BRUSSELS (Reuters) - Any further negative shocks could halt the euro zone's economic recovery, sour improving market sentiment and eventually tip the bloc into price deflation, the International Monetary Fund warned on Monday.
The euro zone economy has been growing for a year but its expansion remains too weak to compensate for the preceding two years of recession across the 18 countries that share the euro or make inroads into record-high unemployment.
"With limited policy space in the near term, further negative shocks - either domestic or external - could sour financial market sentiment, halt the recovery, and push the economy into lower inflation and even deflation," the Fund wrote in a regular report.
News last week of irregularities at a web of family-held holding companies behind Portugal's largest listed bank, Banco Espirito Santo <BES.LS> pushed up borrowing costs for some euro zone countries and revived memories of the region's debt crisis.
The IMF said the euro zone's recovery remained too weak despite governments' attempts to reform, European Central Bank action to spur growth and a clean-up of the financial sector.
Euro zone industrial production dropped sharply in May with only the energy sector thriving, underscoring the fragility of recovery.
The IMF urged the euro zone to support economic demand, complete a reform of the banking sector known as banking union and advance structural reforms.
It said a weaker euro would help buoy the economy.
Real economic activity in the bloc has yet to reach pre-crisis levels and inflation remains worryingly low, the IMF warned, cautioning governments not to go for further spending cuts if growth stumbles.
"The broadly neutral overall fiscal stance is appropriate but any negative growth surprises should not trigger additional consolidation efforts as this would be self-defeating," the Washington-based body said.
In a separate report, the IMF's analysts said that should the ECB deploy quantitative easing - a sustained expansion of a central bank's balance sheet - it must ensure all euro zone countries benefit rather than just big members.
(Reporting by Martin Santa; Editing by John O'Donnell and Catherine Evans)