|Spain's banks have been hit particularly hard by the bursting of the nation's property bubble [EPA]
Spain's debt has been downgraded by one notch to Aa2 by the ratings agency Moody's, which warned it may have to do so again.
The US-based agency cited worries over the cost of restructuring the country's banking sector, the government's ability to achieve its borrowing reduction targets and grim economic growth prospects.
It said a further downgrade was possible if indications emerge that Spain's fiscal targets will be missed, and if the public debt ratio increases more rapidly than currently expected.
Moody's also expressed concern that the funding requirements for Spain's troubled savings banks, called cajas, could end up greater than anticipated.
The cajas have been hit particularly hard by the bursting of the nation's property bubble, which saddled them with billions of euros in bad loans.
On the plus side, Moody's noted the government's resolve in dealing with its problems and added that Spain's debt sustainability is not under threat.
Elena Salgado, the Spanish finance minister, said that the government agreed that the nation must make a better effort to push debt-laden regional governments to reduce their deficits.
However, Salgado said that Moody's should have waited for the Bank of Spain to release its own report on the banks' capital needs after markets close on Thursday.
While the government has previously estimated that the cajas need no more than $27.8bn, or less than two per cent of Spain's gross domestic product, Moody's predicted the cost could reach $55bn to $70bn and might eventually come in at a massive $140bn to $170bn.
Fitch, another ratings agency, said on Thursday that the Spanish banking system would need at least $53bn to clean up its balance sheets, and may require as much as $135bn based on the losses at Irish banks.
Spain's government is trying to tackle its borrowings by reducing spending and raising taxes.
Last year, it reduced its budget deficit by around two percentage points to 9.2 percent of national income.
But unemployment has shot up to more than 20 per cent amid predictions of gloomy economic growth, and Spain is also being hit by high oil prices sent skyrocketing by the unrest in Libya.
Spain's main stock index sank 1.3 per cent following the release of Moody's report.