Bleaker outlook pushes Spain's Rajoy to review economic policy

A bleaker-than-expected economic outlook from the European Commission on Friday will add pressure on Spanish Prime Minister Mariano Rajoy to review economic policy over the rest of his term, economists and European sources say.

Rajoy, who said on Wednesday there would be no relaxation in his efforts to turn around the Spanish economy, had designed a four-year plan to improve the country's finances, cut massive unemployment and win re-election.

Under this scenario, 2012 would be used to implement painful structural reforms, 2013 would see the economy stabilizing, 2014 would see the government implementing tax cuts and business-oriented measures and 2015 would deliver a clear improvement in time for the general elections.

But that plan now looks derailed.

The Commission forecasts Spain will have a deficit of 6.7 percent of GDP in 2013 rather than the 4.5 percent set for it by EU finance ministers and, unless policies change, the gap will reach 7.2 percent in 2014 against the target of 2.8 percent.

The EU's executive is set to offer Spain more time to cut its deficits under the legal ceiling of 3 percent of economic output but senior European sources say that will come only in return for more structural reforms and additional budget cuts.

Madrid has already been given an extra year, until 2014, to meet Europe-agreed goals of a deficit of under 3 percent of gross domestic product. It is likely to win a new one year extension if reforms are implemented, the sources say.

"The forecasts are clearly not rosy. In May, once we get more solid figures for 2013 and if the government implements what we've recommended, we will offer more leeway," said a senior euro zone source. "The roadmap is clear. The recommendations have been public for some months."

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In May last year, the Commission made eight recommendations that the government should implement by the end of 2013 ranging from a reform of public pensions, a change of the tax system, additional measures to boost job creation and a tighter control of the regions' finances.

Some of these measures such as an increase of the consumer tax, have already been implemented. Others, such as a stricter oversight of the finances of Spain's 17 autonomous regions, have been adopted but the Commission believe the central government should make more intensive use of the new provisions.

A third group, such as a reform of the pension system to crack down on early retirement and accelerate the increase in the retirement age, still have to be passed.

Deputy Prime Minister Soraya Saenz de Santamaria said the government would push to reach a deal with other political parties and adopt new measures soon.

When asked if the government was mulling new budget cuts to try to meet its EU-agreed deficit targets, she confirmed Rajoy's new drive for more stimulus measures and less austerity steps.

"Growth policies are needed if we want this country to create jobs. This does not mean that we won't be implementing other reforms such as the independent fiscal authority or the pensions," Saenz de Santamaria said.

"But no, the government is not considering this kind of (budget cut) measures."

Some economists believe, however, that despite growing social anger it is only a matter of time before Rajoy is forced to adopt additional austerity steps, including making permanent the temporary tax hikes he announced in 2011 a few days after taking office.

"The permanent tax hikes will be just a start. The government may discuss whether it should be done or not but from an economic point of view, there is no doubt," said Jose Carlos Diez, chief economist at Spanish brokerage Intermoney.

"And they'll have to go much further: corporate tax could be increased, the energy tariff deficit needs to be resolved, I wouldn't rule out a new hike of value-added tax and I don't see how they can avoid making deep cuts in the social security system, namely pensions and unemployment benefits."

Diez says the new stimulus measures to help small companies and young unemployed go in the right direction but their scope is too limited to reactivate the economy and create the hundreds of thousands of jobs Spain needs.

"Rajoy should come to a grip with reality. How can you say no more painful efforts and at the same time prepare new cuts?" he said.

(Editing by Fiona Ortiz/Mike Peacock)