Standard & Poor's cut Spain's credit rating on Friday, sending the euro briefly lower and underlining the challenges facing Europe's major powers as they meet G20 counterparts over the euro-zone debt crisis.
S&P, whose move mirrored that by fellow ratings agency Fitch last week, cited high unemployment, tightening credit and high private-sector debt among reasons for cutting the nation's long-term rating to AA- from AA.
Spanish 10-year government bond yields rose slightly in response, although they remained more than 60 basis points lower than those of Italy and, at 5.24 percent, some distance from the 7 percent level widely regarded as unsustainable.
Despite signs of resilience in economic performance during 2011, we see heightened risks to Spain's growth prospects due to high unemployment, tighter financial conditions, the still high level of private sector debt, and the likely economic slowdown in Spain's main trading partners, S&P said.
It also noted the incomplete state of labor market reform and the likelihood of further asset deterioration for Spain's banks, and downgraded its forecast for Spanish economic growth in 2012 to about 1 percent, from the 1.5 percent it forecast in February.
High yields on Spanish government bonds point to concerns that it could be the next euro zone economy to require a Greece-style bailout, and despite an unpopular austerity program, doubts remain that Spain will meet its deficit target of 6 percent of GDP this year.
S&P underestimates the scope of the unprecedented structural reforms undertaken, which will obviously take time to bear fruit, Spain's Treasury said in a statement to investors on Friday.
But a senior Spanish official told the Financial Times that meeting the 6 percent deficit target would be difficult. And if the (2011) deficit is above 6.5 percent, it's worrying, the official said.
S&P announced the downgrade as finance ministers and central bank chiefs from the world's 20 biggest economies were due to meet later on Friday in Paris amid pressure to find an urgent and convincing solution to the deepening debt crisis.
Spanish unemployment, at 21 percent, is the highest in the European Union, reflecting a stagnant economy, the collapse of a decade-long housing boom and cuts aimed at taming a public sector deficit that reached 11.1 percent of GDP in 2009.
The decision to shelve multi-billion-euro privatization plans, mainly due to tough market conditions, has meanwhile deprived the state of much needed revenues to cut borrowing and left little room for maneuver in its public finances.
Juergen Michels, economist at Citi in London, said the market was still wary of developments in Spain's regional public finances, and was aware that fiscal problems would not disappear any time soon.
A botched labor market reform in 2010 did little to alleviate joblessness that is concentrated mainly amongst younger Spaniards, and a new government after November 20 general elections will be under pressure to tackle the issue.
The center-right People's Party is expected to win the election easily and deepen austerity measures but they have shied away from presenting specific policy measures for fear of eroding public support.
Like Fitch, which also now rates Spain at AA-, S&P signaled further possible downgrades for Spain, saying there was still a risk the euro zone's fourth-largest economy could slip into recession next year, with a 0.5 percent contraction.
The euro reached a session low of $1.3723 after the downgrade, but later recovered to hit $1.3828 on reports the European Central Bank was buying Spanish and Italian debt.
Hopes that G20 officials would agree on the outlines of a plan to resolve the debt crisis ahead of a European Union summit on October 23 also buoyed the shared currency, which remained on course for its biggest weekly rally since January.
Spain's blue chip index was little affected by the rating cut.
Finance chiefs from outside the euro zone are expected to speak frankly when they meet their European counterparts at Friday's G20 meeting, given impatience growing over the crisis and its implications for the rest of the world.
Canadian Finance Minister Jim Flaherty set the tone late on Thursday, telling reporters before leaving Ottawa that euro zone actions were short of what was needed.
On Thursday, Fitch cut credit ratings or signaled possible downgrades for several major European banks. It downgraded UBS and Royal Bank of Scotland. It also placed Barclays Bank, BNP Paribas, Credit Suisse, Deutsche Bank and Societe Generale on watch negative.