Fitch sliced its rating on government debt three notches from A to BBB, barely above junk status, blaming the enormous projected cost of cleaning up the country's troubled banking sector, the deep recession and soaring national debt.

The downgrade came after it emerged European officials were weighing up a bailout programme for Spain that would aid its banking sector while imposing only limited conditionality on Madrid.

“Spain's high level of foreign indebtedness has rendered it especially vulnerable to contagion from the ongoing crisis in Greece,” Fitch said in a statement.

A leaked IMF report showed the country needs an immediate  €40bn cash injection, but it's estimated the country's banks would need at least  €60bn, or even as much as  €100bn in a “severe stress scenario” to pull them back from the brink of the financial abyss.

It is likely Spain will be mired in recession for the rest of this year and 2013.

A closely watched Spanish sovereign debt auction yesterday went better than some strategists had feared, but investors are still worried the state will struggle to pay its debts.

Ministers had already warned the government was close to being locked out of borrowing markets.

“Although the yield on the 10-year borrowing costs is just a tad below secondary market levels, these are prohibitive rates which underscore the dramatic deterioration in Spain's perceived creditworthiness,” said Nicholas Spiro of Spiro Sovereign Strategy.
“If it wasn't for its banks' continued support at auctions, Spain would be unable to sell its debt.”

German Chancellor Angela Merkel, who held a meeting with UK Prime Minister David Cameron, said the EU stood ready to act, but she has called for Europe to take a gradual path towards political union. Cameron urged immediate action, calling for measures to calm nervous markets.