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(Adds Moody's analyst comments and possible long-term market impact)
By Alonso Soto and Marcela Ayres
BRASILIA, Feb 24 (Reuters) - Moody's Investors Service on Wednesday became the third major rating agency to downgrade Brazil's debt to junk, cutting its rating by two notches to Ba2 as the former emerging market star sinks deeper into its worst recession in decades.
Moody's said the outlook for Brazil's rating was revised to negative due to the prospect of further deterioration in its debt ratios as well as the risk of further external shocks.
Rivals Standard & Poor's and Fitch stripped Brazil of its investment grade rating last year. Moody's two-notch downgrade places its rating at the same level as S&P, which cut Brazil further into junk territory last week.
The latest downgrade is a blow to President Dilma Rousseff, who is under pressure to relax an austerity drive and stimulate economic growth as she seeks to survive impeachment proceedings.
The government said Moody's decision did not alter its commitment to reducing a fiscal deficit that topped 10 percent of gross domestic product last year. Treasury officials also said they did not expect the move to trigger an exodus of foreign capital.
Moody's analyst Samar Maziad told Reuters the two-notch downgrade was an uncommon decision but reflected the magnitude of the deterioration of Brazil's finances, which has been exacerbated by ongoing political paralysis.
Brazil's progress in shoring up its finances would be slow and growth anemic for the next two to three years, Moody's said. It warned that government debt would likely top 80 percent of GDP within three years.
The political environment, including ongoing efforts to impeach Rousseff, would complicate attempts to reduce the fiscal deficit and implement economic reforms, the ratings agency said.
"For us uncertainty is not positive ... and this uncertainty is reflected in the outlook," Maziad said.
The downgrade could exert further downward pressure on Brazil's currency and prompt investors to exit an economy that only four years ago was growing above 4.0 percent annually. The Bovespa stock index closed down 1 percent on Wednesday, amid weakening international equity markets.
Investors said while a Moody's downgrade had been widely expected, the size of the two-notch move came as a surprise.
"We are moving ever further away from investment grade and that will mean Brazilian assets are going to remain as junk for a lot longer, delaying an economic recovery even further," said Pablo Stipanicic Spyer, head of operations at Mirae Asset Wealth Management in Brazil.
The impact of the downgrade on Brazilian markets will likely be limited as most funds with investment restrictions dropped local assets after the other two rival agencies cut the country's rating to junk last year, analysts say.
Brazil is struggling with what is expected to be its worst recession since at least 1901, following a mix of fiscal largesse and interventionist policies during Rousseff's first term in office which zapped investors' confidence.
Rousseff, a left-leaning economist, is considering measures to bolster the economy without abandoning austerity efforts that include tax increases and spending cuts, aides said.
Many analysts, however, doubt she can spur growth without incurring fiscal costs that threaten to widen the deficit.
The Brazilian economy likely contracted nearly 4 percent last year and is expected to drop again by more than 3 percent this year, the worst back-to-back annual declines on record.
Even with the economy shrinking, inflation surged more than 10 percent in 2015, to its highest level in more than a decade.
Impeachment proceedings against Rousseff for allegedly violating the country's budget laws will likely delay the approval of austerity measures and other reforms to shore up the country's finances.
Additional reporting by Paula Arend Laier and Flavia Bohone in Sao Paulo; Editing by Daniel Flynn and Tom Brown