Standard & Poor's cut Spain's credit rating 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 almost 60 basis points lower than those of Italy and, at 5.27 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.
The Financial Times quoted a senior Spanish official as saying that meeting the 6 percent deficit target would be difficult.
But Spain's Economy Minister Elena Salgado said later on Friday that there would be some margin for maneuver this year thanks about 2 billion euros raised by an auction of wireless frequencies and lower interest payments.
Interest payments by the central government will be at least 2 billion euros below budget. So the combined effect of the spectrum auction and lower interest payments will mean we have a margin of 0.4 percent (of GDP) Salgado 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 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.
The market's perception of Spain is that it's in a stronger position (than other debt-laden states) - with a strong defense on bank capitalization in place from the FROB bad bank fund, aggressive government action to control and cut spending and a 70 percent debt/GDP ratio, said Bill Blain, senior director at broker NewEdge Group.
The biggest problem, but the issue I read least about, is the unresolved crisis between central government making cuts and the reticence of regions to follow, he said.
Salgado said the government will shortly announce its plans to ensure Spain's heavily-indebted regions meet their tough 2011 deficit targets.[nE8E7L700E]
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 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.
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.
(Reporting by Balazs Koranyi, Mark Bendeich, Elisabeth O'Leary and Judy MacInnes; Editing by Catherine Evans and Patrick Graham)