Euro zone needs to be vigilant on fiscal policies: Lagarde

In a CNBC special interview to Maria Bartiromo, IMF's Managing Director, Christine Lagarde says it believes the ECB has room to ease interest rates. She is not in a mood to renegotiate on Greece and said Euro zone authorities have to be extremely vigilant on their fiscal policies.

Also read: IMF revises US 2012 growth downwards to 2%

Here is an edited excerpt of the interview. Also watch the accompanying video.

Q: What’s being done right now to stop Europe’s debt situation from becoming a full on global fiscal crisis?

A: Investments straight from the European Stability Mechanism (ESM) into the banks avoids the circuit via the sovereign. As a result it does not impact on the sovereign debt level of that sovereign, which is what the Spaniards were so concerned about, that is number one.

Number two; it goes directly to the bank. I mean they are going to decide how it is organized and whether the ESM holds shares or any other instruments that would be convertible into the capital of banks depending on the status of banks. But it will have a multiplier effect because it will consolidate the banks, it help them to lend appropriately to the real economy. It's what the ESM should be doing with its money. It has 500 billion euros or will have at the end of the process. It should use the multiplier effect that is highest. Clearly, banks can produce a good multiplier effect.

Q:  Do you worry that this removes pressure on governments to carry out the economic policies, the austerity that they need to as the Bavarian Prime Minister has argued against this approach?

Lagarde: I don’t think so because there is a clear understanding in all European particularly the Euro zone authorities that they have to be extremely vigilant on their fiscal policies, on their growth policies. On accommodating both short-term sensible contractions, importance should be given to consolidation rather and longer-term anchoring of their determination to keep the deficit down and to reduce their debts.

Q: So are you poised to renegotiate the terms for Greece?

A: I am not in the negotiation or renegotiation mood at all. I am very interested in seeing what has been done in the last few months, in terms of complying with the programme.

Q: In terms of banking sector and ESM money going towards the banks, what else needs to be done in terms of creating that confidence that you have been talking about so much to stabilize markets?

A: Direct involvement from ESM into the banks, that is under way, banking union, that is clearly their target. It is not enough. We think that fiscal union is the next step that they need to explore. One step at a time process is annoying, it is disconcerting. We would like more to happen more quickly because that is the spirit of the time, to move fast and to absorb and digest.

But that is the way Europe is built and has developed overtime. If they do that banking union before year-end, and if their next step is to put in place fiscal union, which at the end of the day should give rise to common fiscal policy, agreed upon objectives, maybe one day one single debt agency for the whole of the Euro zone, maybe one of these days, one single minister of finance for the whole of the Euro zone.

Q: How do you keep lower rates fast enough to avoid this negative spiral that keeps happening? Can you really expect Spain and Italy to pay 7% and 8% in borrowing costs and really expect change?

A: It is a supply and demand issue. The best thing to actually encourage the rates to go down is to restore confidence.

Q: And of course the ECB meets this week. What would be more effective? Lowering interest rates or expanding their asset program, their asset purchase programme? What would you like to see happen on Thursday?

A: What they are generally vocal about is the interest rate modification. That is talked about. We believe at the IMF that the ECB has room available in terms of traditional monetary policy and could possibly use it. We are not sure this is the best channel at the moment, because, you know, Germany does not need lowering of the interest rates set by the ECB but Italy and Spain do.

So you can't associate when you use that kind of monetary policy instrument. On the other hand, the asset purchase programme is much more selective and can be used in a more judicious way.

Tepid recovery would be my two words and associated with two major downside risks. So the first downside risk is the domestic one, the one that policy makers can address if they want to and this is clearly the debt ceiling and fiscal cliff.

The second downside risk is the risk coming from outside that is the Euro zone, a deterioration of the situation in the Euro zone area would be a risk to the US recovery.