UPDATE 3-Spain's Rajoy tries stimulus as recession deepens
* PM promises first stimulus package of his government
* Says will still hit budget targets
* Economy slumped 0.7 percent in Q4, stats office data shows
* Dire economy contrasts with buoyant bond market
By Tracy Rucinski
MADRID, Jan 30 (Reuters) - Prime Minister Mariano Rajoy promised Spain a small dose of economic stimulus on Wednesday, leavening a strict diet of austerity for the first time as figures showed the country's recession had deepened.
Economic output fell 0.7 percent in the fourth quarter of last year from the third, its steepest contraction in a year as households hit by state spending cuts and stubbornly high unemployment slashed spending.
The data from statistics institute INE suggests that, notwithstanding improved conditions in the debt market, the government faces an uphill battle to put public finances back on a sustainable footing as the economic outlook remains gloomy.
"The bleak GDP data is a reminder of the growing disconnect between market sentiment and economic reality in Spain and southern Europe," Nicholas Spiro of Spiro Sovereign Strategy said.
Reflecting the scale of the task, Rajoy told parliament he was planning a package of stimulus measures that would include tax breaks for entrepreneurs.
While the announcement marked a departure from the rigorous pro-austerity policies that his government has stuck with since taking office in December 2011, economists doubted the measures would be game-changing as Spain sticks to planned budget cuts.
"The missing ingredient is still growth. The government is caught between a rock and a hard place and has very little room for fiscal maneuvering (...) even if it is cut some more fiscal slack," Spiro said.
Spain has already been given an extra year, until 2014, to meet Europe-agreed goals of cutting its public deficit to 3 percent of gross domestic product.
On Monday, the European Union's Economic and Monetary Affairs Commissioner Olli Rehn said fiscal targets could be extended further if the economy was found to have worsened.
BOOMING MARKET, BUSTED ECONOMY
A buoyant bond market to which yield-hungry foreign investors have returned in droves has helped Spain get a testing 2013 debt issuance programme off to a flying start.
Italy has also benefited from increased investor appetite for peripheral economies' debt despite these countries' poor economic prospects, selling 3.5 billion euros of 10-year bonds on Wednesday at lower yields.
But that bright beginning - which has eased pressure on Rajoy to request an international bailout - contrasts starkly with the economic gloom that looks likely to dominate the mood in Spain for the foreseeable future.
The Bank of Spain says the return of international investors to its debt market had not translated into the real economy.
Analysts say that, however well Spain's bonds are selling, the country will struggle to get out from under a still-growing debt pile that has put it at the centre of the euro zone crisis.
A significant part of that burden comes from bills racked up by the country's 17 autonomous regions, which control their own healthcare and education budgets.
The government stumped up 17 billion euros in June to clear this debt with service providers up to the end of 2011.
But public hospitals owed drug companies a further 3.2 billion euros ($4.3 billion) by the end of 2012, lobby group Farmaindustria said on Wednesday.
Spain's economy fell back into recession in the final quarter of 2011 due to the fall-out from a burst property bubble, and it has struggled to gain traction since against a backdrop of heavy public and private spending cuts and unemployment that has risen steadily to 26 percent.
The government expects the economy to grow again before the end of this year, but many economists say this is optimistic.
"The recession deepened in the final quarter of 2012, and we expect the economy to endure a similarly punishing first quarter of 2013," said Rah Badiani of IHS Global Insight.
"The outlook for the remainder of 2013 and 2014 is no better. The main impediments to any recovery prospects remain the fallout of the ongoing financial crisis hanging over Spain, coupled with still-punishing employment losses," he added.
The preliminary GDP data on Wednesday undercut analysts' forecasts for a drop of 0.6 percent. It was also worse than Bank of Spain figures released last week, which showed the economy contracted by 0.6 percent in the fourth quarter from the third and 1.7 percent on the year.
On an annual basis, GDP shrank 1.8 percent in the fourth quarter after a 1.6 percent decline in the third, INE said, worse than economists' forecasts for a 1.7 percent contraction.
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