Moody's Investors Service has downgraded Spain's government bond ratings by one notch to Aa2 from Aa1 with a negative outlook, saying that the eventual cost of bank restructuring will exceed the government's current assumptions, leading to a further increase in the public debt ratio.

The government estimates the cost to be a maximum of €20 billion, less than 2 percent of gross domestic product (GDP), which is based on the capital requirements as percentage of risk-weighted assets as of Dec. 31 2010.

However, Moody's believes the overall cost is likely to be nearer to €40-50 billion, reflecting more than twice its earlier estimates of €17 billion.

Indeed, Moody's believes that, in a more stressed scenario, recapitalization needs could increase to about €110-120 billion.

Risks to Spain's government finances remain skewed to the downside as 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 ratings agency also expressed concerns over the ability of the Spanish government to achieve the required sustainable and structural improvement in general government finances, given the limits of central government control over the regional governments' finances and moderate economic growth in the short to medium term.

The recently published budget execution data for 2010 revealed that the path to fiscal consolidation remains unclear for some of Spain's regional governments. Last year, 9 out of 17 autonomous communities breached the budget deficit target of 2.4 percent of GDP, some by a wide margin. This casts doubts over the ability of the central government to exercise sufficient control over the regions to ensure compliance with deficit targets.

However, the agency said the Spain's country ceilings for bonds and bank deposits are unaffected by ratings action and they remain at Aaa in line with the Eurozone's rating. Spain's P-1 short-term rating is also unaffected by the latest downgrade.

What Could Further Push The Rating Down

Moody's would downgrade the ratings further if there are indications that Spain's fiscal targets will be missed and if the public debt ratio increases more rapidly than currently expected.

The ratings could also face further downward pressure if the recapitalization needs for the banking sector increase further beyond Moody's current expectations, as this would result in a further rise in government debt and increasing pressure on debt affordability.

What Could Change The Rating Up

Moody's would return the outlook to stable and upgrade the ratings if the rebalancing of the Spanish economy proceeded much faster than currently expected. The rating agency expects a modest acceleration in GDP growth in 2011 to an average rate of 0.8 percent.

On average, real GDP growth is expected at around 1.5 percent for the period 2012-2014. A sustained rebalancing towards a more export-driven economic model would also contribute to a reduction in the still elevated external vulnerability of the Spanish economy.

The implementation of effective policies to address the structural spending pressures at the regional government level, combined with stricter control by central government, would also be positive for Spain's creditworthiness.