UPDATE 1-Portugal's recession worsens, tax hikes set to further weigh on demand

Thu Feb 14, 2013 6:05am EST

* Entering 3rd year of recession

* GDP falls 1.8 pct in Q4 q/q, shrinks 3.2 pct in 2012

* External demand weakens amid euro zone slowdown

LISBON, Feb 14 (Reuters) - Portugal's economy contracted much more sharply than expected in the final quarter of last year, putting it on a weak footing as it headed into 2013, its third year of recession when huge tax hikes are expected to further sap domestic demand.

Debt-laden Portugal has raised taxes, slashed spending and resorted to pay cuts to meet tough fiscal goals under its 78-billion euro EU/IMF bailout, which affected consumption and investment.

Gross domestic product fell 1.8 percent in the fourth quarter from the previous three months, after dropping 0.9 percent in the third quarter, the National Statistics Institute (INE) said in a flash estimate on Thursday, blaming weakening demand for Portuguese exports.

Analysts had forecast the economy would shrink 1 percent quarter-on-quarter.

Under the weight of austerity dictated by the bailout agreed in 2011, Portugal's economy slid into its worst recession since the 1970s last year, with the GDP diving 3.2 percent for all of 2012. That was slightly worse than the government's forecast of 3 percent and followed a 1.6 percent contraction in 2011.

In the fourth quarter of 2012 gross domestic product fell 3.8 percent from a year earlier, worse than forecasts for a decline of 2.9 percent and a 3.5 percent drop in the third quarter.

"The numbers are a bad sign as we start 2013," said Jose Brandao de Brito, chief economist at Millennium bcp bank in Lisbon.

"Regardless of how well the budget policy is executed, a sharp drop in economic activity restrains tax revenues and makes it more difficult for Portugal to reach its budget goals."

The euro zone - the main market for Portuguese exports - slipped far deeper than expected into recession in the fourth quarter as Europe's two largest economies, Germany and France, both shrank markedly at the end of the year, data showed on Thursday.

This year the Portuguese government expects the economy to contract by around 1 percent. But the Bank of Portugal forecasts a much sharper GDP slump of 1.9 percent after the largest tax hikes in decades kicked in last month.

The government has to cut the budget deficit to 4.5 percent of GDP this year under its bailout programme, after achieving last year's 5 percent target mainly due to one-off measures.

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