Moody's has cut Spain's credit rating by another notch, escalating the ongoing debt crisis in the eurozone.

Spain's rating was downgraded to Aa2, Moody's third highest rating, as the agency warned that the country had under-estimated the cost of rescuing its banking sector. The move came as borrowing costs continued to rise for weaker members of the eurozone, raising fears that further rescue packages will be needed.

"Although Moody's acknowledges that the government's recently announced acceleration of efforts to restructure the cajas [Spain's savings banks] is likely to strengthen the country's banking landscape, the rating agency believes there is a meaningful risk that the eventual cost of the recapitalisation," said Moody's. It now believes the rescue package will cost between €40bn and €50bn (£34.4bn and £42.8bn), more than twice its own earlier estimate of €17bn.

"The heat has been turned up on the bubbling tensions in the Eurozone," said Jane Foley, senior currency strategist at Rabobank.

The downgrade knocked around half a cent off the euro, which fell to a one-week low of $1.3804. Stock markets also suffered losses, with the FTSE 100 losing 63 points to 5873.

Moody's had threatened three months ago that it might downgrade Spain, but the decision was swiftly criticised by Madrid. The Spanish government pointed out that it is scheduled to release new data on its banking recapitalisation plans on Thursday evening.

Under this plan, Spain is expected to partially nationalise the cajas, force them to become conventional banks and then float them on the stock market.

Spanish treasury director Soledad Núñez also accused Moody's of overlooking its efforts to cut its deficit, and its reform of public sector pensions.

Foley warned that Europe's current rescue fund would be almost wiped out if Spain and Portugal required a bailout.

"It remains essential that the European Financial Stability Facility is bolstered to reassure markets that there is enough ammunition to protect EMU against all eventualities," Foley said.

The cost of insuring government debt issues by Spain, Greece and Portugal all widened following Moody's move, according to Markit.

"The rating agencies have often been on the sidelines during the sovereign debt crisis. But this week they have shown that they can still move markets. Greece received a multi-notch downgrade from Moody's on Monday and now Spain has been cut one notch to Aa2 by the same agency," said Gavan Nolan, Markit's director of credit research.

"The sovereign market is already racked by uncertainty ahead of the EU summit tomorrow, and the downgrades raise the stakes for the EU. Greece is now at record wide spreads and the other peripherals are all widening significantly," Nolan added.