MADRID — 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.
Moody's Investors Services 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 the nation's real estate bubble that burst, saddling them with billions of euros in bad loans.
On the plus side, Moody's 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, but added that Moody's should have waited to issue its report until the Bank of Spain later Thursday issues detailed breakdown on how much money the cajas need.
Spain's main stock index sank 1.3 percent after the report was released, 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. While the government has previously estimated they need at most €20 billion ($27.8 billion), or less than 2 percent of Spain's gross domestic product, Moody's predicted the cost could reach €40-50 billion and might eventually come in at a massive €100-120 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.