FRANKFURT, July 27 (Reuters) - Germany's powerful Bundesbank pushed back on Friday against European Central Bank President Mario Draghi's pledge to do whatever is necessary to protect the euro zone from collapse, but markets rallied on a report of imminent policy action.
French newspaper Le Monde reported that the ECB and euro zone governments were preparing co-ordinated action to cut Spanish and Italian borrowing costs. European shares extended gains to trade some 1 percent higher after the report's release.
The newspaper, citing unnamed sources, said the ECB was willing to take part in the action if governments agreed to tap the bloc's bailout funds, the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM).
The report came a day after Draghi, in his boldest comments since taking the ECB's helm last November, pledged to do whatever was necessary to protect the euro zone from collapse.
Markets took Draghi's pledge as a signal that the central bank is ready to defend Italy and Spain, whose borrowing costs have hit unsustainable levels, by buying their bonds.
But the Bundesbank regards central bank purchases of sovereign debt as monetary financing of governments, from which the ECB is prohibited by European law. The German national central bank's resistance could narrow the ECB's options.
"The mechanism of bond purchases is problematic because it sets the wrong incentives," a Bundesbank spokesman told Reuters.
The Bundesbank saw the possibility of the EFSF bailout buying government bonds "as less problematic", the spokesman added.
German Finance Minister Wolfgang Schaeuble said he welcomed Draghi's pledge and Berlin said it stood ready, just like the ECB, to do all in its power to ensure the survival of the euro.
"The president of the ECB said the ECB will do all that is necessary to maintain the euro and the German government will do all that is politically required to maintain the euro," government spokesman Georg Streiter told a news briefing.
"The ECB makes its contribution and the German government makes its contribution," Streiter added, though the government reiterated its opposition to granting a banking licence to the euro zone's bailout funds.
In Paris, French Finance Minister Pierre Moscovici kept up pressure on the ECB to act.
"I trust Mr. Draghi to do exactly what is needed, that is to act so that markets are appeased and there can be a relaxation of the interest rates for Spain, for Italy," Moscovici told France 2 television.
French President Francois Hollande and German Chancellor Angela Merkel will speak on the telephone later in the day to discuss the implementation of decisions made at an end-June European Union Summit, a French source said.
The French, Italian and Spanish governments are pushing for the decisions made in Brussels to be implemented swiftly in order to speed up help for Italy and Spain, where borrowing costs have soared in recent days.
ECB policymaker Ewald Nowotny broke ranks with his colleagues on Wednesday by saying he saw merits to boosting the firepower of Europe's permanent bailout fund, the ESM, by granting it a banking licence so that it could tap ECB funds.
But the idea appears to have little support among other ECB policymakers and the Bundesbank also said it would be against EU rules.
"A banking licence for the bailout fund would factually mean state financing via the printing press and would be a fatal route, which therefore is prohibited by the EU treaty," a Bundesbank spokesman said, narrowing the ECB's policy options.
Highlighting the level of concern about the intensification of the crisis, euro candidate country Latvia said the bloc should expel near-bankrupt Greece as soon as possible as the country is dragging on the region's recovery.
"It must be understood that one cannot entertain illusions that one can keep Greece in the euro zone," Finance Minister Andris Vilks told Latvian public radio, adding that European efforts to deal with the crisis were far too slow.