MADRID (Reuters) - Spain's economy looks set to slip into recession after contracting for the first time in two years in the last quarter of 2011, highlighting the challenge for EU leaders as they meet to find ways to boost growth while cutting budgets.
The leaders are meeting in Brussels on Monday with the goal of helping Europe's economy but they have to balance austerity with the need to help countries struggling with dismal economic performance.
The finances of neighboring Portugal faced fresh scrutiny by markets on Monday and Spain's prime minister said this year's official growth goal would be missed.
Gross domestic product in Spain shrank 0.3 percent in the fourth quarter from zero growth the previous quarter, preliminary data from the National Statistics Institute showed, in line with forecasts in a Reuters poll.
Spain has massive unemployment -- around a third of the euro zone's unemployed are Spanish -- and a banking sector that has been hobbled by a collapsed property sector.
"I don't see any way countries like Spain can avoid recession through the first half of the year at the very least," said Steve Webster, economist at consultancy 4Cast.
"Politicians in Davos are talking about not just relying on austerity and are talking about growth efforts. But that won't be easy, and so a prolonged recession is the risk."
On an annual basis, the economy grew by 0.3 percent, slowing from 0.8 percent in the previous quarter but slightly above expectations for growth in a Reuters survey.
Many economists are concerned the euro zone's deficit-busting strategies aimed at easing market fears over fiscal imprudence will make growth difficult, potentially condemning the region to a "lost decade."
The Bank of Spain said it expects the economy to shrink 1.5 percent this year due to stringent cost-cutting aimed at cutting the public accounts shortfall to 4.4 percent of GDP from around 8 percent in 2011.
Spain, Greece, Portugal and Ireland face a year or two of economic problems as austerity measures hurt growth prospects, a Reuters poll January 27 showed.
Germany has weathered the euro zone's crisis better than most, underscoring the divergence that has developed among Europe's economies, and is leading the drive for fiscal austerity.
Spain will miss the official growth target of 2.3 percent in 2012 Prime Minister Mariano Rajoy said. His centre-right government, which trounced the Socialists in November's election, is due to announce new growth targets in March.
Spain has suffered from the collapse of the once-powerful property market as well as falls in spending by consumers unable to get loans from cash-strapped banks and afraid to spend their nest eggs while faced with the EU's highest unemployment rate.
"We now expect to take a more downbeat view in the February forecast round, with the economy condemned to shrink for two successive years, by 1.5 percent in 2012 and 0.2 percent in 2013," economist at Global Insight Raj Badiani said.
"A major factor behind the darker outlook is the government's continued commitment to the fiscal budget deficit targets ... which will require even tougher austerity measures to prop up the multi-year budget deficit reduction plan in the face of a poorer economic climate."
The economy has remained virtually stagnant since emerging from recession in the first quarter of 2010, with only strong exports keeping it from shrinking again, but a slowdown among key trade partners has hit its only pillar of growth.
The European Commission forecasts 2012 economic growth of just 0.5 percent for the 17 nations in the euro zone compared with growth of 1.5 percent in 2011 and 1.9 percent in 2010.
The International Monetary Fund expects the region to contract 0.5 percent in 2012 and warned it could drag the world into recession.
Spain will pass a decree on further restructuring its banking system later this week and a draft labor law in February, Rajoy said on Monday, as part of its reformist agenda for the damaged economy.
The ailing banking sector holds billions of euros of unsaleable property, overpriced land and bad loans to defunct property developers, prompting some economists to say the government will need to use public cash to solve the problem.
Rajoy has said he wants the banks, which have been through a restructuring process over the last two years more than halving the number of regional savings banks through mergers, to cough up 50 billion euros to cover potential losses.
The Bank of Spain says around half of banks' exposure to the real estate sector is problematic -- equivalent to 176 billion euros of foreclosed property and unrecoverable loans. Around 33 percent of those assets, have already been provisioned for, the central bank said.
The government's other main reform will focus on the labor market in an effort to bring down the unemployment rate which ended 2011 at 22.9 percent.
Editing by Anna Willard