Spain’s economy may contract 1.2 percent, the Washington- based IMF said in a report, compared with an estimate for a 0.6 percent slump published earlier this month. The economy will shrink 1.7 percent this year, more than the prior forecast of 1.5 percent, pushing unemployment to 24.9 percent.

“The new fiscal package, regional government actions and structural measures are broadly in line with staff recommendations,” the IMF said. The deficit squeeze will have a “significant impact on growth, especially in 2013.”

Rajoy announced 65 billion euros ($80 billion) of budget cuts on July 11, ditching election pledges as he raised value- added tax, reduced unemployment benefits and scrapped tax rebates. He is trying to stem a surge in borrowing costs to euro-era records and comply with conditions linked to a 100 billion-euro European bailout for the nation’s banks.

The prime minister is also battling unemployment that’s at the highest level in the country’s democratic history. Data today showed that Spain’s jobless rate rose to 24.6 percent in the second quarter from 24.4 percent in the prior three months.

Bank Bailout

The IMF praised the terms of the bank rescue, saying they were “in line” with the fund’s recommendations. Still, it said the bailout will help push Spain’s sovereign debt burden to 97.3 percent of output in 2015 if European leaders don’t agree to lend rescue funds directly to banks.

The fund also said that while the loan and agreements to strengthen the euro region made by leaders last month “mitigate short-term risks,” they may not be enough.

“Market tensions could intensify further, threatening market access, particularly if policies fail to stem capital outflows or due to further stress elsewhere in the euro area,” it said. “Downside risks dominate.”

The report underlined Spanish banks’ increasing dependence on the European Central Bank for funding, after Spanish lenders’ net borrowings from the central bank jumped to a record 337 billion euros in June. The collateral the banks use to obtain cheap funding from the ECB is vulnerable to ratings downgrades and margin calls, while banks’ capacity to generate new collateral is weakening, the IMF said.

“Liquidity stress tests in the context of the Financial Sector Assessment Program show that liquidity risk can potentially become the biggest risk should ECB support not be renewed,” the report said.