By SARA SCHAEFER MUOZ And ILAN BRAT

Spain Wields $36 Billion Budget Ax

MADRIDSpain unveiled its most severe budget cuts in decades on Friday as it finds itself once again cast as a central battleground in the fight to contain the euro-zone crisis. The new conservative government of Prime Minister Mariano Rajoy presented more than 27 billion ($36 billion) in budget cutswith a 9.6% reduction from 2011 central-government spendingthrough income-tax increases, spending cuts by ministries and incentives for tax avoiders and repatriating income. "We are in a desperate situation when it comes to the fiscal outlook," said Deputy Prime Minister Soraya Senz de Santamara. "We're looking to turn the situation around, as well as putting the foundations for growth and job creation." The draft awaits approval from parliament, where the prime minister's party has an absolute majority. It is likely to be implemented by May, but not without a public uproar: the government faced a general strike over its labor reforms that drew an estimated 800,000 people to protests. Spain has slipped back into the crisis's cross hairs just a few months after it appeared to have weathered the worst of Europe's travails. The price the country pays to borrow from the market has risen again as worries intensify that its economic woes are entrenched and that a return to growth is unlikely soon. Now, if the euro-zone's fourth-largest economy can't convince European Union leaders and investors its financial house is in order, it may be forced to receive some form of external aid, economists and investors say. Such a move would be a test of Europe's resources and resolve to preserve the euro and could potentially destabilize the region. The situation in Spain is also a test of whether austerity measures, in effect in many troubled European countries, can ultimately reignite the renewed economic growth that has been elusive since the outset of the crisis. Spain demonstrated its resolve to stay on that path with its budget Friday, its most austere of the post-Franco era.

By SARA SCHAEFER MUOZ And ILAN BRAT

But there are concerns over whether Spain's 17 autonomous regions can meet a target deficit of 1.5% of gross domestic product laid out in Friday's budget. The regions control about a third of public spendingincluding on education and health care and accounted for more than half of 2011's budgetary overrun. "This is a very austere budget, without a doubt," said Juan Jos Toribio, a professor emeritus of economics at the IESE Business School in Madrid. "I think there's confidence in the central administration, but we'll have to see what happens with the regional governments." Critics warn that painful cuts will strangle much-needed growth. Spain's economy is already set to contract 1.7% in 2012, according to the Spanish government. "The big question is: Can Spain's sickly economy endure such harsh austerity?" said Nicholas Spiro, managing director of Spiro Sovereign Strategy, a London sovereign-risk consulting firm. More than 1 trillion in cheap loans from the European Central Bank has relieved pressure on European markets. That was initially true in Spain as well, and investors were cheered by the new government's determination to cut its budget and take steps to increase competitiveness through labor reforms. But in recent weeks, confidence in Spain has started to erode. The government said it wouldn't meet certain budget targets; deep-seated economic problems such as high unemploymentshow no signs of abating; and negative growth has tipped the country back into recession. Such problems have raised questions as to whether moves toward tighter financial union in the euro In a sign of investor nervousness, the amount of interest Spain pays on its 10-year debt has crept upto 5.36% Friday from 4.88% at the start of March though it fell slightly as Spain announced its budget. The country's fiscal woes were pushed into the foreground about a month ago, when the government surprised the market twice in a week. First, Spain announced a 2011 deficit of 8.5% of gross domestic product that overshot the target by 2 percentage points. Then Spain's decision to weaken its 2012 deficit target to 5.8% from a previously agreed 4.4% spooked investors once again. European Union leaders later got Spain to tighten its 2012 objective to

By SARA SCHAEFER MUOZ And ILAN BRAT

5.3%, but that failed to allay investors' concerns that the country will be unable to rein in its public debt. "There has been such a high degree of fiscal slippage, and even the target of 5.3% is looking highly unachievable," said Hetal Mehta, European economist with U.K. fund Legal & General Investment Management. The failure of Spain's ruling party to secure a majority in elections in the large region of Andalusia was another blow to confidence, highlighting investor worries that the central government won't have enough clout to have regions reduce spending on health care and education. Andalusia's 2011 budget deficit was 3.2%, far above the 1.3% target, according to the Bank of Spain. Longer-term problems continue to fester. The unemployment rate stands at 23%, according to Eurostat, and is likely to climb. Mr. Toribio and other observers worry the country will have to spend more on unemployment checks and other welfare benefits even as it tries to tighten its belt. Meanwhile, housing prices are falling precipitously, and property-loan defaults are rising, saddling struggling banks with increasing amounts of bad debt. Prospects for sustainable growth appear dim. "Spain has lost its major engine of growth in the past 10 to 15 years, which was led by unsustainable construction spending and investment in unproductive capital," says Jacques Cailloux, chief European economist at Royal Bank of Scotland. Economists are divided over the prospect of external intervention. Citigroup Chief Economist Willem Buiter said this week the Spanish government is likely to accept some kind of bailout because Spanish banks have been big recipients of cheap ECB loans. Others, however, say such talk is premature, with the banksflush with cash from the ECBbuying up the country's debt. David Romn contributed to this article.

WALL STREET JOURNAL

31 march 2012