The Spanish government's dilemma over whether to request a European bailout has become more acute following a downgrade of the cash-strapped country's credit rating.

Standard & Poor's late Wednesday cut its rating on Spain's debt by two notches to BBB-, just a step above junk status, or non-investment grade. By indicating that it's a riskier asset to hold, S&P's downgrade may make it more expensive for the Spanish government to borrow money as it might scare off some of its bond investors.

The agency said it was concerned by the deepening economic recession, which has seen unemployment rise to nearly one in four and fueled social discontent. It also noted that the government's hesitation in requesting a European financial lifeline was "potentially raising the risks to Spain's rating."

Though S&P's warning may nudge the Spanish government to make a bailout request sooner rather than later, rival agency Moody's has indicated it may cut its rating for Spain in the event of a bailout request.

"It would appear that when it comes to the rating Spain is a bit between a rock and a hard place," said Gary Jenkins, managing director of Swordfish Research.

The Spanish government said the downgrade was unjustified but argued that it would have little, if any effect, on its plans to raise money in the money markets.

"The evaluation by Standard and Poor's caught us by surprise," Spain deputy Economy Minister Fernando Jimenez Latorre said Thursday. "We don't agree with its reasons."

Despite the downgrade, Spanish stocks posted solid gains as investors were cheered by some strong U.S. jobs data. And the yield on the country's 10-year bond was more or less unchanged, around the 5.74 percent level, as investors weighed up whether the country would tap a new facility from the European Central Bank.

Last month, the ECB announced a new plan to keep a lid on the borrowing costs of indebted countries like Spain. It said it would buy unlimited amounts of debt of struggling European countries. However, the governments first need to apply for a eurozone bailout and so far the Spain's has balked at the prospect.

Instead, the government led by Prime Minister Mariano Rajoy has introduced a series of austerity and labor measures in a bid to bring down its deficit and convince investors it can manage its finances without outside help.

Though it has raised around 90 percent of the money it needs to service its debts in 2012, Spain will have to tap investors for around €200 billion ($258 billion) in 2013.

"Not easy to raise that kind of money with that kind of rating when the economic data is likely to come in worse than government forecasts," said Swordfish's Jenkins.

Like many other countries in Europe, Spain is living way beyond its means. Its budget deficit is running at a little over 6 percent of gross domestic product, double the amount allowed by EU rules.

That is adding to Spain's public debt burden, which the government forecasts will rise to 80 percent of GDP this year from 69 percent last year. It projects it hitting 90 percent next.

Households are also struggling financially amid high unemployment and the implosion of a property bubble.

Earlier this week, the International Monetary Fund forecast that the Spanish economy would contract 1.3 percent next year, more than double the Spanish government's own prediction.

Rajoy on Wednesday said the country was making important reforms and that those, combined with Europe's efforts to increase economic integration, would prove the IMF wrong.

"If we follow that strategy ... we'll see that the reality turns out to be better than the forecasts," Rajoy said.

The prevailing view in the markets remains that Spain will have to request outside help, possibly after regional elections later this year, given the scale of the task in hand.

"With a large proportion of their funding for the year already completed we expect them to have sufficient funds to hold out until regional elections are out of the way later this year," said Elisabeth Afseth, an analyst at Investec.

She noted that Spain's bond redemption payments at the end of January may be uncomfortably costly if it does not tap the European financial aid program.

Christine Lagarde, the head of the IMF, this week voiced her concerns at the impact Europe's austerity drive was having on economic growth, both in the continent and globally. The IMF downgraded its global growth estimates for this year and next.

Spain, alongside many other European countries, has slashed spending and raised taxes to get a handle on its debts and to regain investors' confidence in its public finances.


Pylas reported from London.