By Jan Strupczewski
BRUSSELS, Oct 8 (Reuters) - Euro zone finance ministers willlaunch their 500 billion euro ($653.00 billion) permanentbailout fund on Monday, putting in place a major defence againstthe debt crisis that now threatens Spain.
The fund, called the European Stability Mechanism (ESM),will be used to lend to distressed euro zone sovereigns inreturn for strict fiscal and structural reforms that aim to puteconomies that have lost investor trust back on track.
It is part of the single currency area's drive for anoverhaul of its economic structures and deeper integration, adiscussion that will be taken forward on Monday with talks on anidea to create a single euro-zone budget.
Euro zone finance ministers, who form the ESM's board ofgovernors, will hold their inaugural meeting in Luxembourg twoyears after EU leaders endorsed the idea of setting up such apermanent institution.
"The ESM will be operational as of Monday," said a euro zoneofficial, linked to the ESM.
The fund's lending capacity will be based on 80 billioneuros of paid-in capital and 620 billion of callable capital,against which the ESM will borrow money on the market to lend iton to governments cut off from sustainable market funding.
It will reach its full capacity gradually by 2014.
Its first task will be to lend to Spain for therecapitalisation of its banking sector, hit hard by a collapseof the real estate market - a programme inherited from thetemporary European Financial Stability Facility (EFSF).
Madrid is likely to ask for about 40 billion euros torecapitalise its banks following independent assessments of thesectors' needs -- well within the 100 billion euros set aside byeuro zone finance ministers for the purpose in July.
The ESM money would flow to Spain in November, afterEuropean Commission competition authorities approve conditionsfor the recapitalisation for each bank.
SPAIN IN FOCUS
Spain is in investors' focus because it has struggled to cutone of the euro zone's largest public deficits as the countrysinks deeper into its second recession in three years.
In Luxembourg, euro zone ministers will also discuss arequest, expected from Spain sometime in the coming weeks, for aprecautionary credit line from the ESM that they hope will boostinvestor confidence and keep Madrid in the capital markets.
A euro zone source said they may also discuss Spain's tough2013 budget, outlined last month, which the InternationalMonetary Fund and the European Commission both believe is basedon an over-optimistic forecast of a 0.5 percent economiccontraction next year. The current IMF forecast of a 1.2 percentrecession may be revised further downwards on Tuesday.
A revised budget based on updated IMF and EU forecasts maybe one condition for assistance from the ESM.
Such a programme would likely entail the issuance offirst-loss guarantees on bonds sold by Spain at auction, or somesimilar form of rescue to bolster Madrid's credibility.
Guaranteeing the first 20-30 percent loss on new Spanishbonds would allow - through leveraging - all of Spain's 207billion debt issuance in 2013 to be made much more attractive toinvestors using roughly 50 billion euros of euro zone money.
Such an amount would fit comfortably within the 100 billionlimit already approved by parliaments for the bank rescue incountries with strong anti-bailout sentiment like Germany andFinland, making it politically more palatable, even iftechnically it would remain a separate operation.
A credit line for Spain would also open the way forpurchases of Spanish bonds on the secondary market by theEuropean Central Bank -- a prospect that has lowered Spanishyields already from above 7 percent in July to below 5.72 now.
But Germany opposes a Spanish bailout request now, becauseit would prefer to bundle Spain with a request for a small, 15billion euro bailout for Cyprus and a revision of the second,130 billion euro bailout for Greece in one crisis-solvingpackage later this year.
This would allow German Chancellor Angela Merkel, wary ofshaky support for bailouts in her own ruling coalition, to pushthe large crisis package through parliament in one go, ratherthan fight separate battles for each.
As a result, a Spanish request is unlikely for a few weeks.
The ministers will also take stock of the efforts of Greeceto unblock payments from the second bailout agreed in Februaryafter reforms in the debt-laden country stalled because of twogeneral elections in May and June.
Inspectors representing international lenders are in talkswith the Greek government on reforms and austerity needed tounlock financial aid, but their full report is unlikely beforethe end of October.
EU Economic and Monetary Affairs Commissioner Olli Rehn saidon Saturday he expected Greece's government to agree on neededsavings in the coming days since the lengthy talks between thetroubled euro country and lenders had advanced.
($1 = 0.7657 euros)
(Additional reporting by Julien Toyer in Madrid; Editing byPaul Taylor)