The debut bond from Europe's financial rescue fund attracted robust demand on Tuesday, in the latest sign of confidence the bloc is getting to grips with the debt crisis that has haunted it for over a year.

The International Monetary Fund (IMF) cautioned in a report that Europe still had work to do to restore faith in its economies, urging rigorous stress-testing of its banks and a strengthening of the rescue fund, known as the European Financial Stability Facility (EFSF).

But the successful bond sale and a tentative rally in the debt of vulnerable countries on Europe's southern periphery in recent days has offered hope that the euro zone may be finally turning the corner, even if its diverging economies and high debt seem sure to plague it for years to come.

Describing intrest as exceptionally strong, The EFSF said its bond sale had attracted orders from more than 500 investors totaling 44.5 billion euros -- roughly nine times the 5 billion euros of paper on offer.

Demand from Asian investors was particularly robust, with the Japanese government buying over 20 percent of the issue.

The huge investor interest confirms confidence in the strategy adopted to restore financial stability in the euro area, said the EFSF's German Chief Executive Klaus Regling.

Funds raised from the 5-year bond will be used to help finance the bailout of Ireland, which followed Greece last year in seeking a rescue to cope with a financial meltdown in its banking sector.

As 2011 got under way, fears were rife that euro zone contagion would spread from Ireland to Portugal and Spain, stretching the 440 billion euro EFSF to the busting point.

But European leaders are now contemplating changes to the rescue fund which have helped restore market confidence. The euro has risen 7 cents against the dollar over the past two weeks to reach a two-month high above $1.36.

And the risk premiums investors demand to hold Portuguese

and Spanish debt instead of rock-solid German benchmarks have fallen back, although they edged higher in thin trade on Tuesday.

NEW POWERS

Among the steps euro zone leaders are considering is an increase in the effective capacity of the EFSF, which for technical reasons can only lend about 250 billion euros, and giving it new powers to buy bonds directly or make loans to troubled countries, possibly so they can buy their own bonds.

Other ideas include reducing the interest rates Greece and Ireland are forced to pay under their rescues. Many economists believe the two countries, which are pushing through draconian budget cuts, will ultimately be forced to restructure their debt unless new steps are taken to relieve their burden.

Problems in Greece, and now Ireland, have reignited questions about sovereign debt sustainability and banking sector health in a broader set of euro area countries and possibly beyond, the IMF said on Tuesday in an update to its Global Financial Stability Report released in Johannesburg.

Shock news that Britain's economy contracted by 0.5 percent in the fourth quarter of 2010 served as a reminder on Tuesday of just how vulnerable European economies remain as they slash spending and boost taxes to rein in swollen deficits..

And another note of caution came from Ireland's central bank governor Patrick Honohan, who told Reuters in an interview that Irish banks were likely to face higher prospective loan losses after the completion of a new capital review.

Tough austerity programs are already raising pressure on euro zone politicians and raising questions about whether governments could backslide on ambitious savings goals as voters turn on them.

POLITICAL BACKLASH

Irish Prime Minister Brian Cowen is expected to be booted out of office in an early election next month and the parties likely to form the next government are vowing to renegotiate aspects of the country's EU/IMF rescue deal.

Spanish Prime Minister Jose Luis Rodriguez Zapatero has won plaudits from the markets for his economic reforms, but his party faces a drubbing in crucial regional elections in May and a national vote next year..

Germany, Europe's largest economy, remains an exception. Last week the government raised its 2011 growth forecast to 2.3 percent and on Tuesday, data showed consumer morale pushing up to its highest level since October 2007.

But even Germany's leader Angela Merkel will have to tread carefully to avoid alienating voters with steps to shore up struggling euro zone partners ahead of key state election tests in February and March.

Against this complex economic and political backdrop, European leaders may struggle to reach a consensus on the comprehensive package of anti-crisis measures they have promised to unveil at a March summit.

Berlin is pushing for closer economic coordination, but only on its own terms. It would also like to see more automatic sanctions for deficit sinners and the extension of German-style debt-brake legislation across the euro zone -- steps that may be politically unacceptable for its economically strapped euro zone partners.

Ahead of a meeting with Merkel at a German government estate north of Berlin on Tuesday evening, European Commission President Jose Manuel Barroso cautioned against complacency, and in an apparent dig at Germany warned against procrastination.

One of the messages from the markets is clear -- let's not react behind the curve, he said.

(Writing by Noah Barkin)

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