Europe's economy will shrink in 2012, with Italy and Spainfacing sudden crunches as they battle to escape the debt crisis,the European Commission said.

The 17-nation euro economy will contract 0.3 percent, thecommission said, abandoning a November forecast of 0.5 percentgrowth. The downgrade was mainly due to projected contractions of1.3 percent in Italy and 1 percent in Spain.

“The euro area has entered into a mild recession,” EuropeanUnion Economic and Monetary Commissioner Olli Rehn told reportersin Brussels today after releasing the forecasts. “Prospects haveworsened and risks to the growth outlook do remain, but there aresigns of stabilization.”

Two days after Greece clinched a second bailout, the forecastsshowed an economy pockmarked by the two-year-old fiscal crisis andlooked set to stiffen resistance in southern Europe to furtherdoses of German-demanded austerity.

The full-year Europe-wide contraction would be the first since2009, when a 4.3 percent drop in the wake of the U.S.-led bankingcrisis exposed the over-borrowing and imbalances that plungedEurope into its sovereign debt troubles.

Financial markets “remain still rather fragile, but there arealso signs of stabilization,” Rehn said.

The euro pulled off its high against the dollar after theforecasts were published, trading at $1.3313 at 10:16 a.m. inLondon, up 0.5 percent on the day, after reaching $1.3343earlier.

The growth downgrade went along with a higher inflationforecast, potentially limiting the European Central Bank's scopefor a further cut in its main interest rate from 1 percent.Euro-area inflation will reach 2.1 percent, topping the centralbank's 2 percent limit, the commission said. In November it hadcounted on 1.7 percent inflation.

With countries along the Mediterranean rim plagued by too muchdebt and too little competitiveness, divergences within what issupposed to be a unified continental economy have become more“pronounced,” the commission said.

Declining employment, two years of budget cuts and financingconstraints for businesses will combine for a “substantial drop” inItalian domestic demand in 2012, the commission said.

It painted a similar picture in Spain, stuck with a 22.9 percentunemployment rate and mounting doubts whether Prime MinisterMariano Rajoy's government will meet deficit-reduction targets.

Growth Differentials

Spain is still suffering from the aftershocks of the bursthousing bubble, compounded by fiscal austerity and high corporatedebt that is holding back business investment, the commissionsaid.

“Growth differentials are set to remain substantial,” thecommission said.

The divergences carried through to the three countries — Greece,Portugal and Ireland — forced to fall back on a combined 386billion euros of financial aid to stave off default.

Greece met with the sharpest downgrade, with this year'scontraction now seen at 4.4 percent compared with 2.8 percent inNovember. Portugal's economy will shrink 3.3 percent, compared withthe previous forecast of 3 percent. Ireland, by contrast, will grow0.5 percent, expanding for the second straight year.

Germany, Europe's largest economy, will muster 0.6 percentgrowth, down from a November estimate of 0.8 percent. Germany willget away with a “temporary interruption” of its economic momentuminstead of tipping into a technical recession, the commissionsaid.

Germany's decoupling from southern Europe was reflected in agreater-than-expected increase in business confidence, according toa separate report by the Ifo institute today.

The EU forecast for France, the second largest, was scaled backto 0.4 percent from 0.6 percent. In a potential fillip for thestruggling re-election campaign of President Nicolas Sarkozy, thecommission said France too will escape a recession, commonlydefined as two consecutive quarterly contractions.

Overall, the EU was more downbeat than private-sector analystssurveyed by the ECB, who on Feb. 16 predicted a 0.1 percentdecline. The ECB's latest projection, released in December, was for0.3 percent growth. It will put out new forecasts next month.

The economic retrenchment will be “rather mild and temporary,but the turnaround of the trend needs to be confirmed in comingmonths,” Rehn said.

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