07/29/2011 08:11 EDT | Updated 09/28/2011 05:12 EDT

Moody's: Spain Credit Rating Could Face Downgrade

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MADRID - Moody's warned on Friday that it may downgrade Spain's credit rating over the coming three months given the country's weak economic growth prospects as well as ongoing funding pressures.

In a statement, the ratings agency said any reduction of the current Aa2 rating would likely be limited to one notch unless an "unexpected development" happens. A one notch reduction would take the rating down to Aa3, still a healthy investment grade.

Separately, Spain announced Friday that that the nation's jobless rate for the second quarter dropped slightly — to 20.9 per cent from 21.3 per cent during the January-March period. It is still the eurozone's highest unemployment rate.

Most job gains were in the services sector as Spain headed into its heavy summer tourism season, though industry also posted a small uptick. The country shed more jobs in the construction and agriculture sectors.

Moody's said funding pressures on Spain are likely to increase following last week's bailout package for Greece, which has set the "precedent" of private sector involvement. Banks are being asked to rollover and swap their Greek debt holdings in an effort to relieve the burden on the country.

Moody's said Greece's second bailout package "has signalled a clear shift in risk for bondholders of countries with high debt burdens or large budget deficits."

Spain has struggled with the aftermath of a collapsed real-estate boom, and experts are predicting years of sluggish growth ahead. Though its debt burden is not as high as Greece's, it does run a fairly sizable budget deficit, which requires funding in the bond markets on a constant basis.

Its cost of borrowing has been going up sharply in recent weeks even after last week's Greek deal, which was also supposed to ease the pressures on much bigger economies such as Spain and Italy.

Spain's costs — and Italy's for that matter — rose further in the aftermath of the Moody's warning. The yield on Spain's 10-year bonds ratcheted up another 0.10 percentage point in early trading Friday to 6.10 per cent. That means that the difference between Spain's rate and the benchmark German rate stands at 3.5 percentage points.

Though Moody's said its ratings are not affected by short-term market moves, it added that the risk of "a sustained rise in funding costs nevertheless has to be factored into the agency's analysis of a country's prospective debt affordability."

Usually, these reviews take up to three months to be completed.

Moody's downgraded six Spanish regions by one notch Friday. Some of the biggest regions, including Catalunya and Castilla-La Mancha, saw their ratings cut. Others, including the Basque Country and Galicia, have been placed under review for downgrade.

The agency said one of the reasons behind its downgrade review for Spain as a whole is the state of the regional governments.

"Moody's views positively that the central government has been successful in meeting its near-term fiscal consolidation targets, but the rating agency nonetheless notes that challenges to long-term budget balance remain due to Spain's subdued economic growth and fiscal slippage within parts of its regional and local government sector," Moody's said.

In addition, Moody's placed five Spanish banks, including Banco Santander SA and Banco Bilbao Vizcaya Argentaria SA, on review for possible downgrade.

Banco Santander is Spain's top bank and eurozone's largest by market capitalization. BBVA is Spain's No. 2 bank. Both are making significantly more money from Latin American operations, while their Spanish businesses continue to erode.