Bailed-out Portugal's economic recovery program is proceeding as planned but "formidable challenges" stand in the country's path amid a steep recession and market misgivings about Europe's response to its debt crisis, the International Monetary Fund said Thursday.

Portugal's debt-laden economy was engulfed by the debt crisis crippling the 17 countries that use the euro last year. It followed Greece and Ireland in taking an international bailout after worried investors began charging unaffordable amounts to lend the country money, shutting it off from the financing needed to keep its economy functioning.

Portugal avoided bankruptcy with a (EURO)78 billion ($102 billion) loan from the International Monetary Fund and its European partners in May. In return, they demanded a commitment to cut the country's debt burden through austerity measures and adopt economic reforms aimed at ending a decade of average growth below 2 percent.

Its financial predicament has helped aggravate the shared currency bloc's political and economic woes, and any sign its three-year recovery plan is faltering could ignite another bout of market nervousness.

The IMF's senior representative in Portugal, Abebe Aemro Selassie, said that "policy slippage ... must be avoided at all costs."

The IMF said in its latest report on Portugal that Lisbon's implementation of the recovery program "remains satisfactory."

Even so, it noted that the spreads on loans to Portugal _ a measure of investor confidence in the country _ are still "elevated and volatile," reflecting market skepticism about Portugal's chances of restoring its health anytime soon.

The continuing market uncertainty has fueled speculation that Portugal might need more financial aid, like Greece.

The IMF isn't ruling out the possibility that Portugal will be able to return to bond markets and finance itself in 2013 as planned _ at the moment the yield on Portuguese 10-year bonds is way beyond its means at around 12 per cent _ but its report pointed to a host of threats that could knock Portugal off course, including the country's weak market reputation, a worsening recession and European crisis responses viewed by many as too little and too late to spare the continent from further difficulties.

Portugal's prospects are "highly contingent on ... a strengthened European crisis response mechanism," the report said.

Eurozone countries last week boosted their emergency bailout funds for heavily indebted countries to (EURO)800 billion _ shy of the (EURO)1 trillion the IMF and other international leaders reckon is needed to stabilize financial markets.

In its first post-bailout test, Portugal will need markets to finance a (EURO)9.7 billion bond redemption in September 2013. The following year it needs to find (EURO)15.9 billion, followed by (EURO)14.5 billion in 2015 and (EURO)25.4 billion in 2016.

"Should recovery of market access in fact be delayed, it may become necessary to call upon the pledges by European leaders to continue to provide adequate support to Portugal as long as the program is on track," the IMF said.

The promises of assistance are "an important fallback," Aemro Selassie told reporters.

The IMF can only loan money to countries whose funding is fully covered for the year ahead. That means if in six months' time it appears clear Portugal won't be able to go back to longer-term bond markets in 2013, the IMF could halt disbursements unless more help is guaranteed.

The IMF also highlighted the risk of trying to reduce debt through pay and welfare cuts and tax hikes, which cut consumer demand, while simultaneously attempting to accelerate growth _ a dilemma seen in other EU nations.

The Bank of Portugal expects the economy to contract 3.4 percent this year after a double-dip recession last year. Unemployment has climbed to a record 15 percent.

The IMF projects growth to be 0.3 percent next year and 2 percent in 2014.

Another danger is that if the recovery falters, further austerity would bring little benefit and political support could begin to erode, the IMF said. Portugal has so far benefited from broad support for the bailout program, with all three major parties endorsing it.

The budget deficit fell to 4.2 percent of gross domestic product last year _ down from 9.8 percent in 2010 _ though without one-off measures it would have stood at 7.7 percent, according to Portugal's National Statistics Agency. The government is aiming for a deficit of 4.5 percent this year.

Public debt, currently at 107 percent of GDP, is expected to stabilize at some 115 percent of GDP in 2013 and then decline gradually.

Economic reforms have included new labor laws that make it easier for employers to hire and fire workers and alter their working hours and duties; a restructuring of the legal system and state-owned companies; and scrapping rent controls.

Also, privatizations have gone well, with the sale of blue-chip energy companies bringing total proceeds so far to (EURO)3.3 billion. That represents two-thirds of the amount projected under the program.

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Gabriele Steinhauser contributed to this report from Brussels.