Spain's credit rating downgraded

Moody's downgraded its credit rating on Spain today, citing worries over the cost of the banking sector's restructuring and the government's ability to achieve its borrowing reduction targets.

The agency said it was reducing its rating by one notch to Aa2 and warned that a further downgrade could be in the offing if there were indications that Spain's fiscal targets will be missed and if the public debt ratio increases more rapidly than currently expected, or if the funding requirements for the so-called savings banks - the cajas - are greater than anticipated.

Though noting the government's resolve in dealing with its problems and that Spain's debt sustainability is not under threat, Moody's said that "Spain's substantial funding requirements - not only those of the sovereign, but also those of the regional governments and the banks - make the country susceptible to further episodes of funding stress".

One of the main motivations behind the downgrade was Moody's expectation that the eventual cost of recapitalising the cajas will be much more than the government's current projections. While the government reckons the cost will be a maximum of 20 billion euros (£17 billion), or less than 2% of Spain's gross domestic product, Moody's thinks the likely cost will be near 50 billion euros (£43 billion) and could eventually come in at a massive 120 billion euros (£103 billion).

The Spanish government is trying to get a handle on its borrowings by reducing spending and raising taxes. The expectation in the markets is that the country managed to reduce its budget deficit from over 11% of national income in 2009 to around 9% last year.

However, it is doing all this at a time when unemployment remains above 20% following the collapse of a property and construction boom that sent the economy skidding into a two-year recession.

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 the EU can contain the government debt crisis, even if Portugal is forced to tap a bailout fund. However, Spain would be a different matter and could test the limits of the existing bailout fund - the European Financial Stability Facility, or EFSF - potentially putting the euro project itself in jeopardy if governments don't put up more cash.

Earlier this week, Moody's Investor Services cut its rating on Greece too, 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 is standing 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.