The credit rating agency Standard & Poor's has cut Spain's sovereign debt rating, warning that the government's budget situation is worsening, even as new data showed that the country's unemployment figures had hit record levels.
S&P cut the country's rating to "BBB+" from it's previous level of "A", saying that it expected the Spanish economy to shrink over the next two years.
The agency also cut the country's short-term rating, and placed it on negative outlook, meaning that there is a risk of further downgrades to come.
"We believe that the Kingdom of Spain's budget trajectory will likely deteriorate against a background of economic contraction in contrast with our previous projections," it said in a statement on Thursday.
"At the same time, we see an increasing likelihood that Spain's government will need to provide further fiscal support to the banking sector."
S&P predicts the Spanish economy will shrink by 1.5 per cent this year, having previously forecasted growth of 0.3 per cent. Spain's new conservative government has forecast that the economy will contract by 1.7 per cent this year.
In 2013 it expects the economy to contract 0.5 per cent, having previously predicted growth of one per cent.
The Spanish central bank confirmed this week that Spain is in recession for the second time in three years.
The "BBB+" rating is still in investment grade, three levels above junk status. Nevertheless, the lower rating could increase Spain's borrowing costs because investors will likely demand higher interest rates to compensate for the perceived increase in risk.
S&P's cut in Spain's rating was not unexpected. Ratings agency Moody's had cut the country's rating by two notches in early February, citing the country's difficult fiscal outlook.
According to new data released on Friday, Spanish unemployment levels hit 24.44 per cent at the end of March, the highest level since a statistical series began in 1996.
The number of unemployed people in the country has now risen to 5,639,500 people, according to the national statistics institute.
Unemployment has risen 1.5 per cent, from a level of 22.9 per cent of the labour force in the final quarter of 2011.
The institute also said that the number of households with every member unemployed rose by 153,400 to 1.7 million.
Spain has the highest unemployment rate in the 17-member eurozone.
The Spanish government responded to the cut by S&P by saying that the agency did not properly take into account reforms put in place to reactivate the economy.
"They haven't taken into consideration the reforms put forward by the Spanish government, which will have a strong impact on Spain's economic situation," Esther Barranco, a government spokeswoman, told the Reuters news agency.
The agency did praise some of the government's measures aimed at bolstering the economy.
"Despite the unfavourable economic conditions, we believe that the new government has been front-loading and implementing a comprehensive set of structural reforms, which should support economic growth over the longer term," said S&P.
It added that Spain's commercial banks are increasingly leaning to official sources for funds as they struggle to deal with piles of bad loans, especially in real estate.
S&P also pointed out, however, that Spanish incomes have been falling, businesses have been rapidly cutting debt rather than investing, and the government's plans to cut expenses in order to balance its budget.
All of these factors, it said, will act as a drag on ecomomic growth.
Al Jazeera's Sonia Gallego, reporting from Madrid, said that economists were concerned that while the government has been implementing reforms, the country simply does not have enough economic growth.
"What economists have been forseeing is that on the one hand there's all these reforms that the Spanish government is putting into place that are necessary. On the other hand, though, it is also necessary in order for those reforms to work for there to be some kind of growth ... in the Spanish economy. And that's something that's just not happening right now," she reported.
The government of Prime Minister Mariano Rajoy has pushed through deficit-reduction steps including labour market and financial sector measures. S&P praised the government's labour market reforms, which it said would slow the pace of job-cutting and eventually help improve the employment picture.
It warned, however, that the measures would not create new jobs in the short-term.
"As a consequence, the already high unemployment rate - especially among the young - will likely worsen until a sustainable recovery sets in,'' S&P said.
The agency also gave a damning assessment of the situation in the rest of Europe, saying: "In our view, the strategy to manage the European sovereign debt crisis continues to lack effectiveness."
The agency suggested measures by the eurozone could include a pooling of resources and obligations between member countries and policies to harmonise wages across the currency bloc.