Europe must take "deep breath" and enact reforms: Merkel

Speaking at a meeting of the Federation of German Industries (BDI), Merkel acknowledged that Germany was "not an island" that could disconnect from economic developments in Europe and the world economy.

But she placed the onus on Berlin's struggling euro zone partners to fix their own economies, rejecting the idea that Germany should relax its own productivity drive in order to help its partners.

"We need to take a deep breath to overcome this crisis," Merkel said. "We must make the efforts that will allow Europe to come out of this crisis stronger than it went in."

"There is a lack of confidence on financial markets that some euro zone states can pay back their debts in the long term," she continued. "The world wonders how competitive euro zone countries are."

The German leader said tough reforms in southern Europe had led to some convergence of unit labor costs across the euro zone, but made clear that there was still work to do.

She also expressed regret that the European Court of Justice had not been given stronger powers to intervene in national budget policies in the euro zone.

"We can't have support without controls. The two go hand in hand," Merkel said.

The German economy has held up well during the crisis, with unemployment holding near post-reunification lows. But there are signs that economic weakness across much of Europe and a slowdown in Chinese growth are beginning to bite.

Business sentiment is at its weakest level since early 2010, data released by the Ifo economic think tank showed on Monday. And some economists believe Germany could fall into a technical recession in the second half of this year.

"NOT AN ISLAND"

"We are feeling that Germany is not an island. We are an export nation. Forty percent of our exports go to the euro zone, 60 percent to the European Union. We can't disconnect from European and global economic developments," Merkel said.

Merkel held up the fiscal compact for budget discipline and plans to introduce pan-European banking supervision as signs of Europe's progress.

She dismissed the notion that Berlin was slamming on the brakes in the creation of a European banking watchdog. In recent weeks, the German government has made clear that it sees a January deadline for putting this in place as unrealistic.

"We want stronger European banking supervision," she said.

Merkel was due to meet European Central Bank President Mario Draghi on Tuesday afternoon. Later he will give a speech to the same industry conference.

Draghi's plan, unveiled at the start of the month, to buy the bonds of struggling euro countries, combined with a green light from Germany's Constitutional Court for Europe's new rescue fund have been welcomed by markets.

But worries have grown in the past week over Spain's reluctance to seek a bailout that would allow it to profit from the ECB's bond plan. Also weighing on the euro on Tuesday was a report that lawyers at the German Bundesbank were looking into the legality of Draghi's bond scheme.

(Reporting by Noah Barkin; Editing by Giles Elgood)