* Merkel says ready to back larger financial firewall
* Critical meeting to take place in Copenhagen on March 30-31
* Expectation is for fund with capacity of around 700 bln euros
* Rising Spanish bond yields keep policymakers' minds focused
By Luke Baker and Noah Barkin
BRUSSELS/BERLIN, March 26 (Reuters) - Germany signalled for the first time on Monday its willingness to increase the resources available for tackling the euro zone debt crisis, a shift that may help protect Spain as its bond yields rise and concerns grow about its public finances.
Euro zone finance ministers will meet in Copenhagen on March 30-31 and are expected to agree on a method of bolstering the crisis firewall by combining some of the resources left in the temporary EFSF bailout fund with the ESM, a 500-billion-euro facility that comes into force from July.
Until Monday, Germany had sent no clear signal on combining the resources, with officials indicating that it may not be necessary to do so now that financial markets are calmer.
Merkel removed some of those doubts, telling a meeting of her conservative Christian Democrats:
"We say the ESM should remain permanently at the 500 billion euro level, but in order for us to have 500 billion euros in available money, then we can imagine ... allowing the programmes ... to run in parallel," she said.
Around 200 billion euros of the 440 billion euros in the EFSF have already been deployed to help bail out Greece, Ireland and Portugal, and those programmes would continue to run.
But German government sources told Reuters that Berlin was prepared for the remainder in the EFSF also be made available for a year after the ESM is up and running, bolstering the potentially deployable resources.
Germany has been under pressure from international partners to agree to an increase in the firewall, with countries such as Britain saying that without it, they will refuse to make additional funds available to the International Monetary Fund.
While Merkel's shift sends a positive signal to the euro zone, it may not be sufficient to satisfy financial markets as the proposal she has made appears in respects to fall short of expectations for even greater resources to be deployed.
It may also prove difficult to win backing from all the parties in her coalition as it will increase the total amount of guarantees Berlin has to make to 290 billion euros from 211 billion euros. In Germany, the issue of Germany's guarantees is particularly sensitive to voters.
Last week, the European Commission prepared a confidential paper with three options for boosting the firewall, all of which rely on combining the EFSF and ESM resources in different ways.
Officials had indicated that the most likely outcome in Copenhagen was an agreement to create a fund of around 740 billion euros by combining the ESM with what is still undeployed from the EFSF.
But the proposal Merkel has sketched out would appear to be less firm than that. An official said his expectation was for a hybrid agreement to emerge, as often the case in EU decision-making.
Ultimately the euro zone needs to come up with a solution that goes far enough to convince the IMF that it too should bolster its resources when the board meets on April 20-22.
"I expect that on Friday a decision can be made on increasing the joint capacity of permanent ESM and temporary EFSF funds, to strengthen confidence," Olli Rehn, the European commissioner for monetary affairs told reporters on Monday.
"Negotiations are ongoing and my aim is to secure that strong enough stability fund can be created to convince our partners they should reinforce the IMF's resources."
European leaders have been debating what action to take on the firewall for months, with German and Finnish officials quietly sceptical about the need to boost resources given that the debt crisis has calmed since the European Central Bank summoned up over a trillion euros of three-year money for banks.
Others argue that it is critical the euro zone act now to bolster resources, capitalising on the relative calm to show that the region is determined not to be complacent.
While bond markets have stabilised this year and yields have fallen across the board, there has been a sharp pick up in concern about Spain, Italy and Portugal in recent days.
Spain's borrowing costs have risen markedly since Madrid ripped up a budget deficit target agreed with Brussels. Both Italian and Spanish yields fell on Monday on reports Berlin was ready to agree to a stronger rescue fund for a limited time.
Italian Prime Minister Mario Monti said he was concerned about contagion from Spain if it didn't keep finances in order.
"(Spain) certainly made profound reform of the labour market but it did not pay the same attention to public finances," Monti said at a conference in Italy. "This is causing us big concern because their yields are rising and it wouldn't take much to recreate trends that could spread to us through contagion."
The Spanish government convinced the Commission this month to soften its budget deficit goal for 2012, shifting the target to a deficit of 5.3 percent rather than 4.4 percent to give it some room to focus on growth measures. It must still reduce it to 3.0 percent in 2013.
"We're pretty much looking at Spain as the next point of stress, the next point of weakness," Peter Allwright, head of rates and currency at RWC Partners, which manages assets worth $4 billion, said last week.
The aim of bolstering the euro zone's firewall is to create a fund big enough to handle problems in Spain and Italy should they follow Greece, Portugal and Ireland in needing bailouts.
But part of it is also psychological - that a vast fund will convince financial markets the euro zone is doing everything necessary to calm the situation and restore confidence.
Carsten Brzeski, an economist at ING, expects Portugal to need another bailout, says Spain could need help "for two to three years" and Italy may need some "short-term relief".
"If we get an agreement on a 740-billion-euro fund this weekend and then some external help from the IMF, then we should be fine, there should be enough," he said.