* Moody's flags Spain's vulnerability to funding stress
* Says has serious concerns about regional funding
* Spanish Treasury says downgrade reflects short-term mkts
By Walter Brandimarte and Elisabeth O'Leary
NEW YORK/MADRID, Oct 19 Moody's cut Spain's sovereign rating by two notches, citing the country's vulnerability to the euro zone debt crisis and piling pressure on EU leaders to act decisively at a summit this weekend.
It was the third, and most aggressive downgrade of Spain by a major rating agency in recent weeks. Moody's warned it could downgrade the euro zone's fourth-largest economy again if the crisis escalates further, saying high levels of debt in the banking and corporate sectors leave Spain vulnerable to funding stress.
Standard & Poor's and Fitch Ratings both rate Spain one notch higher than Moody's, which cut Spain's rating to A1 from Aa2.
Madrid has said it will get its public deficit down to 6 percent of GDP this year from 9.3 percent of GDP in 2010, but many economists say that is ambitious given a lack of fiscal discipline at regional government level.
"Downgrades of Spain's credit rating are coming fast and furious and are a reminder that the agencies, and many investors for that matter, have not become more sanguine about Spain. They have just become more concerned about Italy," said Nicholas Spiro, managing director of Spiro Sovereign Strategy.
In a statement, Spain's Treasury said the downgrade reflected a short-term reaction to negative euro zone debt markets, rather than a change in medium and long-term economic fundamentals, adding that the government remained committed to fiscal consolidation and reform.
The downgrade was not unexpected and Spanish bond yields rose only slightly. The 10-year Spanish government bond yield was 2.5 basis points higher at 5.391 percent in early European trade.
Madrid has imposed a deficit target on all 17 regional governments of 1.3 percent of GDP for this year, but many of them are expected to overshoot, pushing up the overall public deficit.
Moody's warned that worsening growth prospects for the euro zone will make it more challenging for Spain to reach its fiscal targets and said it continues to have serious concerns about regional governments' funding situation.
"Not all the regions are the same. But we do think the regions will deviate from the aggregate (deficit) target for this year," Kathrin Muehlbronner, senior analyst for sovereign ratings at Moody's, told Reuters by telephone on Wednesday.
Since Moody's placed Spain's rating under review in late July no credible resolution of the sovereign debt crisis has emerged, and it will take time for confidence in the area's political cohesion and growth prospects to return, Moody's said in a report.
"Moody's threatened to downgrade us by one notch in July, we enshrined a spending cap in the constitution and adopted various fiscal consolidation measures and now they downgrade us by two notches. We can't agree with them on this," an Economy Ministry spokesman said.
The downgrade puts more pressure on euro zone leaders, who will meet this weekend to discuss how to resolve the crisis.
"If the euro zone can't figure a way to handle the situation, you are going to see Spanish yields continue to go up, and they are going to have a problem funding themselves," said Jessica Hoversen, currency and fixed income analyst at MF Global in New York.
SPAIN REFORMS WELCOMED
Moody's move on Spain follows its recent downgrade of Italy's sovereign rating, to A2 with a negative outlook.
Moody's Muehlbronner, however, said Spain's efforts on reform of its pension system, the labour market and the financial sector, and other measures, had boosted its credit worthiness compared with that of Italy.
With Spanish elections due next month, Moody's will be monitoring the new government's actions and its commitment to fiscal consolidation, Muehlbronner said, welcoming recent cross-party support on the need to achieve fiscal consolidation and a balanced budget.
In August, the ruling Socialists and the centre-right opposition People's Party (PP) reached an agreement to establish limits on the public deficit and debt as part of the constitution.
The PP are expected to win a landslide victory at the Nov. 20 election.