In the first quarter, the economy shrank 0.3 percent in the compared with the last quarter of 2011, and was down 0.4 percent year on year, the National Statistics Institute said on Thursday, its sharpest annual fall since the first quarter of 2010.

"The recession is proceeding at a gradual pace but taking in to account the latest business survey it seems that the contraction in economic activity is going to stretch well in the coming quarters," said economist at Unicredit Tullia Bucco.

Spain's manufacturing sector shrunk at the fastest pace in nearly three years in April, while the service industry contracted for the 10th straight month, according to Markit's purchasing manager's indices (PMI).

The expansion of export sector, the only area of Spain's economy to have grown in the last two quarters, slowed in the first quarter as the country's main trading partners in Europe saw their own economies contract.

Madrid is fighting to persuade investors, who have been selling its debt in droves, that it can control its public finances with wide-sweeping spending cuts, but fears remain that rebuilding the battered banking sector will cost dearly.

The premium investors pay to buy Spanish over German debt rose to its highest level since the euro's introduction this week, at over 500 basis points, on concerns on the country's banks and doubts over Greece's future.

The Treasury faces its latest test in international debt markets later on Thursday when it auctions three bonds to raise up to 2.5 billion euros ($3.2 billion).

Economists said the Spanish growth figures were in line with expectations, but noted that they were revising forecasts as uncertainties grew in the region.

"The depth of the recession really depends on upcoming events, such as whether Spain will be forced to ask for aid to refinance its banks and Greece. We're revising our growth forecasts for Spain right now, but the situation is very fragile at the moment," one economist, who asked not to be named, said.

(Reporting by Paul Day. Editing by Jeremy Gaunt.)

• A Permanent Economic Emergency