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EU's Van Rompuy warns Cameron over sensitive budget issues

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* EU's Van Rompuy expands on his idea for euro zone "budget"

* UK's Cameron mixes euro zone fund with wider budget talks

* Summit on Oct. 18-19 set to debate euro zone fund proposal

* Initiative is latest effort to get on top of debt crisis

By Luke Baker

BRUSSELS, Oct 11 (Reuters) - The European Union's topofficial fleshed out his ideas for a separate budget for eurozone countries on Thursday, and indirectly warned British PrimeMinister David Cameron about using the proposal for his ownpolitical gain.

At a conference to discuss the state of Europe after nearlythree years of debt and financial crisis, Herman Van Rompuy, thepresident of the European Council, said a separate euro zonebudget was an idea that needed close examination.

Even if it is a long-term project and there are a host ofpolitical and financial obstacles to overcome, it could helpunderpin the stability of the single currency, he said.

"We have to do everything to stabilise the situation in theeuro zone, and if a fiscal capacity or a separate budget canhelp and can contribute to this stability, then you have toreflect on it, to discuss it," he told conference delegates, whoincluded several ministers from EU member states.

"Every currency union needs also a fiscal capacity, andcertainly a fiscal capacity to stabilise the euro zone."

The 27 countries in the European Union currently finance abudget which amounts to around 130 billion euros a year - 1percent of EU output - and which is used for spending onagriculture, science, infrastructure and other areas.

But there is no equivalent budget among the 17 countriesthat share the euro, a shortcoming that many economists believehas undermined the stability of the currency project.

Van Rompuy first raised the possibility of a separate eurozone budget in September and developed his thinking in adocument sent to EU capitals in early October. It forms part ofa series of initiatives to try to resolve the debt crisis.

Germany and France strongly support the proposal and, in asurprise to many EU diplomats, Britain does too, but fordifferent reasons. Cameron sees a euro zone budget as a way offurther separating Britain and its increasingly EU-scepticalelectorate from the currency bloc and its problems.

He also sees a euro zone fund as a way of potentiallyreducing the amount Britain has to pay into the EU budget, whichis negotiated annually as part of a seven-year framework. Theissue has become particularly acute as the EU prepares tonegotiate the next seven-year plan at a summit in November, adeal Cameron has threatened to veto unless he gets his way.

"There will come a time when you need to have two Europeanbudgets, one for the single currency, because they are going tohave to support each other more, and perhaps a wider budget foreverybody else," Cameron said on Sunday, the first day of hisConservative Party's annual conference.

Asked if he was prepared to block the long-term EU budget ifspending wasn't cut further, Cameron replied: "If we cannot geta deal that has proper control of that budget, if they putforward ideas for massive increases, I won't say yes to it."

TOUGH NEGOTIATION

The concern for Van Rompuy and others is that Cameron iscombining very early discussions on the possibility of a eurozone fund with negotiations on the EU budget, and by doing soputting both processes at risk.

"I want to clear out any confusion - this must not be mixedup with the European Union's multi-annual budget," Van Rompuytold the "Friends of Europe" conference.

"Since we decide on a multi-annual financial framework inNovember, it is important that we don't start mixing up thatdiscussion with the embryonic idea" of a euro zone budget.

"The objectives are different and the timeframes arecompletely, completely different," he said, adding that thosewho try to mix the two should be careful.

But beyond trying to keep Cameron from muddying the waters,Van Rompuy also faces a battle to try to convince the EuropeanCommission and several euro zone member states that having aseparate budget for them is a good idea.

Van Rompuy's thinking - firmly backed by Germany - is thatsome form of "fiscal capacity" among the euro-area countrieswill allow them to iron out labour market and othersocio-economic imbalances that build up in the bloc.

The fund could be used to help a country such as Spain,which has unemployment of 25 percent and is struggling toreinvigorate growth. In exchange for budget rigour, thepan-eurozone fund could provide targeted assistance.

"The fiscal capacity could perform stabilising functionsspecific to the euro zone, for instance help countries absorbasymmetric shocks over economic cycles, so we limit theadjustment cost in terms of growth and employment," Van Rompuysaid. "This would also make the euro area as a whole moreresilient."

While economically it may make sense, politically it islikely to prove challenging to convince all 17 countries thatthey need to pay more into a fund they hope they never need.

(Writing by Luke Baker; Editing by Susan Fenton)

((luke.baker@thomsonreuters.com)(+32 2 287 68 32)(ReutersMessaging: luke.baker.thomsonreuters.com@reuters.net))

Keywords: EUROZONE BUDGET/VANROMPUY