Portugal's caretaker government signed up to a 78 billion euro EU/IMF bailout on Thursday, warning its terms would push it into recession this year and next.

Finance Minister Fernando Teixeira dos Santos confirmed what sources had told Reuters - that the economy would shrink by two percent in both 2011 and 2012 as a result of higher taxes and steep spending cuts required by the package.

IMF mission head Poul Thomsen told a news conference Portugal's economy will face significant headwinds in the next three years, and that the country needed to become much more open to competition to be able to grow again.

The IMF will provide 26 billion euros, with the rest of the sum coming from the European Union. Portugal is the third country to succumb in the euro zone debt crisis and seek financial assistance.

Dos Santos said consumption taxes, but not income tax, would rise and that Portugal's debt/GDP ratio would keep climbing until 2013 before falling.

This is a program aimed at returning to growth and employment, he told a news conference.

Caretaker Prime Minister Jose Socrates announced late on Tuesday that Lisbon had reached a three-year bailout agreement to the tune of 78 billion euros with the European Union and International Monetary Fund after weeks of talks.

Socrates resigned in March after parliament rejected his minority government's latest austerity plan.

A return to recession will make it even more of a challenge for the heavily indebted country, which has had some of the lowest growth rates in Europe for a decade, to return to financial health.

Portugal was forced to seek a bailout after its government collapsed last month, sending its borrowing costs soaring.

Officials from the European Commission, the International Monetary Fund and the European Central Bank have been in Lisbon for almost a month to hammer out the agreement.

OPPOSITION SUPPORT

Portugal's two key opposition parties signaled after meeting European and IMF officials on Wednesday that they will back the bailout.

With elections due in a month, the backing of the opposition, and especially the PSD, which is ahead in the polls, is crucial to guarantee that the EU signs off on the deal.

European officials want to ensure cross-party agreement by Portugal on the bailout in order to avoid the possibility of having to revisit terms of the deal after the June 5 election.

They are also worried that Finland, where an anti-euro party could form part of the next government, may hinder a deal.

The bailout memorandum seen by Reuters showed Lisbon won some leeway from its lenders. This year's budget deficit target was raised to 5.9 percent of gross domestic product from 4.6 percent previously.

That still represents a sharp cut given the deficit totaled 9.1 percent of GDP last year and, under the deal, it must be lowered to 4.5 percent of GDP in 2012 and 3 percent in 2013.

EU officials have suggested that lessons had been learned from very strict terms handed out to Greece when it was bailed out last year, which backfired because investors saw them as unachievable.

The deal includes up to 12 billion euros for the banking sector to recapitalize and orders banks to raise their core Tier 1 capital ratios gradually to 10 percent by the end of 2012, an official source said on Wednesday.

Teixeira dos Santos said the banking measures were aimed at ensuring finance for the economy. He said Lisbon hoped to return to the debt markets toward the end of the three-year bailout program.

The plan also envisages 5.3 billion euros in privatization revenues up to 2013.

The interest rate on Portugal's bailout loan is expected to be set at a meeting of euro zone finance ministers in mid-May.

Portuguese agreement to the loan terms is needed by June 15, when Lisbon has to redeem 4.9 billion euros of bonds.

(Writing by Mike Peacock/Janet McBride)

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