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Spain in recession as austerity bites

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Spain sank into recession in the first quarter and economists said spending cuts aimed at meeting strict EU deficit limits together with troubles in the banking sector would delay any return to growth until late this year or beyond.

It is the second recession in just over two years for the euro zone's fourth largest economy and comes as the government tries to convince investors it will not need outside aid to pay its bills like other countries caught up in the debt crisis.

The country is facing intense pressure from its European peers to fix public finances as well as growing domestic resistance to austerity measures that have helped push unemployment to more than double the EU average.

Ratings agency Standard & Poor's added to the country's problems with a two-notch rating downgrade last week and on Monday it chopped the credit score of eleven banks.

While the 0.3-percent contraction from January to March from the previous quarter was slightly better than the forecast drop of 0.4 percent, it confirmed the economy is in a tough spot.

"The wheels are very clearly coming off the economy," Jefferies economist David Owen said.

"It wouldn't surprise me to see a very significant decline in GDP both in the second and third quarters this year, and it's still reasonably easy to envisage GDP to be down about 1.5 percent this year."

Spain was last in recession, defined by two straight quarters of economic contraction, at the end of 2009. On an annual basis, the economy contracted by 0.4 percent, compared with growth of 0.3 percent in the previous quarter, Monday's official data showed.

The government's latest economic plan, published on Friday before it was sent to the European Commission for approval, forecast a contraction of 1.7 percent in 2012 turning to 0.2-percent growth by next year.

Spanish bonds showed little reaction to the report but yields have risen to around 6 percent in recent weeks as investors digest the country's worsening economic news. Yields of around 7 percent are seen as financially unsustainable.

BANKS IN FOCUS

The S&P downgrades of both the financial institutions and the sovereign put the country's fragile banking system back into the spotlight, while massive unemployment will remain a drag on already tight public accounts.

"Did you need any more reasons to short Spanish debt?" the 4Cast consultancy said in a research note on Monday.

"(The downgrade) is a slap in the face of the government's austerity drive, especially as it is partly based on the expectation of fiscal slippage in 2012-2015 and partly on 'the increasing likelihood that the government will need to provide further fiscal support to the banking sector'"

The banks were damaged by the real estate collapse that began in 2008 and now bad loans in other sectors of the economy have risen sharply.

They have virtually no access to the wholesale debt markets and have taken on a large amount of cheap European Central Bank debt and have bought domestic debt, helping the Treasury to fulfill half of its gross issuance already this year.

ECB data on Monday showed that Spanish and Italian banks filled their coffers with government bonds last month, confirming that they had helped keep a lid on yields.

But non-residents, which before December held an average of around 50 percent of Spain's debt, held just 37.5 percent in March, the Treasury said.

The country's two largest banks Santander and BBVA have suggested they may not buy any more government debt this year, adding to fears the Treasury may have to pay higher costs to place new debt.

Some investors have been betting the ECB will restart its program of buying bonds of troubled euro zone states to help Spain out but some central bank policymakers are fiercely opposed to the idea.

PROTESTS

As well as facing pressure from Europe to cut its deficit, there is resistance in Spain for the austerity measures needed to achieve this. Thousands of Spaniards took part in protests on Sunday after data showed unemployment at nearly 25 percent in the first quarter.

This tallies with a wave of revolt around Europe to the austerity measures that have been prescribed by policymakers from European institutions and from fiscally conservative countries such as Germany.

Economists, including some from the International Monetary Fund, have started to question whether it is right to push austerity at the expense of restarting growth.

"I assume we get some policy response out of the ECB and Spain is allowed to rein back on its fiscal austerity it is pushing through. There's certainly a lot of push back as people question the German-centric view of the world that everyone needs more austerity." said Owen.

The Spanish government has announced savings of over 40 billion euros ($53.04 billion US) this year from both central and regional government budgets, to try and cut the deficit to 5.3 percent of GDP this year from 8.5 percent of GDP in 2011.

The conservative government, which took power from the Socialists in December, has introduced a labor reform and a banking sector reform which forces the banks to raise over 52 billion euros in capital this year.

However, with property prices expected by some to fall another 20-30 percent, many economists believe increased banking provisions against potential bad real estate loans will not be enough to stabilize the sector.

Some economists say the country will eventually need a financial bailout package like Greece and Ireland but the government has repeatedly said it will not seek outside help.

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