Standard & Poor's has cut Spain's sovereign credit rating to BBB-minus, just above junk level, citing a deepening economic recession that is limiting the government's policy options to arrest the slide.
The S&P downgrade on Wednesday comes with a negative outlook reflecting the credit ratings agency's view that there are significant risks to economic growth and budgetary performance, plus a lack of clear direction in eurozone policies.
"In our view, the capacity of Spain's political institutions (both domestic and multilateral) to deal with the severe
challenges posed by the current economic and financial crisis is declining," S&P said in a statement.
The country has been in recession since earlier this year, its second economic contraction in just a few years, and
unemployment is stubbornly high at close to 25 per cent with a return to job creation still two years away.
Falling tax revenue and rising costs of unemployment benefits are confounding the government's efforts to hit a 2012 deficit reduction target of 6.3 per cent of gross domestic target agreed with the European Union.
Both the International Monetary Fund and Spain's own Central Bank cast doubt on the savings envisioned in Prime Minister Mariano Rajoy's 2013 budget, saying they are based on a too-rosy outlook for the economy.
In the wake of the downgrade, the euro dropped about 0.25 per cent to $1.2865 in late New York trade from just under
$1.29 prior to the news.
"This is weighing on the euro. A downgrade from S&P could be followed by a downgrade from Moody's, and while S&P did not downgrade Spain to junk, Moody's might," said Kathy Lien, managing director at BK Asset Management.
'Respect our commitments'
The downgrade came just hours after the leaders of France and Spain, meeting in France, vowed concerted
action on the eurozone.
"France and Spain share the same concept of what needs to be done," French President Francois Hollande said at a joint press conference, adding that EU leaders at a summit later this month must "move forward as much as possible" on issues including bank supervision, the role of the European Central Bank and a banking union.
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Rajoy also stressed the importance of the banking union and banking supervision and said action was needed before the end of the year "to show that we are taking this seriously and that we respect our commitments".
He also said that Greece, another troubled economy, should stay in the eurozone.
"I am entirely convinced that between all of us, we will find the formula so that Greece can respect its commitments and the others can make opportune decisions so that Greece can remain in the eurozone."
Europe's debt crisis is having a disastrous effect on the economy. France has not seen economic growth for three quarters and Spain is in its second recession in three years.
"If we resolve the eurozone issues, if we implement our decisions, if we are conducting policies, our budget control and, at the same time, support productivity and competitiveness, then we will have growth figures that will be different from the forecast growth figures that are related to the context," Hollande said.
"The IMF's forecast has been done in the context of today. But the pole of politicians is to ensure tomorrow isn't the same as today."
Rajoy's centre-right People's Party has an absolute majority in parliament and so far has been able to pass spending cuts and economic reforms without any problem.
However, street protests have increased in recent months as Spaniards revolt against public sector wage cuts and lower spending on education and healthcare. Resentment is also rising over huge public bailouts for the country's crippled banks, while social benefits are cut.