Fitch cut Spain's credit rating by one notch on Friday, sending markets lower and capping a horrible week for a government struggling to convince investors it can solve its economic woes and avoid a Greek-style debt crisis.
Fitch Ratings linked the downgrade to AA plus from AAA to the record levels of household and corporate debt in Spain, as well as mounting public debt, which it said would act as a drag on economic growth.
World equities slid and the euro fell below $1.23 after the downgrade, which stoked fears that Spain, the euro zone's fourth largest economy, could suffer a crisis similar to the one which forced Greece to agree a 110 billion euro rescue with the EU and IMF earlier this month.
Because the Spanish economy is far bigger than Greece's, a crisis there would have far more serious implications for the 16-nation euro zone and global growth.
"Spain is the 800-pound gorilla in the room," said Win Thin, a senior currency strategist at Brown Brothers Harriman in New York.
Fitch is the second agency to cut its rating on Spain after Standard & Poor's downgraded the country last month. In addition to the debt woes, Fitch cited the inflexibility of the labor market and the cost of restructuring Spain's network of unlisted savings banks as hurdles to recovery.
The Spanish economy hit a wall when a housing bubble fueled by cheap credit burst. It was the only major economy in Europe not to emerge from recession last year.
The Spanish government said on Friday that talks with unions to agree an overhaul of labor market rules were not going well and that if necessary it would push a reform of workplace laws through parliament.
Unions have threatened a general strike if Socialist Prime Minister Jose Luis Rodriguez Zapatero's government pushes ahead with a reform to cut the cost of hiring and firing without their consent.
In order to reassure markets about the country's long-term solvency, the government was set to make a last-ditch attempt to clinch a deal in three-way talks at the weekend that will also include employers.
The prospect of industrial strife piles further pressure on Zapatero, whose government averted a bullet on Thursday by winning passage of a 15 billion euro ($18.4 billion) austerity package by a single vote in parliament.
A week after cutting its 2011 growth forecast to 1.3 percent from 1.8 percent, the government on Friday revised down its growth estimates for 2012 and 2013 to 2.5 percent and 2.7 percent, respectively.
Unions, which are already set for a public sector strike over pay cuts, have threatened a broader walkout to block a reform of rigid labor market rules that economists say is needed to put Spain on a solid economic footing.
There are also no guarantees that Zapatero would be able to win parliamentary approval for labor market changes given that his Socialists run a minority government.
"Even though the opposition is broadly in agreement with the reform, they're always going to go against the government's proposals," Nicolas Lopez, analyst at M&G Valores said.
The unions are traditional allies of the Socialists, and have until recently held back from big protests, like those seen in Greece, despite an unemployment rate of around 20 percent.
But Pedro Schwartz, an economist at San Pablo University in Madrid, said that could change quickly.
"Now they are beginning to make noises, things are so harsh they have to show they are not happy," he said.
Unions, which represent less than 20 percent of the workforce, are already set for a one-day strike over public sector pay cuts for June 8.
Unlike Greece, Spain's level of public debt remains low at under 70 percent of gross domestic product (GDP). But debt markets fear that without labor reform, unemployment will stay high, pushing the government down an unsustainable fiscal path.
The government's austerity drive aims to reduce the budget deficit to 9.3 percent of GDP this year and to 6 percent in 2011, down from 11.2 percent in 2011.
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