Greece must shrink state to avoid default: lenders

International lenders told Greece on Monday it must shrink its public sector and improve tax collection to avoid default within weeks as investors spooked by political setbacks in Europe dumped risky euro zone assets.

Hours before a telephone conference between the Greek Finance Minister and senior officials of the European Union and the International Monetary Fund, the IMF representative in Greece spelled out steps Athens must take to secure a vital 8 billion euro rescue payment next month.

The ball is in the Greek court. Implementation is of the essence, Bob Traa told an economic conference.

Additional savings measures were needed 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, he said.

Greek Finance Minister Evangelos Venizelos said the country would do what was necessary to get more rescue funds, but would not allow itself to be scapegoated by euro zone policymakers who had failed to deal with the region's debt woes.

European stocks and the euro fell sharply on fears of an early Greek default, 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.

In a sign of mounting stress, market yields on Italian and Spanish yields rose further above 5 percent despite six weeks of European Central Bank buying in an effort to stabilize them. The cost of insuring peripheral debt against default also rose.

Without its next, eight billion euros loan tranche, Athens says it will run out of cash in mid-October, leaving it unable to cover state salaries, pensions and pay its bills.

The Greek cabinet was due to meet after the teleconference with the IMF/ECB/EU troika, pushed back to 1600 GMT, to discuss further austerity measures to make up for a fiscal shortfall.

Prime Minister George Papandreou canceled a planned trip to Washington and the United Nations at the last minute and returned home on Saturday 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.

What is on the table is full compliance with the agreed targets, Commission spokesman Amadeu Altafaj said in Brussels.

PUBLIC SUPPORT LACKING

The IMF's Traa acknowledged that the IMF/EU bailout program 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.

Venizelos said the economy was set to contract by 5.5 percent this year after 4 percent in 2010. Cutting spending would be a priority of the 2012 budget, he said.

Asked whether Greece would get the next loan tranche, Venizelos told Reuters: Yes, of course.

Even if it does, many economists and investors believe Athens will have to default on its debt mountain -- more than 150 percent of gross national product -- perhaps within months.

Former IMF managing-director Dominique Strauss-Kahn joined this chorus on Sunday, saying in a French TV interview that Greece's debt must be reduced, and government and private creditors should take losses now rather than playing for time.

(EU) governments are not solving things, they are kicking the problem down the road, and the snowball is growing and making the problem bigger and bigger, he told TF1 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 (FDP) junior coalition partners crashed out of the Berlin regional assembly with just 1.8 percent of the vote, raising pressure from some party activists to take a more Eurosceptical line.

The Berlin regional vote ended a cycle of seven state elections this year and appeared to leave the cautious Merkel with less room for maneuver to take bold action in defense of the euro.

Leaders of both the Bavarian Christian Social Union (CSU) and the FDP have raised the prospect of Greece defaulting and having to leave the 17-nation single currency area, ignoring rebukes from the chancellor for alarming markets.

In another illustration of the pressures on Merkel, German central bank chief Jens Weidmann told parliament that planned measures to beef up the euro zone's rescue fund do not encourage countries to put their budgets in order.

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.

The decisions mark a large step in the direction of joint liability and lower disciplinary action by capital markets, without in turn noticeably strengthening control and influence on national financial politics, Weidmann said.

U.S. Treasury Secretary Timothy Geithner pressed euro zone finance ministers apparently in vain at a meeting in Wroclaw, Poland, 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.

In normal circumstances comity would require deference by others to European authorities on the resolution of European problems. Now when these problems have the potential to disrupt growth around the world all nations have an obligation to insist that Europe find a viable way forward, Summers wrote.