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* Central authority would manage European debts
* Pressure mounts for policy action at end-June EU summit
* Merkel ready for deeper EU integration, no taboos in talks
* Proposals for a banking union also under consideration
* Rajoy says Spain "not on the eve of apocalypse"
By Julien Toyer
MADRID, June 2 (Reuters) - Spain, the latest combat zone in Europe's long-running debt wars, urged the euro zone to set up a new fiscal authority to manage the bloc's finances and send a clear signal to markets that the single currency project is irreversible.
Prime Minister Mariano Rajoy said the authority would also go a long way to alleviating Spain's woes which, along with the prospect of a Greek euro exit, have threatened to derail the single currency project.
It is not the first time a European leader has proposed creating such an authority but the problems and the size of Spain - a country deemed too big to fail - have prompted EU policymakers to hurriedly consider measures such as creating a fiscal and banking union ahead of a EU summit on June 28-29.
Germany, the paymaster of the euro zone, and others insist such a move can only happen as part of a drive to much closer fiscal union and relinquishing of national sovereignty.
Overspending in the regions and troubles with a banking sector badly hit by a property crash four years ago have sent Spain's borrowing costs to record highs and pushed the country closer to seeking an international bailout.
The risk premium investors demand to hold Spanish 10-year debt rather than German bonds rose to its highest since the launch of the euro - 548 basis points - on Friday.
The Spanish government, which has hiked taxes, slashed spending, cut social benefits and bailed out troubled banks, argues that there is little else it can do and the European Union should now act to ease the country's liquidity concerns.
In private, senior Spanish officials have said this could be done by using European money to recapitalise directly ailing banks or through a direct intervention of the European Central Bank on the bond market.
They have also said the euro zone should quickly move towards a fiscal union to complete its 13-year monetary union but Rajoy went a step further by making a formal offer.
"The European Union needs to reinforce its architecture," Rajoy said at an event in Sitges, in the north-eastern province of Catalonia. "This entails moving towards more integration, transferring more sovereignty, especially in the fiscal field.
"And this means a compromise to create a new European fiscal authority which would guide the fiscal policy in the euro zone, harmonise the fiscal policy of member states and enable a centralised control of (public) finances," he added.
He also said the authority would be in charge of managing European debts and should be constituted by countries of the euro zone meeting strict conditions.
Earlier this week, ECB President Mario Draghi said EU leaders should break away from the incremental approach that has failed to get ahead of the euro zone debt crisis for more than two years and quickly clarify their vision for the future of the currency.
Adding to growing pressure for dramatic policy action at this month EU leaders' summit, he warned that the ECB could not fill the policy vacuum.
Establishing a new authority could require a change in the EU treaties, a usually lengthy and politically painful process which requires ratification in all 27 member states of the bloc.
A spokesman for Olli Rehn, the EU commissioner in charge of economic and monetary affairs, s aid draft legislation d esigned to step up financial discipline in the euro zone, would create such a fiscal authority by granting new powers to the EU's executive.
"This would grant enhanced powers to the European Commision on fiscal surveillance, including allowing the sanctioning of countries," said Amadeu Altafaj.
"Even before a budget is drafted and reaches the national parliament, the Commission could ask for a revision of the budgetary plans if it considers this would not allow a country to meet its fiscal commitments, and thereby could endanger financial stability."
Germany has said further integration in Europe was required, including additional controls on national public finances, and was ready to consider revising the treaties if needed.
A day after Berlin supported giving Spain an extra year to cut its deficit down to the 3 percent of GDP threshold, Chancellor Angela Merkel said it should be possible for countries that violate fiscal rules to be sued in the European Court of Justice.
The idea is already part of a new "fiscal compact" signed by 25 EU states and which is due to come into force next year.
Several countries, including France, Austria and Finland, have already signalled they are not willing to give up their parliaments' budgetary powers.
Merkel also praised higher German wage deals and signalled flexibility on a financial transaction tax, in a sign she is open to new measures to boost growth in Europe.
The comments, at a conference of her Christian Democrats (CDU) in Berlin, show that she is ready to heed calls for Germany to do more for growth but wants other euro states to accept giving up sovereignty over their budgets in exchange.
"You can't ask for euro bonds, but then not be prepared to take the next step towards closer integration," she said.
In an interview with Greek newspaper Vima, Italian Prime Minister Mario Monti said while he believed common bonds in the 17-nation euro zone would become a reality they should not become a "licence to spend and burden others."
With the debt crisis now centred on Spain's teetering banking sector, talks are also under way on creating a banking union in the euro zone based on centralised supervision, a European deposit scheme and a central fund that would cope with failed lenders.
Germany's finance ministry said on Friday it was willing to consider this option in a mid-term perspective.
Rajoy backed the idea on Saturday and said that the government would explain before the end of June how it would recapitalise Spain's banking sector, which is currently being reviewed by independent auditors.
Spain has picked the "Big Four" accounting firms KPMG , PwC, Deloitte and Ernst & Young to carry out a full, individual audit of its ailing banks, a source with knowledge of the decision told Reuters on Saturday.
Moving away from pessimistic speeches in recent weeks, Rajoy said Spain would weather the financial storm by stepping up efforts to rein in public finances and by implementing structural reforms at national and European level.
"We're not walking on a bed of roses but we're also not on the eve of the apocalypse," he said.