Spain will reveal deep budget cuts on Friday despite stiff popular resistance, increasing concerns that austerity measures demanded by the EU will only push the economy deeper into recession.
A day after a general strike disrupted transport, almost paralysed heavy industry and brought thousands of protesters into the streets, the conservative government must say how it can meet deficit targets that many believe it will struggle to achieve.
Prime Minister Mariano Rajoy cannot afford to upset nervous bond markets that pushed the premium for Spanish 10-year debt on Thursday close to their highest levels since early January.
Markets fear the government, which took power at the end of last year, will fail to deliver the budget cuts even though the European Union has softened the deficit targets.
Brussels has agreed to let Rajoy aim for a 2012 deficit equal to 5.3 percent of gross domestic product, a less-demanding goal than the original 4.4 percent but still a huge step from 8.5 percent last year.
Even after the relaxation of the 2012 deficit reduction target, we think that making ends meet will be challenging, though not impossible, Morgan Stanley said in a research note.
We expect the Spanish economy to shrink by 2 percent this year, courtesy of a substantial belt-tightening, still tight credit conditions, slowing exports and higher oil prices.
The Spanish economy entered recession in the first quarter of this year, according to government estimates, the second since 2009 and after two years of anaemic growth.
More austerity is likely to make matters worse as Spain tries to avoid the downward spiral suffered by Greece and Portugal, both of which needed international bailouts.
While government sources have said the necessary cuts will be around 35 billion euros (29.24 billion pounds), some economists say the downturn means the figure may need to be almost double that.
An adjustment this deep will obviously lead to a hard recession, which will make the adjustment even more difficult to meet. You only have to look at Greece and Portugal, said Angel Laborda, economist at Madrid-based think tank Funcas.
Spain is the fourth-largest economy in the euro zone and if its borrowing costs became unaffordable, Europe would have to stage a rescue dwarfing those of Greece, Portugal and Ireland.
Unions staged the general strike on Thursday to protest against austerity and labour reforms the government declared unstoppable, although many ignored the action, fearing for their jobs in a country with the EU's highest unemployment rate.
TAX HIKES AND SPENDING CUTS
Within two weeks of taking office, Rajoy announced the previous Socialist government had badly missed the 6 percent of GDP deficit target and, reversing electoral promises, raised taxes and cut ministry spending to save 15 billion euros.
Full details of the cuts will not be revealed until the budget goes to parliament next Tuesday. But the plan, which the government is expected to present to a news conference at around 1130 GMT on Friday, will include general indications of the size and where savings can be found.
The conservatives have ruled out increasing value-added taxes and cuts to the treasured welfare state, alluding only to tweaks in the corporate tax rate and savings at the ministerial and regional levels.
However, spending will have to be trimmed from the education and health budgets eventually to reduce the deficit to 3 percent of GDP by the end of 2013, economists say.
If all cuts are not made this year, they will probably need to be made the following year. We cannot sustain the current model of the welfare state, said Juan Jose Toribio, professor at Spanish business school IESE.
Some economists, including at Citi, believe the country will have to apply for some level of help before the end of this year as commercial borrowing costs rise. However, for the moment, Rajoy must at least show he is trying to meet the targets.
We do not expect the government to succeed in bringing its deficit to 5.3 percent of GDP this year, as per the European rule, (we expect 6 percent). They have to try to avoid a political confrontation with their peers, said Gilles Moec, an economist at Deutsche Bank.
(Editing by Sonya Dowsett, David Stamp and Dan Grebler)