UPDATE 3-Fitch cuts Portugal rating one notch on debt levels

* Rating cut to A-plus, with negative outlook

* Growing debt and tough financing environment cited

* Analysts say cut had been expected by markets

* Govt disagrees with timing, says on track to cut deficit (Adds government reaction)

NEW YORK/LISBON, Dec 23 (Reuters) - Fitch Ratings on Thursday downgraded Portugal, citing burgeoning debt levels and a tough financing environment, in a move which analysts said had been largely expected by markets.

Fitch downgraded Portugal’s long-term and local currency ratings by one notch to A-plus, with a negative outlook, adding to a drumbeat of negative news on sovereign debt in Europe.

Portugal has moved into the eye of the storm in Europe’s debt crisis on concerns about its public finances, with investors worried it will be next to take a bailout after Ireland and Greece.

“Failure to meet its 2011 budget headline and structural deficit targets would erode confidence in the medium-term sustainability of public finances that underpins Portugal’s current sovereign ratings,” Fitch said.

The downgrade puts Fitch’s rating for Portugal on a par with Moody’s A1 rating, but still two notches above that of Standard and Poor’s A-minus.

“This is not a surprise, though it is still bad news and will have impact, particularly on Portugal’s financial sector,” said Joao Pereira Leite, an economist at Banco Carregosa in Lisbon, said. “The market was already expecting this and the current interest rates had already priced in this downgrade.”

The Portuguese government, however, questioned the timing.

“The downgrade by Fitch is, in the current moment, difficult to understand,” the Finance Ministry said in comments emailed to Reuters.

“Portugal has approved a 2011 budget with consolidation measures to cut the budget deficit and has budget results in late 2010 that gradually show the effects of measures taken earlier in the year,” it added.

It reiterated that Portugal’s banking system is solid and has the appropriate capital levels for the risks it faces, adding that Portugal has kept its commitments to investors.

“The financing of the republic has been processed at disproportionate prices, no doubt, but with regularity and without any hiccups regarding fulfilling obligations to debt holders,” the Finance Ministry said.

The premium investors demand to hold Portuguese 10-year bonds rather than safer German Bunds fell 2 basis points to 377 bps on the downgrade but recovered quickly to 381 bps, just under Wednesday’s settlement levels.

Last month, the spread hit a euro lifetime record of more than 481 bps but has narrowed since, thanks to bond buying by the European Central Bank.

The euro EUR= fell against the dollar and the Swiss franc after the downgrade. <^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ Graphics: Euro zone debt struggle BREAKINGVIEWS-Moody's warning is too soft [ID:nLDE6BK0PY] More on euro zone debt [nLDE6T0MG] ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^>

The downgrade came just two days after Moody’s Investor Service warned it may downgrade Portugal’s A1 rating by one or two notches after a review that will take up to three months, citing high borrowing costs and weak growth prospects. [ID:nLDE6BK0HV]

The Portuguese government has pledged to cut the budget deficit from a projected 7.3 percent of gross domestic product this year to 4.6 percent in 2011 by increasing taxes and cutting spending, including a 5 percent cut in civil servants’ wages.

Fitch, however, warned the target will be “extremely challenging” especially if, as Fitch expects, the economy falls into recession next year.

“The scenario of a recession in 2011 is understandable, especially as the government’s projection of 0.2 percent growth is based on exports, which is a pretty fragile and unpredictable base that does not depend only on Portugal itself,” Pereira Leite of Banco Carregosa said.

Fitch did say it sees the Portuguese economy entering a sustainable recovery from 2012, which with fiscal adjustment and a smaller current account deficit “will place public and overall foreign debt in a sustainable path.”

“They (Fitch) even say there is light at the end of the tunnel, which is something we haven’t heard for a while about Portugal. So not everything was negative with this report,” said Filipe Garcia, head of Informacao de Mercados Financeiros consultants in Porto. (Reporting by Shrikesh Laxmidas, Sergio Goncalves, Daniel Alvarenga and U.S. Treasury Desk; editing by Ron Askew and Leslie Adler)