The IMF cautioned Spain on Friday that its deficit-reduction goals rely on overly optimistic economic forecasts and its budget picture will darken if the economy proves weaker than the government expects.

In its annual review of the Spanish economy, the International Monetary Fund forecast a more sluggish recovery in the recession-hit Spanish economy than the government had.

The IMF said Spain's recovery would be "fragile and weak'' with domestic demand weighed down by high unemployment — the highest in the euro zone — and budget cuts.

Earlier this year, investors feared Spain would follow Greece into a sovereign debt crisis. Those worries have eased and the government has had no problem raising money and paying its bills.

The IMF projected the economy will shrink this year by 0.4 percent, before growth resumes at a tepid 0.6 percent next year, rising to 1.7 percent in 2012. Compared, the government sees the economy contracting 0.3 percent this year before 1.3 percent growth in 2011.

The Fund said Spain's budget-tightening plans were correctly front-loaded, with nearly two-thirds of the needed adjustment achieved by 2011.

"But the envisaged adjustment is based on potentially optimistic macroeconomic projections,'' IMF staff added.

It is imperative to get ahead of markets with a pro-active, comprehensive and credible deficit-reduction strategy, the IMF said, warning that any delays would not only have implications for Spain but also the rest of Europe.

"The government should thus make the achievement of their targets more credible and aggressively pre-empt any slippage,'' the Fund said.

"Macroeconomic projections should be made more prudent and additional measures prepared to ensure the targets are attained,'' it added.

Based on policies already announced, IMF staff projected that the fiscal deficit will decline to 9.3 percent of gross domestic product in 2010, in line with the government's target.

However, IMF staff sees the deficit falling to only 7 percent of GDP next year, which is one percent of GDP above the government's target.

In 2012, the IMF forecasts a deficit of 6.6 percent versus the government target of 4.4 percent.

In 2013, it sees the budget gap at 5.9 percent, nearly double the 3 percent target envisaged by the government.

"The differences arise from (the IMF) staff's less buoyant macroeconomic projections, which are also subject to significant downside risk,'' the Fund said..

The report said the Spanish authorities thought the IMF projections were too pessimistic and contend the recovery is likely to be stronger than IMF envisages.