Economy Minister Luis de Guindos told Fortune in an interview that the reform package would include two sweeping changes to the country’s stringent labor rules with the goal of making it easier for companies to hire and fire staff and pay them according to their needs rather than meeting national regulations.

The other major initiative will be aimed at reducing the number of the country’s problem banks by demanding that all institutions take hefty markdowns on their problem real estate loans.

A former Lehman Brothers banker in Spain, de Guindos estimated the total write-downs at 50 billion euros ($65 billion). The second leg of the reform is to encourage mergers between weak banks by offering them an extra year longer until they have make the markdowns for problem real estate loans and giving them loans from the government’s bank bailout fund to accomplish the merger.

According to an official who asked not to be quoted by name, because the banks will receive capital injections as loans – in the form of purchases of preferred shares by the government’s Fund for the Orderly Restructuring of the Banks – the government is maintaining that it is providing no public bank bailout funds. It’s perhaps being mindful of the backlash caused by the TARP program in the U.S., which required $700 billion in taxpayer money.

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De Guindos indicated that the government may ask the European Union to relax its demands that the Spanish budget deficit be reduced from 8% of GDP last year to 4.4% this year. That would require budget cuts of $51 billion, which could wreak havoc in a nation in the midst of a recession. “This is something we’ll have to analyze in detail with the European commission and we’ll decide what is the ideal path and direction of the deficit,” de Guindos said. “It is not closed. We have agreed to 4.4% but it may be adjusted.”

The government reported last week that the Spanish economy shrank by 0.3% in the fourth quarter of 2011. The International Monetary Fund forecasts negative growth of 1.5% for the year in 2012. This has led some economists to predict dire consequences for the country if an amount equivalent to 4% of GDP is cut from the government budget in one year. It would largely require the government to lay off thousands of employees.

The new government has already been forced to deal with one nasty surprise: last year’s deficit was supposed to be 6.6% of GDP. But on Dec. 26, it found out that the previous socialist government had run up an 8% deficit despite promises to the contrary to European authorities. As a result, the government of Prime Minister Mariano Rajoy stunned the country – and its conservative backers – by sharply raising taxes, especially on the wealthy, something that it had explicitly promised not to do.

The most contentious reforms will affect Spain’s labor market, which is the most rigid in Europe. The government learned this week that unemployment hit a peak of 23% in the fourth quarter, and even more worrying, 45% for those under 25.

Under Spain’s current system, labor contracts are either negotiated on a national basis or by sector such as the automobile industry. A firm has no choice but to pay the wage increases mandated by those contracts, even if it can’t afford to. The wage rises are determine by the Spanish consumer price index, which often rises faster than Europe’s CPI, meaning Spanish labor is priced out of the market.

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De Guindos says the government plans to effectively end this system. Instead, while contracts will continue to be negotiated nationally, a firm will be free to decide whether to accept the terms or negotiate with its staff an entirely new wage agreement that might even include a pay freeze or cuts if the company is suffering.

The change will be a major blow to Spain’s powerful trade unions, which control the central negotiation mechanism. “The current system is wrong because you are losing flexibility and that’s something that will be modified,” de Guindos says. “What we are going to do is give much more leeway and flexibility at the corporate level.”

If that was not enough to anger the unions, the second proposed reform will certainly enrage them. It will end what is essentially a two-caste system of employees in Spain. One group of employees, who are dubbed permanent and have been employed longer than three years, are entitled to up to two and a half years salary as severance if they are let go. So it is prohibitively expensive for any company to fire them.

The other group, which is known as temporary workers and makes up about one-third of the workforce, gets a maximum 10 days a year severance when fired. The inevitable result is at the end of their third year, these workers are usually let go because if they work one day longer they will be entitled to 10 times the severance payments. It is this system of dual caste employees that many economists believe is responsible for Spain’s very high unemployment.

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The solution will be that the government will pass a new law lowering the amount of severance the permanent workers are entitled to. The idea is to end the huge wall between the two groups and provide more incentive for companies to keep employees on the job, giving them training and other benefits now denied to temporary workers.

But the status of permanent workers is one of the key legacies of the Franco era and the trade unions will likely fight determinedly to preserve the current system, officials say.

“It will really make a huge difference and bring in much needed flexibility into the Spanish system,” says Javier Diaz-Gimenez, a professor of economics at the IESE Business School in Madrid. “The current system is incredibly rigid and expensive.”

Because Spain uses the euro, it can no longer try to remain competitive with other European countries by devaluing its currency as it did regularly in the past. So its only real alternative will be to devalue labor costs internally by allowing regions to have different wage rates, in much the same way that auto workers in South Carolina get paid much less than unionized workers in Detroit.

“The trade unions are going to be extremely upset because this undermines their power base and their role will be diminished,” Diaz-Gimenez said.