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Rajoy's election win celebrations cut short by sobering tasks ahead

Markets greet PP leader's sterling victory with massive sell-off; Valencia lender taken over by Bank of Spain as recession looms

After the joy of a resounding victory in Sunday's general elections, hours later Popular Party (PP) leader Mariano Rajoy was given a timely warning of the enormity of the task facing him in trying to turn the country's ailing economy and finances around.

Investors rained on Rajoy's victory parade by offloading Spanish shares and government bonds, while a leading think-tank predicted the economy would slip back into recession this year.

Also on Monday, the Bank of Spain was obliged to take over the country's first commercial bank since the crisis broke.

The conservative, pro-business PP won 186 seats in the congressional poll for a comfortable absolute majority of 11. The ruling Socialists garnered 110 seats, while the party with the third highest representation in the lower house was the center-right Catalan nationalist group CiU, with 16 seats. The PP also won a majority in the Senate.

But there was no let-up from the markets. The spread between the benchmark 10-year government bond and the German equivalent was up 23 basis points at 464, while the blue-chip Ibex 35 index closed down 3.48 percent. The rest of the global markets also remained under pressure due to the sovereign debt crisis and concerns about the US economy.

On top of the pasting Spanish assets received in the market, the central bank on Monday decided to take over Banco de Valencia at the lender's own request because of the delicate state of its solvency and liquidity positions. The management of the bank will be replaced by officials from the state Orderly Bank Restructuring Fund (FROB), which will inject one billion euros to shore up its capital and grant a credit line worth a further two billion euros.

"As from the publication of this decision in the Official State Gazette, the FROB will manage Banco de Valencia with the aim of stabilizing and recapitalizing the institution, thus enabling its subsequent disposal to another bank through a competitive process," the Bank of Spain said in a statement.

The board of Banco de Valencia earlier Monday had informed the central bank that it was unable to provide a "solution for the future viability of the institution."

Banco de Valencia, which is the unit of Banco Financiero y de Ahorros - an amalgam of seven savings banks formed earlier this year - accounts for only 0.74 percent of the Spanish banking system's total assets.

It was the fourth lender to be intervened by the Bank of Spain since 2007 after the savings banks Caja Castilla-La Mancha, Cajasur and Caja de Ahorros del Mediterráneo.

But the key task facing the Rajoy government will be to come up with measures that convince investors that the country can service its debt.

"Rajoy will have no option but to announce a package of extraordinarily tough reforms to convince the markets and his European partners Spain is different from Italy and Greece," Bloomberg quoted José Antonio Sanahuja, a professor of international relations at Madrid's Complutense University, as saying.

The PP's absolute majority will ensure the passage of unpopular measures in parliament. The party also controls most of the country's regions, which will also enable it to lean on them further to rein in spending in order to meet the government's deficit reduction targets, which call for the shortfall to be cut to six percent of GDP from 9.2 percent last year and to 4.4 percent in 2012 before bringing it back within the EU ceiling of three percent the following year.

The problem of yet more austerity, however, is the risk of pushing the economy back into recession at a time when over a fifth of the work force is already out of a job. FUNCAS, the think-tank of Spain's association of savings bank on Monday predicted that is exactly what would happen.

FUNCAS estimated Spain's GDP would contract by 0.5 percent in 2012, compared with an earlier forecast of growth of one percent. "The prospects with respect to the coming quarters have deteriorated as a result of the severe cuts in spending that will be necessary to carry out if the deficit targets are to be met," the think-tank said.

FUNCAS also cited slowing global economic growth and the ongoing euro-zone debt crisis as reasons for slashing its growth forecast. It predicted the deficit for this year would come in at 7.5 percent of GDP.

Investors, however, are unlikely to give PP leader Mariano Rajoy much of a honeymoon. "If the markets are to regain confidence (slashing the country risk premium) the key will be how quickly Spain's new government announces measures and structural reforms that please European authorities and the markets," brokerage Banesto Bolsa said Monday.

Brokerage M&G Valores said support from the European Central Bank in the form of purchases of Spanish government debt in the secondary market should be enough to maintain bond yields at current levels in anticipation of a new batch of reforms by the incoming administration.

Rajoy has yet to name his Cabinet, particularly the economy minister who faces the challenge of guiding Spain away from that fate of Greece, Ireland and Portugal, the three euro-zone countries that have needed rescuing by the European Union and the IMF. According to Spanish law, the Cabinet cannot be sworn in until December 21.

Frontrunners for the economy portfolio include the PP's spokesman on economic affairs Cristóbal Montoro, who served as finance minister in the government of former Prime Minister José María Aznar, and Luis de Guindos, who was Aznar's secretary of state for the economy and is currently a director with consultant PwC.

One of the key tasks of the incoming government will be to draft the budget for 2012, which was not drawn up by the outgoing Socialist administration after the elections were brought forward from March.

Rajoy on Monday chose the former PP congressional spokesperson Soraya Sáenz de Santamaría to head the transition team that will coordinate the handover of power with the Socialists. That raised speculation that she is in line to be named deputy prime minister.

The PP leader said he had had a "very satisfying" conversation with outgoing Prime Minister José Luis Rodríguez Zapatero on the transition and pledged to have a new government in place before Christmas. "In the handover, we're all going to be very busy," Rajoy said. "Things are very complicated."

In the morning the PP leader talked to German Chancellor Angela Merkel on "Spain's big problems," German government spokesman Steffen Seibert said.