Spain's credit rating slashed

A serious mishandling of the debt crisis by European leaders led Fitch to axe Spain's credit rating by three notches last night (Thursday) and issue a warning on the stability of the country's banks, debt levels and economy.

In a report that will be embarrassing for Berlin and Brussels, the credit rating agency said "policy mis-steps at the European level" and an "absence of a credible vision" for the euro had resulted in a "dramatic erosion of Spain's sovereign profile".

Spain's credit rating was cut to BBB from A, leaving the eurozone's fourth biggest economy languishing just two notches above junk status.

Fitch said the cost of bailing out its banks is likely to cost around  €60bn (£48.6bn) but could rise to as much as €100bn, more than three times higher than the €30bn in its previous "baseline estimate".

Fitch also hiked up its estimates of Spanish government debt levels from 82pc of GDP by 2013, made at the beginning of this year, to 95pc by 2015. The rating agency said that it no longer expected Spain's economy to return to growth next year, but instead to remain in recession for 2012 and 2013.

While Spain is at the centre of the storm, all "sinner states" have been affected, Fitch said. "The absence of a credible vision of a reformed [monetary union] and financial 'firewall' has rendered Spain and other so-called peripheral nations vulnerable to capital flight and undercut their access to affordable fiscal funding," the report said.

It added: "The dramatic erosion of Spain's sovereign credit profile and ratings over the last year in part reflects policy mis-steps at the European level that in Fitch's opinion have aggravated the economic and financial challenges facing Spain as it seeks to rebalance and restructure the economy.

"The intensification of the eurozone crisis in the latter half of last year pushed the region and Spain back into recession, exacerbating concerns over sovereign and bank solvency."

The flight of capital is set to continue as China's biggest sovereign wealth fund, China Investment Corp, yesterday revealed it was cutting exposure to Europe. Chairman Lou Jiwei said: "There is a risk the eurozone may fall apart and that risk is rising. Right now we find there is too much risk in Europe's public markets."

In another blow to Madrid, the deputy governor of the Bank of Spain, Javier Ariztegui, last night warned two more banks - Caixa Catalunya and Novagalicia - need  €9bn of state support. Madrid is determined to wait for the independent audits of its banks before announcing a rescue strategy. A leaked draft of an IMF audit, due to be published on Monday, will recommend that Madrid injects €40bn into the ailing sector.

The euro dropped suddenly against the dollar when Fitch's report was published; European stock markets had already closed.

Shares had staged a second day's rally, fuelled by a surprise move by China to cut its interest rates, and optimism that Angela Merkel was preparing to sanction a central rescue of Spanish banks. Traders were also relieved that Spain managed to hold an expensive but successful auction of €2bn bonds. Earlier gains were pared after Ben Bernanke, chairman of the US Federal Reserve, doused hopes of any imminent monetary stimulus. The FTSE 100 in London rose 1.2pc; Germany's DAX climbed 0.8pc and France's CAC was up 0.4pc.

Mrs Merkel used a joint press conference with David Cameron in Berlin to declare that "Germany is ready" to use the eurozone's full machinery to support Spain and the other sinner states.

The German chancellor said: "We have created the instruments for support in the eurozone and Germany is ready to use these instruments whenever it may prove necessary."

Mrs Merkel did not give details on the type of tools she was referring to, but traders jumped on the hope that the Chancellor was preparing to unleash the bail-out funds to prop up Spanish banks.

Mariano Rajoy, the Spanish prime minister, has lobbied for weeks for the European Financial Stability Fund (EFSF) and the European Stability Mechanism (ESM) to be allowed to lend directly to his country's banks. This week, officials in Brussels said plans were being worked on to use the funds to lead an "austerity-lite" rescue effort. The bail-out could be as much as €80bn.

Although Mario Draghi, president of the ECB, has said the funds do not have the mandate to bail-out banks, experts pointed to the provisions of the EFSF's "precautionary programme" that could be used to help Spain without a full bail-out.

Meanwhile, the eurozone was hit with yet more drastic economic data. French unemployment hit 10pc during the first quarter - up 0.2pc on the previous three months and 0.4pc year-on-year.

Greece's unemployment rate hit 21.9pc in March, spiking from 15.7pc a year earlier.