Portugal could require a second, Greek-style bailout involving private investors, Moody’s ratings agency has warned as it downgraded the struggling country to “junk” on fears it will struggle to meet its current targets and will remain unable to borrow from the bond markets for some time.

Moody’s downgraded Portugal by four notches to Ba2 from Baa1 – equivalent to double B from triple B plus at other agencies – and warned of the “increasing probability” that Portugal would not be able to tap the markets at sustainable rates for some time after 2013.

The agency left in place its negative outlook, signalling further downgrades were possible.

“Such a scenario would necessitate further rounds of official financing, and this may require the participation of existing investors in proportion to the size of their holdings of debt that will become due,” the agency added.

The euro dropped to a low of $1.4404 against the dollar on the news, down 0.9 per cent on the day, from $1.4480.

US equities slipped with the S&P 500 down 0.2 per cent. Treasury bond yields dropped to their lows for the day, with the 10-year note yielding 3.12 per cent, down 7 basis points.

“This is a reminder to the markets that the problems are wider than Greece,” said Marc Chandler, global head of currency strategy at Brown Brothers Harriman. “In a dysfunctional family, its easy to blame all the problems on one person – Greece in this case – and think if you solve their issues, then we’ll be fine. But that ain’t the case and this move just illustrates that.”

Moody’s cited the tortuous negotiations over Greece in its note, warning that although the likelihood of a restructuring in Portugal was lower than in Greece, the European Union’s “evolving” approach to providing further support “implies a rising risk that private sector participation could become a precondition for additional rounds of official lending to Portugal in the future as well.”

Moody’s downgrade is dangerous for Portugal because if other rating agencies followed its example the country’s bonds could fall below the minimum quality threshold for collateral used in ECB liquidity providing operations. Portugal’s banks are dependent on ECB liquidity.

Standard & Poor’s currently rates Portugal at triple B-minus – one notch above junk and two notches above Moody’s new rating.

The ECB has already had to waive the minimum requirement for Irish and Greek bonds - and may now have to do the same for Portugal’s. The ECB had no comment on Tuesday.

Moody’s also voiced concerns that Portugal’s new government would struggle to meet its budget deficit reduction targets because of the “formidable challenges” it faces in cutting spending, boosting tax compliance, supporting its banks and achieving economic growth.

Last week Portugal’s statistics agency said the country’s deficit fell to 8.7 per cent of GDP at the end of the first quarter, down from 9.2 per cent three months earlier. Under the rescue agreement, however, Portugal is committed to cutting the deficit to 5.9 per cent of GDP this year, 4.5 per cent in 2012 and 3 per cent in 2013.

Additional reporting by Peter Wise in Lisbon

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