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FRANKFURT (Reuters) - The European Central Bank said on Sunday it would "actively implement" its controversial bond-buying programme to fight the euro zone's debt crisis, signaling it will buy Spanish and Italian government bonds to halt financial market contagion.
After a rare Sunday night conference call, the ECB welcomed announcements by Italy and Spain of new deficit cutting measures and economic reforms as well as a Franco-German pledge that the euro zone's rescue fund will take responsibility for bond-buying once it is operational, probably in October.
"It is on the basis of the above assessments that the ECB will actively implement its Securities Markets Programme," an ECB statement said.
The statement marked a watershed in the ECB's fire-fighting efforts after modest bond-buying last week failed to stem contagion to the currency bloc's larger economies.
It did not explicitly say that effort would now include buying Spanish and Italian paper, but the fact that last week's purchases were confined to Irish and Portuguese paper drove Italian and Spanish 10-year paper to a 14-year high.
Last Friday's downgrading of the United States' AAA credit rating by Standard & Poor's added urgency to efforts to control euro zone turmoil by raising the risk of global financial meltdown, driving global policymakers into a frenzy of weekend telephone consultations.
"The Euro system will intervene very significantly on markets and respond in a significant and cohesive way," a euro zone monetary source said, speaking shortly before the statement was released.
Germany and France earlier said in a joint statement that the EFSF bailout fund would soon be able to buy government bonds of debt strugglers Italy, Spain, Greece, Portugal and Ireland.
ECB President Jean-Claude Trichet called the Sunday meeting of the policy-setting Governing Council to decide on buying Italian paper after Prime Minister Silvio Berlusconi announced new measures on Friday to speed up deficit reduction and hasten economic reform.
One ECB source said the council would also discuss possible emergency liquidity measures to prevent money markets freezing.
Finance ministers and central bankers of the Group of Seven major industrialized powers were due to hold a teleconference late on Sunday to discuss action to calm market turmoil over the twin euro zone and U.S. debt crises.
German Chancellor Angela Merkel and French President Nicolas Sarkozy said they were committed to getting approval from their parliaments for new powers for the European Financial Stability Facility rescue fund by the end of September.
That will allow the EFSF to buy government bonds in the secondary market if the ECB thinks it is warranted and if euro zone member states agree, potentially absolving the ECB of the need to do so, a policy that a powerful minority of its council members strongly oppose.
"France and Germany are confident that the ECB analysis will provide the appropriate basis for secondary market interventions as it will help determine the case when financial stability of the euro zone as a whole is at risk," the leaders said.
Their statement reiterated the agreement at last month's emergency euro zone summit which granted a second bailout to Greece, but the focus on the EFSF's ability to buy government bonds once the bloc's parliaments have ratified its new powers was meant to encourage the ECB to do the same in the interim.
The ECB was divided last Thursday on the bond-buying programme, with four German, Dutch and Luxembourg members of the 23-member council voting against any resumption of purchases, arguing that it went beyond the bank's domain of monetary policy.
The ECB statement sought to justify the buying by saying it was "designed to help restoring a better transmission of our monetary policy decisions taking account of dysfunctional market segments and therefore to ensure price stability in the euro area."
The ECB bought 76 billion euros in Greek, Irish and Portuguese bonds mostly last year but purchases tailed off in January and there had been none at all for more than four months.
Critics say the intervention brought only temporary relief on bond markets and did not save any of those countries from having to seek EU/IMF bailouts. Stabilizing Italian and Spanish bond prices would require far more massive purchases, they say.
RBS analysts said in an initial reaction that while ECB intervention might half current Italian and Spanish bond spreads over benchmark German bunds from nearly 400 basis points to below 200 bps, that benefit may be short-lived.
"Without guarantees that the ECB will be in the market for the long term, an initial decline in yields will look like an opportunity to exit at much better prices," an RBS note said.
"We see spreads below 200 bps to Bunds for Spain and Italy as a selling opportunity. Indeed, these markets still face key challenges.
"Over time, we believe that ongoing selling pressure will force the ECB/EFSF to eventually hold close to half of the traded Italian and Spanish debt or around 850 billion euros," they said.
Such a huge European holding of southern countries' debt could heighten a political backlash against bailouts in northern Europe.
The ECB initially held back from buying Italian and Spanish bonds last week seeking more front-loaded austerity measures.
Under pressure from EU peers and the central bank, Berlusconi announced late on Friday plans to bring forward balancing the budget by one year to 2013, enshrine a balanced budget rule in the constitution and push through welfare and labor market reforms after talks with trade unions and employers.
Merkel and Sarkozy welcomed the new Italian plan.
"Especially the Italian authorities' goal to achieve a balanced budget a year earlier than previously envisaged is of fundamental importance," they said.
However, details of Italy's austerity drive are thin, leaving many analysts -- and maybe some in the ECB -- skeptical.
After a week that saw $2.5 trillion wiped off global stock markets, political leaders are under pressure to reassure investors that Western governments have both the will and ability to reduce their huge and growing public debt loads.
That had raised pressure on the ECB to act to calm bond markets until the euro zone's 440-billion-euro rescue fund is empowered to intervene on secondary bond markets and give countries in difficulty precautionary credit lines.
It has also prompted widespread calls from economists and market analysts for the euro zone to at least double the size of the European Financial Stability Facility -- a move that EU paymaster Germany and its close ally France has rejected as unnecessary.
additional reporting by Paul Carrel; writing by Paul Taylor and Mike Peacock; editing by Janet McBride