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Spain tops agenda for euro zone permanent bailout fund

By Jan Strupczewski

BRUSSELS (Reuters) - Euro zone finance ministers will formally launch the euro zone's permanent, 500-billion-euro bailout fund on Monday, bolstering the single currency area's defenses against the sovereign debt crisis that is now threatening Spain.

The European Stability Mechanism (ESM) will be used to lend to distressed euro zone sovereigns in return for fiscal and structural reforms that put the economy of a country that lost investor trust back on track.

Euro zone finance ministers, who form the ESM's board of governors, will hold an inaugural meeting of the fund on Monday -- two years after the idea of setting up a permanent bailout mechanism for the euro zone was endorsed by EU leaders.

"The ESM will be able to operate as of Monday afternoon. It will formally exist and it will be operational," one euro zone official, linked to the ESM, said.

The fund's lending capacity will be based on 80 billion euros of paid-in capital and 620 billion of callable capital, against which the ESM will borrow money on the market to lend it on to governments cut off from sustainable market funding.

The first 32 billion of the paid-in capital will be supplied in October, giving the fund an immediate firepower of 200 billion euros. A further 32 billion will come next year, raising the lending capacity to 400 billion, and the final 16 billion in 2014, when the ESM will reach its full 500 billion capacity.

The ESM's first task will be to lend to Spain for the recapitalization of the banking sector, hit hard by a collapse of the real estate market. This is a program the ESM will inherit from the temporary fund, the European Financial Stability Facility (EFSF).

An independent assessment of Spanish banks' capital needs showed that under the worst scenario they would need to get almost 60 billion euros. But officials say the amount will likely to be closer to 40 billion as some of the needed capital would be provided privately or via bank restructuring.

ESM money would only flow to Spain in November, after the European Commission's competition authorities approve the details of the recapitalization for each bank.

Spain is the focus of investor attention now as the government struggles to deflate one of the euro zone's largest public deficits even as the country sinks deeper into its second recession in three years.

In Luxembourg, euro zone ministers will also discuss an expected request by the Spanish government for a precautionary credit line from the ESM that would allow for the issuance of first-loss guarantees on bonds sold by Spain at auction, or some similar form of rescue to bolster Madrid's credibility.

Guaranteeing the first 20-30 percent loss on new Spanish bonds would allow - through leveraging - all of Spain's 207 billion debt issuance in 2013 to be made much more attractive to investors using roughly 50 billion euros of euro zone money.

It would also open the way for buying of Spanish bonds on the secondary market by the European Central Bank -- a prospect that has lowered Spanish yields already from above 7 percent in July to below 6 percent now.

But Germany opposes a Spanish bailout request now, because it would prefer to bundle Spain with a request for a small, 15 billion euro bailout for Cyprus and a revision of the second, 130 billion euro bailout for Greece in one crisis-solving package later this year.

This would allow German Chancellor Angela Merkel, wary of shaky support for bailouts in her own ruling coalition, to push the large crisis package through parliament in one go, rather than fight separate battles for each.

As a result, a Spanish request is unlikely soon.

"I am quite confident that if it were to come, it is not imminent," one senior euro zone official with knowledge of the discussions on Spain said.

Spain's borrowing costs, measured by the benchmark 10-year bond yields are at 5.71 percent -- a level that Madrid cannot sustain for long, but which does not force it to seek help immediately.

"If you look at the current market situation, I see no need for Spain to apply for any program," the senior official said.

The ministers will also take stock of the efforts of Greece to unblock payments from the second bailout agreed in February after reforms in the debt-laden country stalled because of two general elections in May and June.

Inspectors representing international lenders are in talks with the Greek government on reforms and austerity needed to unlock financial aid, but their full report is unlikely before the end of October.

The lenders are represented by the International Monetary Fund, the European Commission and the European Central Bank -- also called the Troika.

One euro zone official said that Greece would be discussed in earnest only at the next Eurogroup meeting on November 12.

"The Troika is in Greece, Troika top representatives will be at the Eurogroup and will inform the ministers about the contentious issues and problems, they will describe state of play. I don't think there will be any milestone decisions," another euro zone official preparing the meeting said.

(Reporting By Jan Strupczewski; Editing by Toby Chopra)

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