The euro zone will not return to growth until 2014 and struggling Spain and France will be among those who miss debt-cutting targets as a result, the European Commission said on Friday.
Paris and Lisbon said they would seek more time from Brussels to reach their deficit goals. Madrid has already indicated the same.
The EU's executive said the euro zone economy, which generates nearly a fifth of global output, would shrink 0.3 percent in 2013 after a 0.6 percent fall last year, blaming a lack of bank lending and record joblessness for delaying the recovery.
That represented a marked downgrade of the Commission's prediction from November that the euro zone would grow this year. The euro slipped on the back of the forecasts.
The currency bloc is consolidating its public finances to regain market trust after excessive government spending, real-estate bubbles and lack of competitiveness triggered a sovereign debt crisis.
"The ongoing rebalancing of the European economy is continuing to weigh on growth in the short term," EU Economic and Monetary Affairs Commissioner Olli Rehn said.
Under EU budget rules, sharpened at the peak of the crisis in late 2011, euro zone countries can face fines if they fail to take action to meet deficit targets set by EU finance ministers.
Progress is uneven among the 17 countries sharing the euro.
The main laggard was Spain, which badly missed the 6.3 percent of GDP target for 2012 with a result of 10.2 percent. While that included 3.2 percent of GDP cost to recapitalize banks, even at 7.0 percent the deficit was above target.
This year, Madrid will have a deficit of 6.7 percent rather than the 4.5 percent set for it. And unless policies change, Spain will have a gap of 7.2 percent in 2014 against the target of 2.8, the Commission said.
Euro zone countries whose economies perform much worse than expected can count on an extension of deficit deadlines.
But they need to show that while they missed the nominal deficit target because of recession, they have still cut the structural deficit, which strips out the effects of the economic cycle and one-off effects.
French Finance Minister Pierre Moscovici said he would talk to Brussels about pushing back the deficit-cutting timetable and now aims to hit 3 percent of GDP in 2014 not this year.
Portuguese Prime Minister Pedro Passos Coelho also chipped in, saying Lisbon needed an extra year to get its budget deficit under 3 percent given a weaker than expected economy.
Rehn said decisions would be looked at in May but others were less charitable, particularly towards Paris.
European Central Bank board member Joerg Asmussen urged Paris to take "concrete and measurable" steps to cut the budget deficit, saying France faced a test of its credibility and had to come as close as possible to its 3 percent goal this year.
Michael Fuchs, a senior lawmaker in Chancellor Angela Merkel's conservative party, referred to France as a "problem child" that was badly trailing its partners on economic reform.
MORE SPANISH LEEWAY?
Madrid looks much further off track.
Spain, in recession last year and seen shrinking again this year, was asked last July to cut its structural deficit by 2.7 points in 2012 to 4.3 percent of GDP and by 2.5 points in 2013.
Commission data showed it came nowhere near doing so, and will fall short again in 2013.
Yet Rehn signaled Madrid's efforts may be seen positively when the Commission decides in May whether to grant more time to governments or to step up disciplinary action.
"In the case of Spain, its seems that the structural fiscal effort has been undertaken and there has been also an unexpected shortfall of growth," he said.
One of Spain's main problems is a record high level of unemployment which is to reach almost 27 percent of the workforce this year. Joblessness in the whole euro zone is set to peak at 12.2 percent, or more than 19 million people, in 2013, the Commission said.
Germany will remain the motor of the euro zone economy, expanding 0.5 percent this year and 2.0 percent in 2014, while the second biggest economy of France stagnates and third biggest Italy only emerges from recession next year.
France will also miss its nominal deficit targets - this year's shortfall will be 3.7 percent rather than the 3.0 percent agreed with the EU, because of the weaker than expected growth.
But Paris hit its nominal deficit target last year and cut its structural deficit by more than required. It could repeat that feat this year.
Commission forecasts showed Portugal's headline budget deficit rose to 5.0 percent of GDP last year from 4.4 in 2011 and will only ease to 4.9 percent this year, unless policies are altered.
But Portugal's GDP is now seen shrinking almost twice as much as previously this year -- 1.9 percent instead of 1 percent.
"I think it would not be surprising if there was an opening on behalf of the European Commission," Passos Coelho said.
(Additional reporting by Annika Breidthardt and Noah Barkin in Berlin, Michael Shields in Vienna, editing by Mike Peacock)