By Fiona Ortiz and Paul Taylor

SPAIN is winning the struggle to restore financial market confidence and is convinced Germany will back a stronger euro zone rescue fund despite Chancellor Angela Merkel's domestic troubles, Prime Minister Jose Luis Rodriguez Zapatero said. “We are winning the battle, but I still have my guard up because we have to implement all the reforms that have generated more confidence,” Zapatero told Reuters Insider in an interview.

He voiced confidence that Merkel would back a strengthening of the European Financial Stability Facility at a March 11 euro zone summit despite political problems sharpened by her party's crushing loss in a state election in Hamburg on Sunday. “I am confident, confident in the capacity and commitment of Chancellor Merkel. We know this a very intense electoral year in Germany, but I am confident,” he said.

The single currency area's fourth biggest economy came under attack in bond markets after a real estate bubble burst, causing a recession and 20 percent unemployment, straining public finances and threatening its fragile savings banks.

Until recently, the fate of the euro appeared to hinge on whether Spain could avoid following Greece and Ireland into a bailout that would stretch Europe's rescue fund to the limits. “I have to admit that less than a year ago there were huge doubts. I felt it directly,” Zapatero said.
Critics said the soft-spoken premier, best known until then for legalising gay marriage and abortion, was in denial. He blamed the crisis on speculators bent on destroying the euro rather than addressing Spain's own structural problems.

But since May, his minority Socialist government has cut spending, imposed unpopular public sector pay cuts, reformed labour law, clinched union backing to raise the retirement age to 67, and forced savings banks to merge and raise new funds. HUGE LESSONS “I feel like I have been in battle since the last quarter of 2008,” he said in an hour-long session in his Moncloa office. “I have learned huge lessons because none of the classic manuals of the art of war are any use.” Pressure mounted on Spain after European partners and the International Monetary Fund rescued Greece from the brink of bankruptcy in May. A second wave of selling erupted when Ireland was forced to seek an international bailout in December.

Comparing his task to running a marathon, he said: “You think you are there and then, suddenly, Ireland happens.” Zapatero responded to the Irish collapse by accelerating reforms. He announced the sale of stakes in the state lottery and airport operator, and coaxed trade unions and employers into signing a landmark social pact on pension reform and employment incentives. “Spain's reform agenda is truly impressive in any international or historical context; something the market still doesn't seem to fully appreciate,” Goldman Sachs chief European economist Erik Nielsen wrote this week.

Zapatero is now working to make collective bargaining rules more flexible by mid-March, organising negotiations by company rather than sector and linking pay to productivity, not just inflation.

His approval rating has sunk and his party trails the conservative opposition Popular Party by more than 10 points in opinion polls, prompting some analysts to say he is on a suicide mission that will end in certain defeat in 2012.

But Zapatero said any prime minister would have done the same to save his country. The 50-year-old lawyer, in office since 2004, declined to say whether he would seek a third term next year or step aside for a more popular Socialist candidate.

The prime minister said Madrid was willing to give binding legal force to long-term deficit reduction policies but Spain's rigid constitution made it impractical to pass a German-style “debt brake” amendment as Merkel has sought.

He said he would take further steps to ensure that Spain's autonomous regions stuck to their spending limits. “We are part of the culture of maximum budget stability. The two big political parties have a consensus on that,” he said, endorsing Franco-German “competitiveness pact” proposals for greater economic policy coordination in the euro zone.

Spain will have achieved its goal of cutting the deficit to 9.3 percent of gross domestic product in 2010 when final figures are published in the next two weeks, Zapatero said, and it would meet its commitment to slash it to 6 percent this year. “We do not expect tensions on Spanish debt. We must reduce the spread over German bonds to improve our financing costs, but the reforms of the financial system and the savings banks will contribute to reducing our risk premium,” he said.

Spain's cost of borrowing soared in November and December in the run-up to the Irish rescue.
Madrid had to pay 3 percentage points more on bonds than Germany, but that has fallen to 2 percentage points, still far above the 0.7 percentage point spread before the crisis began.

Asked if he thought Merkel's domestic problems would make it harder for her to agree to a stronger euro zone safety net next month, he said: “Naturally the chancellor has domestic problems -- we all do -- but when it comes to the decisive moment, she always puts her responsibilty to Europe first”.