THE public sector must change "radically" to cope with annual funding cuts of £500 million, the public spending watchdog warned today.

Auditor General for Wales, Gillian Body, said that although the scale of cuts was difficult to predict, worse losses were not unthinkable and services should get ready for "considerable pain".

They are told to take action now by looking for new and innovative ways to maintain standards before cutbacks kick in from April next year.

In a report drawing on five years' work by the Wales Audit Office, Ms Body offers a stark assessment of an impending squeeze on resources and makes clear a traditional approach of gradual reform will not do.

"If they (public services) carry on with business as usual, they will simply run out of money," it said.

Devolved services have enjoyed five years of booming spending in which funding rose from £12.1 billion to £15.2 billion – an average increase of 5.9 per cent at a time when inflation was an average 2.5 per cent.

A comparatively modest increase of £500 million in the Assembly Government's budget next year is expected to be followed by a cut of the same size in 2011/12 - the first cut in a predicted contraction of £1.5 billion over three financial years.

Forecasts are difficult to make because it is not yet clear how quickly the UK Government will pay off the national debt – a major battle ground in the general election campaign – or how quickly the economy will recover from the recession.

And the Barnett formula, which the Treasury uses to calculate Wales's share of spending, means the Assembly Government's budget depends on how much cash is given to Whitehall departments.

The predicted spending cut is based on work by respected think-tank, the Institute for Fiscal Studies, using Treasury figures.

But a "more challenging scenario" could emerge if there is a double dip recession or if the Government elected after polling day, expected in May, pays off the debt at a faster rate.

The report says real term budgets in 2013/14 would be about £17 billion if funding continued in line with recent trends, "whereas they will probably be around £14 billion".

The gap could be as big as £5.5 billion, it adds.

It warns that ring-fencing some budgets, such as for health and education, will mean the axe falls heavier on other services.

Rising unemployment, an ageing population and climate change will all heap more pressure on services.

The public sector will have to prioritise services based on evidence of what works best, "to support disinvestment in services and programmes that are no longer a priority".

In a speech billed as calling for a "new deal" for public services, First Minister Carwyn Jones last month announced a new drive to make services more efficient.

Ms Body said: "There are tough times ahead which require tough decisions.

"And, in order to deal effectively with these challenges, the public sector needs to change and innovate.

"It needs clear strategies and plans, based on good information to support difficult choices.

"Risk should be managed but the public sector must not be risk averse. Better use should be made of staff, resources and assets. And the public sector needs to work together more, in a joined up way.

"But, most importantly, it's about finding new ways of working based around what matters for citizens."

An Assembly Government spokeswoman said: "We are aware of the exceptional challenges to public service providers in the current financial climate.

"Wales is facing an increasingly tight series of budgets and the challenge is to become both more efficient and more innovative and to put the citizen at the centre of all we do.

"This is why we recently held the first public services summit, bringing all our partners together to pledge a national response to the pressure we face.

"There are no simple answers, but we have to do better and accelerate change. Efficient services across the public sector are nearly always better services."

Tory AM Jonathan Morgan, chairman of the Public Accounts Committee, said: "The Auditor General's report is a must-read for the entire public sector in Wales as it faces its biggest challenge for at least a generation.

"With significant financial cuts on the way, public bodies cannot expect to muddle through by doing the same things with less money.

"If they are to provide citizens with good quality services, they need to focus more attention on finding radical new ways of working."