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Rating agency Moody's put Spain on review for a possible downgrade on Friday, adding to concerns that a Greek rescue package has done little to halt the spread of Europe's debt crisis.
Moody's move to place the Aa2 government bond rating on review cited concerns over growth and said funding costs would continue to be high in the wake of eurozone leaders' bolder moves to curb the Greek crisis last week.
That added to a sense that Spain-and Italy-are still firmly in the firing line, and the euro and Spanish bond prices fell in response.
Particular focus rested on Spain's regional governments, many of whom are struggling with burgeoning debt loads after a decade of reckless spending. Analysts fear control over regions' debt loads is slipping out of the central government's grasp.
Regional authorities will miss their collective budget deficit target by up to 0.75 percent of gross domestic product (GDP), Moody's said, hampering the central government's program of austerity to reduce the overall shortfall.
"Regional governments' finances may prove difficult to control due to structural spending pressures, particularly in the healthcare sector," Moody's said in a release.
International investors are concerned the euro zone's fourth largest economy, hamstrung by anemic growth rates and high unemployment, will fail to put its fiscal house in order and need a Greek-style bailout. Nerves about that have sent bond yields to their highest level in over a decade.
Moody's current rating for Spain is in line with fellow rating agency S&P's AA setting, while Fitch Ratings has the country one notch higher at AA+
The euro fell more than 40 pips against the dollar in response and Spanish bond yields rose. Spain's cost of borrowing over ten years is now 6.11 percent compared to the 7 percent level broadly seen as unsustainable for the euro zone governments at risk in the crisis.
The country's rating remains at a high investment grade, far above those of Greece, Portugal and Ireland.
But while Moody's said any cut for Spain would likely be limited to one notch, it said the Greek package had signaled a clear shift in risk for bondholders across the euro zone.
"The trigger is that the (Greek) deal last week has not really rebuilt confidence across the euro zone so Spain is still on their radar screens with costs rising," said Giada Giani, analyst at U.S. bank Citi.
The Spanish Treasury said the external arguments supporting the ratings review relied excessively on short-term market developments in a letter sent to investors on Friday morning and seen by Reuters.
"Moody's assumes that the current high yields that have been generated by the resolutions around the Greek crisis will become a permanent burden on non-AAA sovereign funding costs," the Treasury said.
Spanish bank shares also fell over 2.4 percent as Moody's placed the debt and deposit ratings of five Spanish banks, including the euro zone's biggest bank Santander, on review for downgrade, in line with the sovereign.
RESCUE FUND CONCERNS
While the Greek rescue package set a precedent for private sector participation in future restructuring in the euro area, Moody's highlighted concerns about when or how the euro zone's rescue fund (EFSF) would be able to engage more strongly in battling the crisis.
"The package has not relieved market concerns over the position of such sovereigns because (i) it sets a precedent for private sector participation in future sovereign debt restructurings in the euro area, and (ii) while an expansion of powers has been proposed for the EFSF, it is not clear when the powers will be implemented," the agency said.
Moody's placed the Aa2 rating of Spain's bank restructuring fund, the FROB, on review for possible downgrade as its debt is underwritten by the sovereign.
The agency also downgraded the ratings of six Spanish regions reflecting the deterioration in their fiscal and debt positions. The regions were Castilla-La Mancha, Murcia, Valencia, Catalonia, Andalusia and Castilla y Leon.
It placed a further seven regional debt ratings under review for downgrade.
The Spanish government has set a deficit target of 1.3 percent of gross domestic product for the 17 regions for this year and next, but some of their new governors say this will be impossible due to previous leaders' fiscal mismanagement.
"That the regions are going to overshoot is clear," said Antonio Garcia Pascual, chief economist for Southern Europe at Barclays Capital in London.
"The question will be whether the central government can create a buffer which is big enough to offset that effect, and that is going to be complicated. In the fourth quarter all the skeletons will start to come out of the closet."
According to a Deutsche Bank study, if all the regions with a deficit above 3 percent in 2010 follow Catalonia's lead in missing the deficit target by a third, it would inflate the overall public deficit by 0.64 percentage points.
The government is aiming for an overall public deficit of 6.0 percent of GDP this year, compared to 9.2 percent of GDP in 2010-something that also largely depends on growth.
Data on Friday showed Spain's unemployment inched down to 20.9 percent in the second quarter, remaining by far the highest in the EU.
"There seems to be an indication that there's some stabilization, but the key point is the labor market remains extremely distressed," economist at RBS Silvio Peruzzo said.