Spain will probably miss its budget-deficit target of 5.3 percent of gross domestic product this year after the shortfall was 8.9 percent last year, the Washington-based lender said in a statement on its annual review of Spain. The government, which aims for a 3 percent shortfall next year, shouldn’t try to correct any slippage too quickly as the IMF forecast the economy will continue shrinking in 2013.

“The medium-term targets are broadly appropriate, but a smoother path would be appropriate during a period of extreme weakness” in order to reduce “the risk of creating a negative feedback loop,” the IMF said.

Spain’s 10-year bond yields surged to 6.874 percent today, as investors increased bets that the country’s 100 billion-euro ($128 billion) European bank bailout may not be enough to prevent the state losing market access. The government forecasts the economy will shrink 1.7 percent this year, returning to growth next year.

The IMF called for banking supervision to be “upgraded” and said the government should make the most of the bank bailout to overhaul the industry. Banks should be “triaged” into those that don’t need help, viable ones that do and “non-viable banks.” It should also deal with “legacy real estate assets,” the fund said, without giving details.

Wages and Prices

The IMF praised Spain’s labor-market overhaul even as it said it could be strengthened to help bring down the 24 percent jobless rate. Net exports will continue to contribute to growth, the lender said, as it called for wages and prices to come down. It also proposed public-wage cuts.

“A cooperative solution, where workers accept greater wage moderation, employers pass on the cost savings to prices and hire, and banks recapitalize, could result in a faster reallocation of resources to dynamic sectors and a better outcome for all,” the IMF said.

The IMF said Spain shouldn’t “rule out” any options for cutting the deficit over the medium term. The country has scope to increase value-added tax and could do so immediately, while the government should also sell assets. VAT hikes and public wage cuts could be written into law now to bolster confidence, and only reversed if the goals are met, the report said.

Rebates for mortgage payments, which Prime Minister Mariano Rajoy restored as one of his first initiatives after coming to power in December, should be scrapped. Temporary and one-time measures should be avoided, as should tax amnesties such as the one introduced this year, the report said.