Moody's downgraded Spain's credit rating on Thursday, citing worries over the cost of the banking sector's restructuring, the government's ability to achieve its borrowing reduction targets and grim economic growth prospects.
The agency reduced Spain's rating by one notch to Aa2 and warned that a further downgrade is possible if indications emerge that Spain's fiscal targets will be missed, and if the public debt ratio increases more rapidly than currently expected.
On the plus side, Moody's Investors Services noted the government's resolve in dealing with its problems and added that Spain's debt sustainability is not under threat.
Spanish Finance Minister Elena Salgado said the government agrees that the nation must make a better effort to push debt-laden regional governments to reduce their deficits.
However, Moody's also warned that concerns could rise if funding requirements for Spain's troubled savings banks — called cajas — end up greater than anticipated. They have been hit particularly hard by a burst real estate bubble, which saddled them with unperforming loans.
In a statement sent hours after the downgrade, the Bank of Spain said the banking sector needs euro15.5 billion ($21.4 billion) in new cash. That is well below the government's earlier top estimate of euro20 billion ($27.6 billion), published last month when it announced new capital requirements for commercial banks and, in particular, the savings banks.
The Bank of Spain said a total 12 banks need to raise capital to comply with the February decree, which was approved Thursday in Parliament. Two are Spanish banks, two are subsidiaries of foreign banks and eight are savings banks, or cajas, the main source of concern.
Topping the list of the needy 12 are Unnim, a fusion of Spanish cajas that the central banks says needs euro568 million in additional capital, followed by the local unit of Barclays at euro552 million.
The central bank said the euro15.5 billion figure is subject to change, depending on how banks go about raising capital as required by the government.
Spain's main stock index sank after the Moody's report to close down 1.2 percent, and the yield on Spain's ten-year bonds rose 0.01 percentage point to 5.50 percent.
One of the main reasons for the downgrade was Moody's expectation that the eventual cost of recapitalizing the cajas will be much more than the government's current projections. Moody's predicted the cost could reach euro40-50 billion and might eventually come in at a massive euro100-120 billion.
The Spanish government is trying to get a handle on its borrowings by reducing spending and raising taxes, and reduced its budget deficit by around two percentage points last year to 9.2 percent of national income.
But unemployment has shot up to more than 20 percent amid predictions of gloomy economic growth, and Spain is also being clobbered by high oil prices sent skyrocketing by the unrest in Libya.
"Spain's vulnerability to market disruption remains elevated given the high funding requirements, not only for the sovereign but also for the regional governments and the banks," Moody's said.
The big worry in the markets is that Spain will get sucked into Europe's debt crisis, which has already seen Greece and Ireland get financial bailouts from their partners in the EU and the International Monetary Fund. Portugal is widely expected to be next.
Most analysts think that the EU can contain the government debt crisis, even if Portugal is forced to tap a bailout fund. However, Spain has the eurozone's fourth largest economy and could test the limits of the existing bailout fund — the European Financial Stability Facility, or EFSF. That would potentially put the euro project itself in jeopardy if governments don't put up more cash.
"It remains essential that the EFSF is bolstered to reassure markets that there is enough ammunition to protect monetary union against all eventualities," said Jane Foley, senior currency strategist at Rabobank International.
Earlier this week, Moody's Investor Services cut its rating on Greece, prompting a sharp tirade from the Greek government about the role of credit rating agencies.
The downgrades have come amid signs that Europe's debt crisis is flaring up again ahead of the March 24-25 summit of EU leaders in Brussels. Portugal's cost to borrow 10-year bonds stands near a euro-era record.
Though a "comprehensive solution" to the debt crisis has been trumpeted, there are growing fears that the 17 countries that use the euro will not agree a revamped bailout mechanism, set new rules on budget deficits and a system of support funds to flow from richer countries in the single currency bloc to the poorest.
Moody's had put Spain on notice for a downgrade in December.
Pylas reported from London. Daniel Woolls and Barry Hatton contributed to this report from Madrid and Lisbon.