Moody's cut Ireland's credit rating this morning, citing weaker growth prospects and the cost of rebuilding the country's crippled banking system Photograph: Martin Argles for the Guardian

Credit ratings agency Moody's has downgraded Ireland's debt rating, adding to investor jitters about the state of Europe's heavily indebted economies.

The agency cut Ireland's sovereign bond rating by one notch to Aa2 this morning, citing weaker growth prospects and the high cost of rebuilding the country's crippled banking system. It added that the outlook was stable.

But the downgrade comes after the International Monetary Fund and the European Union pulled a €20bn (£17bn) financing deal for Hungary over the weekend. Talks broke down on Saturday after the European commission voiced concerns over the newly elected Hungarian government's budget plans.

This means Hungary will not have access to remaining funds of €5.5bn in its €20bn credit line, agreed two years ago, until a review is completed. Hungary's currency, the forint, plunged more than 2.5% against the euro on the news and bond yields surged by up to 30 basis points.

Ireland's downgrade came ahead of a bond auction tomorrow.

"Today's downgrade is primarily driven by the Irish government's gradual but significant loss of financial strength, as reflected by its deteriorating debt affordability," said Dietmar Hornung, lead analyst for Ireland at Moody's.

The cost of bailing out Anglo Irish Bank last year gave Ireland a budget deficit of 14% of GDP, the highest in Europe, which could rise to 20% this year.

Martin Mansergh, Ireland's minister of state for finance, said the Moody's verdict was no surprise. "It's really not telling us anything that we don't know already. We all know that banking and real estate are not going to be sources of growth."

Tax breaks on new buildings led to a massive property bubble, with construction suddenly making up a fifth of Ireland's economy. Irish banks went on a lending spree and by the time of the global financial crisis held a huge amount of debt (Anglo Irish Bank alone had €73bn of loans – half of Ireland's GDP). Not surprisingly, Ireland was the first country in the eurozone to plunge into recession.

Gary Jenkins at Evolution Securities noted that Moody's also placed Spain's ratings on review at the end of last month.

"Nothing on Italy yet, but considering that there is a two-notch differential between Moody's and S&P it would not be a major surprise if Moody's didn't take a look at Italy next," he added.

Guardian.co.uk