(Reuters) - Spain's sickly economy faces a "crisis of huge proportions", a minister said on Friday, as unemployment hit its highest level in almost two decades and Standard and Poor's downgraded the government's debt by two notches.
Unemployment shot up to 24 percent in the first quarter, one of the worst jobless figures in the developed world. Retail sales slumped for the twenty-first consecutive month as a recession cuts into consumer spending.
"The figures are terrible for everyone and terrible for the government ... Spain is in a crisis of huge proportions," Foreign Minister Jose Manuel Garcia-Margallo said in a radio interview.
Standard and Poor's cited risks of an increase in bad loans at Spanish banks and called on Europe to take action to encourage growth.
The downgrade spooked financial markets, raising the interest rate fellow euro zone struggler Italy was forced to pay to sell 10-year bonds at auction. The yield was its highest since January as investors worried about the economic outlook in the bloc's indebted states.
Analysts said the 5.95 billion euro Italian auction went well under the circumstances, but Rabobank strategist Richard McGuire said the 5.84 percent 10-year yield "leaves a question mark over how long Italy will be able to finance itself at levels that can be deemed sustainable".
Italy's main banking association said the economy may contract by 1.4 percent this year, more than the government's 1.2 percent forecast.
Spain's country risk, as measured by the spread on yields between Spanish and German benchmark government bonds, spiked before leveling off to around 420 basis points.
Spain has slipped into its second recession in three years and fears that it cannot hit harsh deficit cutting targets this year have put it back in the centre of the debt crisis storm, pushing up its borrowing costs.
Recovery and job creation are still two years off, Economy Minister Luis de Guindos said on Friday in a news conference where he forecast 0.2 percent growth in the gross domestic product next year and 1.4 percent growth in 2014.
De Guindos also said Spain would increase the value-added tax and other indirect taxes next year, but would seek to reduce payroll taxes. Spain has a low VAT compared with other European countries even after raising it in 2010.
The government has already rescued a number of banks that were too exposed to a decade-long construction boom that crashed in 2008, and investors fear vulnerable lenders will be hit by another wave of loan defaults due to the slowing economy.
"It's a very challenging situation. I don't think that the banks are cornered yet, but the government must come out soon to say how they will address them," said Gilles Moec, an economist with Deutsche Bank.
DEFICIT TARGETS DOOMED
S&P's head of European ratings, Moritz Kraemer, told Reuters Insider television that Spanish banks could need state aid and the country faced further downgrades if its debt troubles continue to escalate.
"It is not going to be an easy job for most Spanish banks to find funding in the market. So the state may be called for at some point. But that, for now at least, is something the Spanish government seems to be unwilling to contemplate," he said.
Spain has ruled out any use of European funds to recapitalize its banks, weighed down by bad property loans. Economy Secretary Fernando Jimenez Latorre said Spain had sufficient financial capacity to handle a rescue itself in case of need.
The government is considering whether to create a holding company for the banks' toxic real estate assets after three rounds of forced clean-ups and consolidations in the financial sector have failed to draw a line under the problem.
Conservative Prime Minister Mariano Rajoy, in office since December, has passed an austerity budget and introduced new laws to try to make the economy more competitive, such as by reducing costs for companies to lay off workers. He has also agreed with Brussels a higher deficit target for this year.
But he has not convinced investors, and Spain's borrowing costs have shot up recently as the effect of a flow of cheap loans from the European Central Bank has worn off.
On Thursday Rajoy said he was determined to stick to austerity measures even though they are aggravating the economic slump and calls for growth measures are mounting around Europe.
The treasury ministry estimated the increase of 365,900 jobless people in the first quarter meant a loss of 953 million euros in tax income, making deficit cutting even harder.
The unemployment rate was up from 22.9 percent in the last quarter of 2011 and was worse than economists had forecast. Half of Spain's youth are out of work, and figures are unlikely to improve for some time as the government slashes spending by 42 billion euros this year, some 4 percent of economic output.
EUROPEAN ACTION NEEDED
S&P now has Spain on a BBB+ rating, which means "adequate payment capacity" and is only a few notches above a junk rating. Fitch and Moody's still rate Spain's sovereign with a "strong payment capacity".
The ratings agency called on euro zone countries to better manage the sovereign debt crisis.
Standard & Poor's said the euro zone should implement growth-promoting structural measures, feeding into the mounting debate in Europe about the self-defeating nature of austerity-only or austerity-first measures.
S&P said steps to restore financial confidence should "include a greater pooling of fiscal resources and obligations, possibly direct bank support mechanisms to weaken the sovereign-bank links, and a consolidation of banking supervision or a greater harmonization of labor and wage policies."
The call for a Europe-wide system to resolve and underpin banks echoed similar comments from the ECB's Executive Board members Joerg Asmussen and Benoit Coeure.