* S&P cites Spain recession and euro zone policy uncertainty
* Agency also cites increased social discontent in Spain
* Dollar gains against euro after downgrade
* Moody's and S&P both have Spain on cusp of junk rating
(Adds comment from S&P text, background)
By Daniel Bases
NEW YORK, Oct 10 (Reuters) - Standard & Poor's on Wednesdaycut Spain's sovereign credit rating to BBB-minus, just abovejunk territory, citing a deepening economic recession that islimiting the government's policy options to arrest the slide.
The S&P downgrade comes with a negative outlook reflectingthe credit ratings agency's view that there are significantrisks to economic growth and budgetary performance, plus a lackof clear direction in euro zone policies.
"In our view, the capacity of Spain's political institutions(both domestic and multilateral) to deal with the severechallenges posed by the current economic and financial crisis isdeclining," S&P said in a statement.
S&P's two-notch downgrade from BBB-plus brings it in linewith Moody's Investors Service's Baa3 rating. Moody's has Spainon review for a possible downgrade.
Both firms have Spain just on the cusp of junk status. FitchRatings has a BBB rating on Spain, one notch higher, but alsowith a negative outlook.
A spokeswoman at Spain's Economy Ministry told Reuters thegovernment had no comment on the ratings action.
The country has been in recession since earlier this year,its second economic contraction in just a few years, andunemployment is stubbornly high at close to 25 percent with areturn to job creation still two years away.
Falling tax revenue and rising costs of unemploymentbenefits are confounding the government's efforts to hit a 2012deficit reduction target of 6.3 percent of gross domestic targetagreed with the European Union.
Both the International Monetary Fund and Spain's own CentralBank cast doubt on the savings envisioned in Prime MinisterMariano Rajoy's 2013 budget, saying they are based on a too-rosyoutlook for the economy.
In the wake of the downgrade, the euro dropped about0.25 percent to $1.2865 in late New York trade from just under$1.29 prior to the news.
"This is weighing on the euro. A downgrade from S&P could befollowed by a downgrade from Moody's, and while S&P did notdowngrade Spain to junk, Moody's might," said Kathy Lien,managing director at BK Asset Management in New York.
"If Moody's goes to junk status, that's even moresignificant, and this adds to the pressure on Moody's to make adecision. It could lead to higher bond yields in Spain and pushthe government closer to asking for a bailout," Lien added.
In European trade earlier on Tuesday, ten-year Spanish bondyields fell 1 basis point to 5.83 percent. Thoseyields spiked above 7 percent earlier this year, but have sincecome down on a European Central Bank bond-buying plan.
SOCIAL DISCONTENT AND EURO ZONE DOUBTS
Prime Minister Rajoy's centre-right People's Party has anabsolute majority in parliament and so far has been able to passspending cuts and economic reforms without any problem.
However, street protests have increased in recent months asSpaniards revolt against public sector wage cuts and lowerspending on education and healthcare. Resentment is also risingover huge public bailouts for the country's crippled banks,while social benefits are cut.
Although Rajoy's PP governs 11 of 17 Spanish regions, whichhave been forced to make massive budget cuts, S&P noted thattensions between the central and regional governments arerising, "leading to substantially diluted policy outcomes."
The agency said Rajoy's resolve will be "repeatedly testedby domestic constituencies."
Although the European Central Bank has set up a bond-buyingprogramme that would support Spanish debt prices on thesecondary market, Spain has balked at signing up forinternational aid because it would come with harsh conditions.
"We view the Spanish government's hesitation to agree to aformal assistance program ... as potentially raising thedownside risks to Spain's rating," S&P said in its note.
The agency also said that euro zone policy makers must showprogress on implementing a banking union that would allow Europeto directly recapitalise Spanish banks, taking the weight off ofthe Spanish government.
(Reporting by Daniel Bases, Luciana Lopez and Steven C. Johnsonin New York; Fiona Ortiz and Carlos Ruano in Madrid; editing byDan Grebler, Gary Crosse and Leslie Gevirtz)
Keywords: SPAIN STANDARDANDPOORS/DOWNGRADE