Moody's Investors Service on Tuesday cut Spain's sovereign ratings by two notches, saying high levels of debt in the banking and corporate sectors leave the country vulnerable to funding stress.
Worsening growth prospects for the euro zone will also make it more challenging for Spain to reach its ambitious fiscal targets, the ratings agency added.
In particular, Moody's said it continues to have serious concerns regarding the funding situation of the regional governments.
Spain has said it will deflate its public deficit to 6 percent of GDP this year from 9.3 percent of GDP in 2010, though many economists are concerned this could be derailed by a lack of fiscal discipline at regional level.
The government's regional deficit target is 1.3 percent of GDP for this year.
Not all the regions are the same. But we do think the regions will deviate from the aggregate (deficit) target for this year, Kathrin Muehlbronner, senior analyst, Sovereign Group Moody's told Reuters in a telephone interview on Wednesday.
Spain could be downgraded again if the euro zone debt crisis escalates further, Moody's warned.
Since placing Spain's ratings under review in late July, no credible resolution of the current sovereign debt crisis has emerged, and it will in any event take time for confidence in the area's political cohesion and growth prospects to be fully restored, Moody's said in a report.
The downgrade puts more pressure on euro-zone leaders, who will meet this weekend to discuss a solution for the crisis. Britain's Guardian newspaper on Tuesday reported that Germany and France have agreed to boost the euro zone's bailout fund to 2 trillion euros, causing markets to rally.
Moody's downgrade on Spain was the third received from the big-three ratings agencies in the past few weeks. Moody's was more aggressive than its rivals, however, cutting the country's ratings to A1 from Aa2.
Standard & Poor's and Fitch Ratings both have Spain one notch higher.
Market analysts said the news, although not unexpected, highlighted the seriousness of the European debt crisis.
If the euro zone can't figure a way to handle the situation, you are going to see Spanish yields continue to go up, and they are going to have a problem to funding themselves, said Jessica Hoversen, currency and fixed income analyst at MF Global in New York.
SPAIN REFORMS WELCOMED
Tuesday's rating action on Spain follows Moody's recent rating actions on the sovereign ratings of Italy, cut to A2, with a negative outlook.
Spain's track record of reforms, including a reform of the pension system, the labor market and the financial sector, have boosted its credit worthiness compared with that of its southern European neighbor, Muehlbronner said.
Moody's will now be monitoring the actions of the next government to emerge after Spain's November elections and their commitment to fiscal consolidation, she said, welcoming recent cross party support for fiscal consolidation and achieving a balanced budget.
In August, the ruling Socialists and the center-right opposition People's Party (PP) reached an agreement to establish limits on the public deficit and debt as part of the constitution.
The PP are expected to win a landslide victory at the November 20 polls.
(Additional reporting by Richard Leong and Daniel Bases and by Judy MacInnes in Madrid, Editing by James Dalgleish, Leslie Adler, Gary Hill)