of future bailouts with tax payers.
European banks are among the largest holders of euro-zone sovereign bonds, once seen as rock-solid investments because of the implicit backing of other euro members.
Officials are also looking at cutting interest rates on the bailout cash and extending the repayment period.
The IMF has estimated that Greece will need another €115-billion by mid-2014 to avoid default.
Echoing the IMF's concerns about contagion, a Royal Bank of Scotland report Tuesday said the euro crisis could become a "large systemic risk event" in a matter of days or weeks as Spanish and Italian bond yields continue to ratchet up.
"Policy makers remain well behind the curve, and are unlikely to do anything material to assist Spain and Italy," Harvinder Sian, a senior bond strategist in London, wrote in an investor report Tuesday. "The conditions for a near-death experience for the euro are in place now, which in turn should finally galvanize a more serious policy reaction."
Yields on Italian and Spanish government bonds jumped to their highest levels since the euro was introduced in 1999 - a message that investors are betting the crisis would soon spread to those countries.
"The story is playing out in Spanish and Italian yields, not in Greece, and it is the absence of European policy levers to prevent even higher bond yields that now concerns," Mr. Sian wrote. "Risk markets are on the cusp of a dramatic decline."
RBS said investors should sell short all "periphery" bonds and "if possible, all non-German paper" in the euro area. Shorting is akin to placing a bet that bonds prices will fall, and yields will rise.