Italy will allow the IMF to monitor its progress with long overdue reforms of pensions, labor markets and privatizations, European leaders announced on Friday, looking beyond the crisis in Greece to the far graver threat to the euro zone.

With its borrowing costs rising and debt levels stuck at 120 percent of GDP, the euro zone's third largest economy is too big to fail. Paralysis in Prime Minister Silvio Berlusconi's weakened government has sapped market confidence.

Berlusconi agreed in late-night talks with euro zone leaders and U.S. President Barack Obama on the sidelines of a G20 summit in Cannes to have the IMF and the EU issue quarterly reports assessing its performance on reform promises.

The move came after a European ultimatum forced Greece to step back from a referendum that could have triggered its exit from the euro and agree instead to seek national consensus to drive through austerity measures.

Discussions with Italy went more smoothly, European diplomats said. Berlusconi understood the gravity of the situation and was thoroughly engaged in the talks.

I see this as evidence of how important Italy's reform process is for the country and for the euro zone as a whole, European Commission President Jose Manuel Barroso said.

The Commission too will monitor Italy and will conduct a first assessment next week. German Chancellor Angela Merkel said the two bodies would produce quarterly reports.

The International Monetary Fund's intervention in Italy, a G8 economy, takes the euro zone debt crisis to a new level. To varying degrees bailout recipients Greece, Portugal, Ireland and now Italy are relinquishing sole control of economic policy.

We need to make sure there is credibility with Italy's targets -- that it is going to meet them. one EU source said.

Concern is growing that Italy, the euro area's biggest government bond market, could go the way of Greece without rapid action. Berlusconi has repeatedly promised to make deep reforms, balance the budget in 2013 and trim the public debt, but there are doubts about his commitment.

NO NEW CASH FOR EFSF

The leaders of France, Germany, Italy, Spain, the European Central Bank, the IMF and European Union institutions also discussed with Obama ways of ramping up the IMF's warchest to help prevent contagion from the euro zone's debt crisis plunging the world economy back into recession.

The shift of focus to the IMF was a tacit admission that Europe's G20 partners had little stomach to invest in Europe's bailout fund.

Merkel said hardly any countries in the G20 had shown willingness to participate. The Europeans had hoped to entice China and other wealthy sovereigns to invest in a special purpose vehicle, but their leaders said they needed more detail on how the system would work before deciding.

No figures were agreed on the IMF but the boost to resources, mostly from large emerging countries such as China, could be in the range of $300-350 billion, G20 officials said.

Sarkozy said G20 finance ministers were instructed to take forward several options for scaling up the Fund's resources.

EU officials said three options were under consideration, including pooling the euro zone countries' rights to borrow from the IMF to build a fighting fund to support vulnerable sovereigns such as Italy and Spain. This could make available another $280-300 billion, the G20 source said.

BEYOND GREEK DRAMA

Delegates gathered in the Riviera resort found themselves watching the euro zone battle to snuff out its biggest fire yet as Greece seemed on the brink of quitting the euro.

An EU source said a precautionary credit line was not seen as a credible option for Italy, where one of the main problems has been market confidence.

With the general climate and Italy's lack of credibility, every small setback or problem is compounded and makes things worse, so the markets cannot have confidence, he said.

Greece's future in the euro zone may hinge on a vote of confidence in Socialist Prime Minister George Papandreou late on Friday night.

If he wins, government sources say he has pledged to step aside and make way for an interim national unity government that would enact the EU/IMF bailout plan, receive a vital aid installment and pave the way for early elections next year.

However, if he loses, Greece will be plunged into deeper political turmoil and may face a hard default and possible exit from the 17-nation single currency area.

SARKOZY AMBITIONS OVERTAKEN

The fast-moving Greek fiasco dominated the last meeting of France's G20 presidency and crushed any hopes by President Nicolas Sarkozy of making a last-minute breakthrough on big early goals such as rethinking the global monetary system.

The draft statement seen by Reuters showed the G20 is considering an IMF proposal to create a new short-term credit line to help countries hit by crippling economic shocks.

G20 sources said talks were looking at an extension of the fund's New Agreements to Borrow (NABS), due to expire next year, and the injection of billions of dollars into the global economy through a special allocation of its Special Drawing Rights.

It all depends on Sarkozy, how hard he pushes, one said.

The plan to ramp up SDRs should also help manage fears rippling through markets over Europe's crisis.

The crisis in Europe is causing a global systemic crisis including Asia. Rather than creating a new global framework, everyone is expecting the IMF to become more proactive, Japanese Finance Minister Jun Azumi said.

The focus of debate is how to set up a firewall but we consider that the IMF should become one big wall.

(Additional reporting by Lesley Wroughton, Gernot Heller, Daniel Flynn,; Writing by Paul Taylor, Janet McBride)

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