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WASHINGTON (Reuters) - The United States needs to act urgently to shield its economy from an escalating credit crisis and Europe must ready plans in case its problems worsen, the head of the International Monetary Fund said on Tuesday.
"We're right at the moment where action is needed," IMF Managing Director Dominique Strauss-Kahn told Reuters.
"A non-perfect plan is better than no plan at all," he said of the $700 billion (388 billion pound) bank bailout plan rejected by the U.S. House of Representatives on Monday.
Strauss-Kahn said restoring market confidence required the bailout plan to be passed quickly and for the U.S. public to understand what is at stake unless the economy starts to function properly again.
As the crisis has spread beyond Wall Street, European countries have stepped up their efforts to avoid bank defaults as concerns grew that more institutions would fail, prompting the Irish government to guarantee all bank deposits.
The lack of a pan-European regulator makes it more difficult to respond to the crisis in the event of the collapse of a big bank whose business crosses borders, Strauss-Kahn said.
"Developing a contingency plan does not mean it's announcing a lot of trouble coming. But they're not totally immune (from the U.S. financial crisis), and so they need to organise. At the European level this is totally needed.
"The EU rules make it much more difficult than in the U.S.," to act across borders, he said.
Strauss-Kahn said the risk of inflation from central bank liquidity was a "risk for tomorrow" and was heightened by rising commodity prices, which is why it is important that the European Central Bank (ECB) maintains tight monetary policy.
He said the IMF was projecting a gradual recovery in the U.S. economy next year but that prognosis hinged on a rescue plan being passed quickly by the U.S. Congress.
"We still do not see a deep downturn and project a recovery next year," Strauss-Kahn said. "But we also do not see a V-shape where you go down and recover rapidly. We see something more along the lines of a U-shape, slow growth for quite some time."
"But this forecast relies on the idea that a comprehensive plan in the US will be put in place and will have a positive effect. If for one reason or another this doesn't happen, then we will need to revisit the forecast," he added.
Strauss-Kahn said there were five principles for government interventions in the financial sector, saying any such plan should have a clear objective and effective oversight.
It should also be clear about how the financial sector is recapitalized and how toxic assets are dealt with. Such plans should also make it possible for the state to share any upside risks from intervention once the crisis passes, he added.
Strauss-Kahn said the crisis has had only a limited impact on emerging market and developing economies, but warned a slowdown in capital flows could worsen, even in country's with strong economic fundamentals, if bank credit dried up or became too costly.
"Thus far the effect has been limited mainly because in most emerging economies, including Asia and Africa and Latin America, direct exposure to the subprime was not as large," he said.
"So far, the effect (of the U.S. financial crisis) has not been big. The question is whether increasing spreads, decreasing capital inflows, and less availability of liquidity will create a shock in the emerging countries. It's impossible to say today if that will not be the case in the coming months."
Reporting by Lesley Wroughton