Euro zone integration may pave way for ECB bond action-officials

* Rapid moves on euro zone integration may open way for ECB to act

* Sources say central bank wants clear signal from member states

* Deeper, faster integration will require EU treaty change

By Jan Strupczewski

BRUSSELS, Nov 25 (Reuters) - A push by euro zone countries towards very close fiscal integration could give the European Central Bank the necessary room for manoeuvre to dramatically scale up euro zone bond purchases and stabilise markets, euro zone officials said.

The ECB, which cannot directly finance governments, has been buying Italian and Spanish bonds on the secondary market since August to try to keep down borrowing costs for the euro zone's third and fourth largest economies and contain the spreading of Europe's sovereign debt problem.

The ECB says it buys the bonds because the current market gyrations impede the transmission of the central bank's monetary policy decisions, but the purchases are relatively small -- recently only 5-8 billion euros worth of bonds a week.

Despite the purchases and a new, technocrat government in Rome, Italian 10-year bond yields jumped to 7.41 percent on Friday, versus 7.18 on Thursday and up from 6.1 percent at the start of November.

Economists see such levels as unsustainable, raising the possibility that Italy will be effectively cut off from markets and be forced to seek emergency lending from the euro zone and the International Monetary Fund.

Spain is in a similar situation, and its new centre-right government, due to be officially sworn in in mid-December, is considering applying for international aid, sources close to the party told Reuters on Friday.

"We are not far from a point when the disruption in the markets is so big that monetary policy transmission does not work at all," said one euro zone official involved in shaping the euro zone's policy response to the crisis.

"If the ECB has the assurance that we are moving towards a fiscal union, they could be ready to go all out," he said.

Such tight fiscal integration is already being considered by France and Germany, with Berlin even pushing to change the European Union treaty to be able to sue a country for breach of EU budget rules in the European Court of Justice.

The European Commission, the EU executive arm, put forward proposals on Wednesday to grant it intrusive powers of approval of euro zone budgets before they are submitted to national parliaments, which, if approved, would effectively mean ceding some national sovereignty over budgets.

Once budget deficits are controlled by the independent European Commission and EU budget rules are part of national legislation, along with the goal of a structurally balanced budget, national debt could not spiral out of control.

This could lead to joint debt issuance for the euro zone, where countries would be liable for each others' debts.

"The eurobonds would be a trade-off for the integration -- a logical conclusion of the integration process," the euro zone official said.

Germany strongly opposes the joint issuance idea fearing spendthrift countries would piggyback on its low borrowing costs -- meaning no gain for the virtuous and no pain for the sinners.

"Germany is not there yet on the eurobond idea, but they are probably more open to compromise than it appears. But there are no discussions yet," the euro zone official said.

LIMITED BOND BUYING

The official said the bond purchase size under the ECB's current Securities Market Programme (SMP) were not big because the bank was waiting for euro zone politicians to decide which direction they wanted the single currency area to go in.

"They are not doing it (big bond purchases) because they don't know in which direction the euro zone is going," the official said.

"Whether it is in the direction of private sector involvement in restructuring, in the direction of kicking Greece out of the euro zone, fragmentation of the euro zone, or towards greater fiscal unity, ceding some fiscal sovereignty in favour of the euro zone," the official said.

"If it is the latter, the ECB will do what is needed."

As part of its response to the escalating debt crisis, which started with Greece and then engulfed Ireland and Portugal, the euro zone is trying to leverage its bailout fund, the European Financial Stability Facility (EFSF), to give it more firepower.

The plan in late October was to leverage the 250 billion euros left in the EFSF's coffers four to five times to around 1 trillion euros.

But the two approved leveraging options -- an insurance scheme and a co-investment fund -- both assume market interest in euro zone sovereign bonds and that is rapidly fading.

Even Germany, the biggest and most stable of the euro zone's 17 countries, was unable to sell all the 10-year bonds on offer at its last auction on Wednesday.

"The failed bond auction in Germany is a signal that this crisis is no longer about individual countries, it is systemic," the official said.

"This could also be an argument for the ECB that monetary policy transmission is not working and that it is time to scale up the SMP," the official said, adding the ECB could easily buy 2-3 trillion euros worth bonds if it wanted.

"The ECB will never say openly that they will buy whatever it takes on the market, but they can simply do it, without talking. The markets would very quickly see that the ECB is getting serious," the official said.

A second euro zone official said that if market pressure on large euro zone countries continued and the EFSF's efforts to boost its firepower were less successful than hoped, getting the ECB more involved could be the only option left.

"If the EFSF leveraging does not meet expectations and markets keep the pressure up on yields there will be no other choice but to put a game-changer on the table -- some form of ECB involvement," the second euro zone official said.

One of the options under discussion now was for national central banks in the euro zone to lend to the International Monetary Fund, which in turn, could use the money to help euro zone countries under market stress.

This would help the ECB side-step the legal problem of financing governments and also help impose IMF-type austerity on the recipients of the aid -- something the ECB cannot do now.

"There are discussions going on on ECB lending to the IMF," the first official said.