By Andrei Khalip and Daniel Alvarenga
LISBON (Reuters) - Portugal will struggle to keep its deficit-reduction program on track in 2013 and may well have to leave austerity with stimulus measures to counter a recession that risks being even deeper than feared, the OECD said on Thursday.
But the country, which is under an EU/IMF bailout, also needs to get as close to its budget target as possible to retain hopes of restoring investor confidence in time to return to debt markets on schedule late next year.
In an economic survey on Portugal, the Paris-based Organisation for Economic Co-Operation held forecasts that the country will stay mired in recession well into 2013.
It expects the economy to shrink by 3.2 percent this year and 0.9 percent next, a more pessimistic view than recent government and IMF estimates.
"The (bailout) program is expected to remain on track but the balance of risks to growth is skewed to the downside," the OECD said, adding that "the risk that fiscal targets are not met because growth undershoots expectations in a credit constrained and weak international environment is significant."
Tapping into a global debate about the limits of fiscal tightening in shrinking economies, the OECD said Portugal might need to consider some form of stimulus if growth was far weaker than expected. It also needed to press ahead further with labor reforms.
"The OECD is right. The major risk is having a deeper than expected recession, and you can only take austerity that far before it becomes counterproductive," said Rui Barbara, an economist at Banco Carregosa.
With the economy having contracted 1.6 percent last year and unemployment rising steadily, Portugal is experiencing its worst recession since the 1970s, one fuelled by painful austerity measures like tax hikes and pay cuts in the public sector under the terms of the 78-billion-euro bailout.
DEFICIT, DEBT CHALLENGES
The government insists it will meet its public deficit targets of 4.5 percent of economic output this year and 3 percent next as the economy should start recovering by early 2013. Last year it met the 5.9 percent deficit goal using a one-off transfer of banks' pension funds to state coffers.
The OECD expects the 2012 deficit to be broadly in line with the target but believes Portugal will miss its 2013 goal by 0.5 percentage points.
While it needed to carry on cutting its budget gap over the economic cycle to restore investor confidence, the government "may (also) need to let automatic stabilizers play at least partially" if GDP dropped more swiftly than projected in the bailout program, the OCED said.
In a recession, such stabilizers might include stimulative tax cuts or spending increases, which would tend to increase the deficit.
The government has said it will not veer off the austerity path, but acknowledged it will consider adopting an IMF-proposed stabilizing measure that would reduce social security contributions for companies to help them through the recession.
As fellow bailout recipient Ireland prepared to return to long-term debt markets for the first time since it was granted aid, the OECD warned Portugal's bond spreads were still very high.
That meant the government "faces additional challenges to regain full market access within the program period".
The premium investors demand to hold Portuguese 10-year bonds over German Bunds has fallen from over 15.6 percent in January, but remains at highly-stressed levels around 10 percent.
The bailout covers Portugal's funding needs - mostly bond refinancing -- through September 2013.
Many economists doubt it will be able to fully finance itself after the end of the program and say it will likely need additional rescue funds - an impression reinforced by Thursday's report.
"It's almost certain that Portugal's assistance program will have to be extended for another year in my opinion," Banco Carregosa's Barbara said.
The OECD added that Portugal still needs to deepen its labor market reform by further reducing severance pay and watering down collective bargaining agreements.
The government has already pushed through parliament labor law changes bringing down unemployment benefits and making it easier for companies to hire and fire.
(Reporting By Andrei Khalip and Daniel Alvarenga; Editing by John Stonestreet)