Moody's Investors Service said on Wednesday it is reviewing Spain's ratings and may lower them by as much as two levels due to sliding growth expectations and mounting fiscal challenges.
The rating's agency, the only major agency that still maintains a top rating for Spain, said it was conducting a three-month review of the country's Aaa local and foreign currency government bond ratings.
The rating agency also cited concerns over the impact of rising funding costs over the medium term.
If at the conclusion of the review, Spain's ratings are lowered, it would most likely be by one, or at most two, notches, Moody's said.
Spain has been the target of intense speculation in sovereign debt markets as the next country in the euro zone to need European Union help after Greece, though the government has firmly denied it had any problem meeting financing obligations.
Moody's senior risk analyst Kathrin Muehlbronner said the review should not be taken out of context and Spain remained a highly rated country.
The contagion has been so dramatic in the markets in the last few months people forget really what a gulf there is between Spain and Greece ... Spain is a very highly credit worthy country, Muehlbronner said in a telephone interview with Reuters following the announcement.
The policies that the government is now proposing to pursue should eventually reach in to the conscience of the market ... but the issue where the deficit and debt has increased and we're looking at a situation that is somewhat more difficult to unwind than it was before.
Spain's had a public deficit of 11.2 percent of gross domestic product in 2009 while the debt-to-GDP ratio stands at around 55 percent, which Moody's said it expects it to rise to 80 percent of GDP by 2014.
The government announced in early June a 15 billion-euro ($18.35 billion) savings plan to help cut the deficit to 3 percent of GDP by 2013, though the rating's agency said low growth forecasts would make this difficult.
Moody's sees Spain's average growth at 1 percent over the 2010-2014 period compared to the government's projections of around 3 percent by 2013.
Moody's believes that more fundamental adjustments to key spending items will be required in order to achieve the government's budget deficit targets, said Muehlbronner in a statement.
The cost to insure Spain's debt with credit default swaps had tightened earlier on Wednesday to 260 basis points, or $260,000 per year to insure $10 million in debt for five years, from 273 basis points on Tuesday's close, according to Markit Intraday.
Spain's 10-year bono spread against the German bund stood at around 202 basis points late on Wednesday, off a recent high of 238 bps, but well above around 80 bps in April.
The euro slightly pared gains versus the dollar after the Moody's announcement.
Moody's said one of the key reasons for the review was concern over the impact of rising funding costs in the medium term as reforms of the labor market, the banking system and the pension system took time to restore investor confidence.
The labor market reform is currently in parliament for review, and Muehlbronner said she hoped legislators would strengthen the bill, which aims to make hiring and firing easier and put more young people to work.
Spain suffers the highest level of unemployment in the euro zone at over 20 percent, while more than 40 percent of those under age 25 available for work are unemployed.
On the banking system restructuring process, which the Bank of Spain said on Tuesday was close to completion, the analyst said she did not think the government would need to recapitalise the banks much more than had been already earmarked.
We don't expect that there is a massive extra recapitalisation need for the banks above what the government has stated, and hopefully the stress tests that come out will help calm the markets, Muehlbronner told Reuters.
The Bank of Spain has said it will publish a stress test for the banks soon.
The consolidation of Spain's mostly unlisted savings banks could cost as much as 30 billion euros, the government has said, though the current round of bank mergers has tapped the bank restructuring fund for just over 10 billion euros so far.
Investor nerves have also been tested over a Spanish debt redemption hump of 16.2 billion euros by the end of July.
The government claims they will not need to tap the market to meet the repayment, but there are concerns they will struggle to meet payments.
We don't see July's redemption as being a problem, Moody's senior analyst Kristin Lindow told Reuters.
Fitch Ratings cut Spain's credit ratings to AA-plus, the second highest level, from AAA on May 28, saying its economic recovery would be more muted than a government forecast, pushing world equities and the euro lower.
The downgrade followed a cut by Standard & Poor's in April.
(Additional reporting by Walden Siew, John Parry and Karen Brettell)