Moody's became the first ratings agency to cut Portugal's credit standing to junk, warning the country may need a second round of rescue funds before it can return to capital markets.
The downgrade on Tuesday was not entirely unexpected and served as a reminder that Europe's debt troubles extend beyond Greece, which has dominated news headlines over its second financial bailout.
Some economists think Ireland may also need additional support, and investors worry Spain and Italy could be next in line for aid.
It goes to show that this whole crisis isn't over just yet, said Jay Bryson, global economist for Wells Fargo Securities in Cape Hatteras, North Carolina. Even if they cough up some more money for Greece, and that looks like it's a done deal, it's not over.
The protracted sovereign debt struggle has darkened the global economic outlook, cooling demand for Asia's exports and leaving financial markets on edge.
Mohamed El-Erian, co-chief investment officer for bond fund PIMCO, said it was unlikely that Europe's troubles would constitute a Lehman moment that paralyses the U.S. economy, but it was a drag on an already disappointing recovery.
The debt troubles add another wrinkle to the European Central Bank's interest rate decision on Thursday. Economists widely expect the ECB to raise its benchmark rate, which would be the second hike this year, to try to cool inflation.
But the move could raise already high borrowing costs for Portugal and other so-called peripheral European countries. Yields on long-term Portuguese government bonds are well above 10 percent, more than three times higher than those of Germany.
Moody's Investors Service slashed Portugal's credit rating by four levels, to Ba2, causing the debt-laden Iberian country to follow Greece into junk territory below investment grade. Greece is rated much lower, at Caa1.
Portugal in April became the third euro zone country to request a bailout, after Greece and Ireland.
Moody's cited heightened concerns that Portugal will not be able to fully meet deficit reduction and debt stabilization targets set out in its loan agreement with the European Union and International Monetary Fund.
Portugal is receiving funds from a three-year, 78-billion-euro EU/IMF bailout program and does not need to issue long-term debt in the market until 2013.
But Moody's said there is an increasing probability Portugal will not be able to borrow at sustainable rates in capital markets in the second half of 2013 and for some time thereafter.
There was a growing risk that Portugal will require a second round of official financing before it can return to the private market, and the increasing possibility that private sector creditor participation will be required as a pre-condition, Moody's said.
Of the three major ratings agencies, Standard & Poor's and Fitch Ratings both have Portugal at BBB-minus, the bottom of the investment grade range.
The first repercussions of the downgrade could come as early as Wednesday, when Portugal is due to place up to 1 billion euros in a 3-month Treasury bills auction. It may have to pay a higher premium to entice buyers.
Portugal's new center-right government said in a statement that Moody's did not take into account strong political backing for austerity after a June 5 election, and an extraordinary tax announced last week.
Unlike the previous minority Socialist government, the new ruling coalition has a comfortable majority in parliament to pass austerity measures and reforms. It did acknowledge, though, that the rating cut shows the vulnerability of the country's economy amid a debt crisis.
It also reaffirmed commitment to deepening and speeding up austerity measures that the country vowed to implement under its bailout pact, saying a strong macroeconomic adjustment was the only way to reverse the course and restore confidence.
The country has to slash its budget deficit to 5.9 percent of gross domestic product this year after overshooting its target last year, when the gap was 9.2 percent, and then reduce it to 3 percent by the end of 2013.
Anthony Thomas, Moody's analyst for Portugal, told Reuters evidence that Portugal is meeting or indeed exceeding its deficit reduction targets could be a positive that may lead the agency to change its outlook on the country's credit rating to stable from negative.
But he also said the outlook depends a great deal on whether euro zone officials will require private-sector participation when extending new financing to the region's troubled countries. Right now, such participation is planned to be only voluntary so as not to cause ratings agencies declaring it a credit event.
Filipe Garcia, head of Informacao de Mercados Financeiros consultants in Porto, said Moody's move was a bit extreme and was likely to exacerbate concerns over Portugal's debt.
The capacity to return to the markets after a while depends on a more global, structural solution by Europe rather than on what each troubled country does. I think it's too early to think of a second bailout for Portugal right now, not this year at least, he said.
Garcia said the ratings agencies were not taking into account the European Union's political determination to avoid a euro zone member's default, despite the union's strong support for Greece, which is in a far worse shape than Portugal.
Either they don't believe in the power of the political will by the European Union to avoid default, or they are underestimating this political union, he said. (Additional reporting by Daniel Bases in New York, Sergio Goncalves in Lisbon and Emily Kaiser in Singapore; Editing by Dan Grebler and Neil Fullick)