By Jan Strupczewski
BRUSSELS, Oct 8 (Reuters) - Euro zone finance ministers will launch their 500 billion euro ($653.00 billion) permanent bailout fund on Monday, putting in place a major defence against the debt crisis that now threatens Spain.
The fund, called the European Stability Mechanism (ESM), will be used to lend to distressed euro zone sovereigns in return for strict fiscal and structural reforms that aim to put economies that have lost investor trust back on track.
It is part of the single currency area's drive for an overhaul of its economic structures and deeper integration, a discussion that will be taken forward on Monday with talks on an idea to create a single euro-zone budget.
Euro zone finance ministers, who form the ESM's board of governors, will hold their inaugural meeting in Luxembourg two years after EU leaders endorsed the idea of setting up such a permanent institution.
"The ESM will be operational as of Monday," said a euro zone official, linked to the ESM.
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.
It will reach its full capacity gradually by 2014.
Its first task will be to lend to Spain for the recapitalisation of its banking sector, hit hard by a collapse of the real estate market - a programme inherited from the temporary European Financial Stability Facility (EFSF).
Madrid is likely to ask for about 40 billion euros to recapitalise its banks following independent assessments of the sectors' needs -- well within the 100 billion euros set aside by euro zone finance ministers for the purpose in July.
The ESM money would flow to Spain in November, after European Commission competition authorities approve conditions for the recapitalisation for each bank.
SPAIN IN FOCUS
Spain is in investors' focus because it has struggled to cut one of the euro zone's largest public deficits as the country sinks deeper into its second recession in three years.
In Luxembourg, euro zone ministers will also discuss a request, expected from Spain sometime in the coming weeks, for a precautionary credit line from the ESM that they hope will boost investor confidence and keep Madrid in the capital markets.
A euro zone source said they may also discuss Spain's tough 2013 budget, outlined last month, which the International Monetary Fund and the European Commission both believe is based on an over-optimistic forecast of a 0.5 percent economic contraction next year. The current IMF forecast of a 1.2 percent recession may be revised further downwards on Tuesday.
A revised budget based on updated IMF and EU forecasts may be one condition for assistance from the ESM.
Such a programme would likely entail 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.
Such an amount would fit comfortably within the 100 billion limit already approved by parliaments for the bank rescue in countries with strong anti-bailout sentiment like Germany and Finland, making it politically more palatable, even if technically it would remain a separate operation.
A credit line for Spain would also open the way for purchases 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 5.72 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 for a few weeks.
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.
EU Economic and Monetary Affairs Commissioner Olli Rehn said on Saturday he expected Greece's government to agree on needed savings in the coming days since the lengthy talks between the troubled euro country and lenders had advanced.
($1 = 0.7657 euros)
(Additional reporting by Julien Toyer in Madrid; Editing by Paul Taylor)