Santander , the euro zone's biggest bank, reported a sharp drop in annual profit after it set aside money to cover foreclosed Spanish property, anticipating government demands for lenders to recognise losses in the sector.

The bank made 3.2 billion euros (2.6 billion pounds) of extraordinary provisions in 2011, of which 1.8 billion euros would allow the lender to raise coverage for repossessed Spanish properties to 50 percent from 31 percent.

Spanish banks have hundreds of billions of euros of unsaleable land and property and unrecoverable loans to bankrupt real estate developers sitting on their balance sheets four years after a housing and construction crash.

Santander's grim outlook on Tuesday comes a day after official data showed the economy looked set to slip into recession after contracting for the first time in two years in the last quarter of 2011.

After making these provisions, Santander's writedown on repossessed property is in line with Ireland's 2009 state-driven cleanup after a similar property boom and bust.

They are sacrificing the present to develop a better future, said Alejandro Varela, Madrid-based fund manager at Renta 4, who owns Santander shares and has around 300 million euros under management.

The quicker they recognise them, the quicker we'll see a recovery in the next few quarters.

The government is expected to announce this week new rules forcing banks to recognize losses on loans to developers and reclaimed property.

Unlike weaker domestic players, Santander can absorb greater provisions thanks to thriving businesses outside Spain, especially Latin America. Spain accounts for less than 10 percent of group profit.

Santander has raised the 15.3 billion euros demanded by European regulators to protect against sovereign default risk in peripheral euro zone countries six months ahead of the deadline.

Regulators classify the bank as systemically important, meaning its capital ratio has to be at least 1 percentage point above the 7 percent global minimum. It has already achieved 9 percent core capital.

(Reporting By Sonya Dowsett; Editing by Tracy Rucinski and Fiona Ortiz; Editing by Erica Billingham)