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Europe's recovery is underway but governments must ensure necessary fiscal consolidation does not hurt jobs or growth and can be slowed in some cases if momentum stalls, the International Monetary Fund said today.

Earlier this month, the Fund raised its growth outlook for the euro area to 1.7 per cent in 2010 and 1.5 per cent in 2011, and it said in the outlook inflation would remain low at 1.6 per cent and 1.5 per cent, respectively.

It said there were still risks, including the possibilities of weaker than predicted global growth as well as renewed volatility on European markets.

In its Regional Economic Outlook for Europe, the IMF said developments in the continent's emerging East would depend on the richer West, where renewed instability could hit trade and capital flows, hurting already weak domestic demand.

Advanced Europe would continue to lag more dynamic economies in Asia and the Americas in part due to the impact of the crisis and the struggle by governments from Britain to the Baltics to rein in budget deficits.

"More than ever... the recovery depends on policymakers getting it just right," the Fund said.

"Fiscal consolidation, while inevitable, should be undertaken in a way that minimises the negative impact on growth and unemployment; if growth threatens to slow appreciably more than we expect, countries with fiscal room could postpone some of the planned consolidation."

But intransigent labour, product and service markets would also limit the euro zone's potential growth, particularly since a restocking cycle that has been a main growth driver is waning.

Ajai Chopra, acting director of the IMF's European Department, added that policymakers should follow up on stress tests conducted at the end of the summer to ensure banks have adequate capital without delay.

"The results of the recent European Union-wide stress tests provide a rough guide of the banks that may need to be merged or recapitalized," he said in a statement.

The Fund said governance of the European Union and euro area need to "be fundamentally improved" and argued evidence showed fiscal consolidation would be more successful by selectively cutting costs than trying to raise revenue through tax hikes.

The Fund noted that, largely based on a rebound in exports, especially to Germany, Europe's developing economies were recovering from the deepest contraction since the 1989 fall of Communism. It forecast growth of 3.9 per cent this year and 3.8 per cent in 2011.

It said fiscal consolidation would help relieve concerns over debt that forced bailouts of Hungary, Romania, Latvia among others, although budgets deficits in Bulgaria, Belarus, Serbia, Kosovo and Montenegro were expected to rise in 2010.

Domestic demand, hurt by a collapse in the lending that spurred double-digit growth in some countries earlier this decade, continued to remain weak and countries needed a new model to resume catching up with the West, it said.

"Beyond the short term, the region will need to find new growth engines, as the growth model of the boom years - driven by capital inflows, rapid credit growth, and domestic demand booms - will need to shift toward greater reliance on the tradable sector as an engine of growth," the IMF said.