By Julien Toyer and Daniel Bases
MADRID/NEW YORK (Reuters) - Standard & Poor's on Thursday cut its credit rating on Spain by two notches, citing expectations the government finances will deteriorate even more than previously thought as a result of a contracting economy and an ailing banking sector.
The ratings agency, which downgraded Spain to BBB-plus from A, also put a negative outlook on the credit and said Spain's situation could deteriorate further unless ambitious measures were taken at European level.
"We think risks are rising to fiscal performance and flexibility, and to the sovereign debt burden, particularly in light of the increased contingent liabilities that could materialize on the government's balance sheet," S&P said in a statement.
Moody's Investors Service rates Spain at A3 with a negative outlook, and Fitch Ratings at A, also with a negative outlook.
It was the first downgrade for Spain since Prime Minister Mariano Rajoy took office in December.
A spokeswoman for Spain's Economy Ministry said the S&P move did not properly reflect the impact that reforms announced by the government would have on reactivating an economy which has now entered in its second recession in three years.
"They haven't taken into consideration the reforms put forward by the Spanish government, which will have a strong impact on Spain's economic situation," Esther Barranco told Reuters.
The new centre-right government has announced a raft of reforms since being sworn in, including ones to make Spain's rigid labor market more flexible, strengthen its banking sector or prevent overspending in its highly devolved regions.
On Wednesday, the country's tightest budget since the 1970s passed its first hurdle in parliament after disappointing first-quarter figures fueled concerns the government would miss targets for reining in its deficit.
Spain spooked debt markets last month by unilaterally announcing a more modest budget deficit target. It has since agreed with the European Union to reach 5.3 percent of Gross Domestic Product this year and 3 percent by 2013, down from 8.5 percent of GDP in 2011.
But most economists view the task as being just impossible to achieve.
S&P, which forecast a 6.2 percent deficit in 2012 and 4.8 percent in 2013, said the front-loading of fiscal austerity in the country would likely exacerbate the numerous risks to growth over the medium term.
Sonny Kapoor, Managing Director at Re-Define, an economic think tank, said this would not be the last downgrade of both Spain and other euro zone countries "as the austerity-first approach starts to take its toll."
Several EU leaders backed a call on Thursday to aim the EU's stalling economy towards growth, saying that concentrating on budget savings alone could leave the continent in a prolonged slump.
S&P called on euro zone countries to manage better the sovereign debt crisis and said the Spanish economic outlook could deteriorate further unless strong measures were adopted at European level.
"Such measures at the eurozone level could include a greater pooling of fiscal resources and obligations, possibly direct bank support mechanisms to weaken the sovereign-bank links, and a consolidation of banking supervision or a greater harmonization of labor and wage policies," it said.
S&P also warned further downgrades could occur if it sees a rise in the net general government debt to more than 80 percent of GDP in the 2012-2014 period or political support for the reform agenda wanes.
(Reporting By Daniel Bases, Burton Frierson, and Pam Niimi; Editing by Dan Grebler and Sandra Maler)