Forget Greece and Ireland... one of the most important eurozone countries just took a turn for the worse

Spain's credit rating was cut to Aa2 by Moody's Investors Service, which said the cost of shoring up the banking industry will eclipse government estimates. The euro weakened and Spanish bond yields rose.

Spanish lenders will need as much as 50 billion euros ($69 billion) to meet new capital requirements, Moody's forecast, more than double the 20 billion euros seen by the government. The risks to public finances are "skewed to the downside," the company said in a statement today. The outlook is "negative," suggesting more rating cuts are under consideration.

Spain has taken unprecedented measures to avoid following Greece and Ireland into a bailout, implementing the deepest budget cuts in at least three decades. As European leaders negotiate a reinforced rescue effort, Spain is tightening capital requirements for banks in a bid to show investors that its lenders can weather a fourth year of economic slump with an unemployment rate over 20 percent.

"This will put extra pressure on EU policy makers when they meet later in the month to offer some kind of credible solution to the crisis, including raising the funds available to back countries which at least at this stage do not have a real solvency problem, such as Spain," said Sebastian Paris-Horvitz, chief market strategist at HSBC Private Bank Suisse SA.

Spread Widens

The gap between Spanish and German borrowing costs widened 3 basis points today to 225 basis points, as the yield on 10-year notes rose to 5.49 percent. The cost of insuring Spain's debt rose 8 basis points to 258, according to CMA prices for credit-default swaps. The euro slid 0.5 percent to $1.3836 as of 10:00 a.m. in London.

Moody's shows a "clear excess of zeal in evaluating the risks," and doesn't take into account "the manifest commitment of the government" to deficit cutting, Soledad Nunez, the director of Spain's Treasury said in a phone interview. It's "quite surprising" that the company didn't wait for the Bank of Spain to publish its assessment of banks' capital shortfall later today, "given the importance Moody's assigns to the budget impact of restructuring the financial system," she said.

Spain's bond yields remain within budgeted levels and the Treasury has completed 24 percent of its planned financing via bonds for this year, Nunez said.

EU Efforts

As Spain tries to convince investors that struggling savings banks won't overburden its public finances, European Union leaders have set a March 25 deadline to approve a package of measures to end the sovereign debt crisis.

"The crisis in the euro region is going to take a long time to resolve, and the rating downgrade of Spain is a reflection of that," said John Stopford, head of fixed income at Investec Asset Management in London, which manages about $80 billion. "Any expectation that meetings in March are going to lead to a quick solution is a bit naive."

The 40 billion to 50 billion-euro estimate for banks includes funds that may be raised privately, Bart Oosterveld, managing director at Moody's Sovereign Risk Group, said in an interview. He declined to forecast how much of that total the government may end up providing.

Finance Minister Elena Salgado has said "all or part" of the government's 20 billion-euro maximum estimate will be raised privately. Goldman Sachs Group Inc. said on March 8 it estimates the system has capital needs of 22 billion to 59 billion euros.

'Fickle' Markets

"Meaningful private-sector involvement in recapitalizing the cajas could reduce the number on the debt," Oosterveld said. "Markets are fickle and Spain is one of the countries that would be susceptible to possible funding stress in the market."

Moody's had put Spain's rating on review on Dec. 15, after lowering its credit grade to Aa1 from Aaa in September. Fitch Ratings, which calls Spain AA+, changed the outlook to "negative" on March 4. Standard & Poor's rates the nation AA, after stripping it of its top AAA grade in January 2009.

As part of its effort to regain investors' confidence, the government tightened capital requirements for lenders on Feb. 18, setting core capital ratios of 8 percent for listed banks and 10 percent for lenders that don't have shareholders and depend on wholesale funding.

Economic Slump

Spain's economy emerged from an almost two-year recession last year before contracting again in the third quarter. The government forecasts economic growth of 1.3 percent in 2011, even as the unemployment rate remains above 20 percent, the highest rate in Europe.

Spain is trying to cut the budget deficit to 6 percent of gross domestic product this year – in line with France's targeted shortfall – from 9.2 percent last year when it was the third-largest in the euro region. While the central government beat its budget goal last year, regional administrations, which control health and education and employ half of public workers, overstepped their combined target, government data show.

Moody's cited the 17 regional governments as a risk for the overall budget.

"There are no new policy initiatives to reduce the regions' structural spending pressures in the areas of healthcare and education," the company said. This year's deficit target for the regions of 1.3 percent of GDP is "significantly more ambitious than that of last year, and the effort required to implement it would be quite unprecedented for many regions."