Markets have been giving Spain "the benefit of the doubt" while they focus on Italy, but the country could be next to feel the heat, according to a new report from the investment bank UBS.

The country has drifted in and out of the market's crosshairs over the course of the last nine months, with particular concern surrounding its banking industry, which took a beating by the bursting of a property bubble in the country. Spain has taken steps to reform the sector by forcing its "cajas" - savings banks - to merge and insisting on recapitalisation. The government's debt stock is 60% of its gross domestic product (GDP), which is considerably less than Italy's, currently running at nearly 120%. Elections are due on November 20, and the polls indicate that the centre right opposition party will win with a sizeable majority, making it easier to reduce the country's budget deficit. Yields on the country's debt are high, but nowhere near the

Together, this has meant that markets have left Spain alone, but UBS economist Stephane Deo believes that might be about to change.

"We think the market’s attitude towards Spain could be severely challenged in the next few months, if not weeks. Essentially, there are three reasons for our worries: slippage of the deficit, the possibility of a deep recession, and acknowledgement of the banking crisis that will likely eventually result in a surge of liabilities being transferred to the government balance sheet," Deo wrote on Friday.

UBS believes that Spain will miss its deficit reduction targets when it reports its year end figures, as local government budgets and weakening tax receipts hit the public purse. As austerity measures bite after the election period, the country is likely to head towards a recession, Deo added. Spain is relatively competitive, and might have been able to export itself out of weak growth despite softer domestic demand, but the faltering growth in the rest of the eurozone might mean that demand will fall.

"We think the risks are definitely biased on the downside for Spain," Deo said.

More concerning, however, are those troublesome banks. The European Banking Authority (EBA), which ran stress tests in the summer, estimated that Spain needs around €26bn to recapitalise the sector and buffer it against future shocks. The crisis in Europe has moved on since then, and the stress tests have been shown to be less stringent than the market wanted. Dexia, the Franco-Belgian bank, passed the tests but still ended up needing a rescue in October.

UBS believes that the €26bn figure dramatically underestimates the total liabilities that assisting the banks will add to Spain's budget. The government has proposing the creation of a "bad bank" which would take assets off the balance sheets of private sector institutions and move them onto that of the government. Local reports suggest that the total size of that "bad" fund would be €150bn, and UBS said it would probably be more.

"This is a very different number from the €26bn of recapitalisation," Deo said. "We are now talking about bad assets worth 15% of the GDP being transferred to the government balance sheet."

Investors are getting worried, he added. While Spain is, broadly speaking, responding well to the economic crisis, if the markets lose confidence in the country then they could undermine its efforts, as was seen with Italy this week.

A medium-term view, looking several years ahead has to be constructive on Spain, if indeed the fiscal situation is stabilised and the issues with the banking sector are addressed properly," Deo said. "We strongly expect, however, that the market will blink should this avalanche of bad news comes. At this point, we expect the data will turn very bad while constructive views on the future will rest on hypotheses that the effort will be successful. We think the market will then take it negatively."