Spain faces crisis of confidence after deficit slip

* Spain hikes 2011 deficit to 8.9 pct from 8.5 pct of GDP

* Change a disaster for Spanish credibility-economist

By Paul Day

MADRID, May 19 (Reuters) - Spain's government faces a crisis of confidence from nervous investors after admitting late on Friday its 2011 public deficit was higher than it had previously reported due to adjusted accounts in three of its regions.

Spain revised its 2011 public deficit to 8.9 percent of gross domestic product from a previous 8.5 percent of GDP, a figure which was already sharply higher than the original target of 6 percent of GDP.

The three offending regions, Valencia, Madrid and Castilla y Leon, are all governed by the ruling People's Party, an embarrassment for Prime Minister Mariano Rajoy who has made much of the Socialist party's inability to control their accounts.

"This is a major disaster ... and a serious hit for Spain's credibility. I wouldn't be surprised if we see a leap in risk premiums on Monday. The news left me cold when I saw it. The worst that could happen to us right now was something like this," Antonio Cabrales, economist at Madrid's Carlos III university, told Reuters.

The yield Spain pays for its benchmark 10-year bonds has soared to six-month highs in the last week, close to levels considered unsustainable, amid concerns over its banking sector and talk that Greece may be forced to leave the euro zone.

The government took control of the country's fourth largest bank Bankia, battered by bad loans in to the collapsed property sector, fuelling worries over the potential public cost of a banking sector clean up.

Spain's economy has been in recession or stagnated ever since the burst of a housing bubble four years ago and despite forecasts GDP will contract by around 2 percent this year, it has made deep spending cuts to meet Europe-set deficit targets.

The country will still meet the goals, the government said after presenting the revised data on Friday, but many economists say the slump means they are impossible to reach without condemning the economy to deeper downturn.

REGIONS

"The credibility of Spanish fiscal policy is in tatters - not because the government is shirking its responsibilities, but because of the infeasibility of the fiscal adjustment being demanded of it at a time when the economy is in recession," Nicholas Spiro, of Spiro Sovereign Strategies, said.

Rajoy has passed austerity measures worth around 45 billion euros ($57.25 billion) to deflate the deficit to 5.3 percent of GDP this year, and will be forced to cut deeper still next year to reach a target of 3 percent of GDP.

The 2011 deficit deviation, inherited from the Socialist government which was trounced by the conservatives in November's election, was largely due to over spending in Spain's 17 regions, which account for around half of total spending.

"What the government wants to do is make sure the regions show all the bills that they have and start again from scratch. It's not worried about the deviation because it's not recurrent and won't happen again in 2012," a Treasury Ministry source said.

However, with confidence in the euro zone's fourth largest economy on a knife's edge, late night admissions of accountancy errors over regional accounts will do nothing to rebuild faith.

"We've lived through another crucial week in which risk premiums have hit record highs and situations such as the lack of control over regional accounts shows perfectly well why investors are watching us so closely," right-leaning newspaper El Mundo said in an editorial on Saturday.

($1 = 0.7860 euros) (Additional reporting by Blanca Rodriguez; editing by James Jukwey)