Fitch Ratings on Monday downgraded California’s long-term bond rating from A- to BBB, citing the state’s failure to close its budget deficit last week and its new reliance on IOUs to pay bills.

The announcement by the New York ratings house potentially increases California’s borrowing costs for public works projects and serves as the latest benchmark of the state’s deteriorating fiscal condition reports the reports the Sacramento Bee.

Gov. Arnold Schwarzenegger and state lawmakers remained at odds Monday over how to close the state’s $26.3 billion deficit. Republicans and Democrats disagree on how much to cut health and welfare programs, and Schwarzenegger wants permanent changes that impose tighter eligibility requirements on public benefit recipients.

Fitch moved California only two notches away from junk-bond status; the ratings house said it kept the state’s bonds at investment-grade because “expectations of default risk remain low.” Fitch kept the state’s general obligation bonds on a “negative watch” due to the possibility that “institutional gridlock could persist.”

California has the lowest bond ratings of any state.

“The downgrade to BBB is based on the state’s continued inability to achieve timely agreement on budgetary and cash flow solutions to its severe fiscal crisis,” Fitch said in a statement.

Two other major ratings services, Moody’s Investors Service and Standard & Poor’s, have not dropped the state’s bond rating as low as Fitch has.

State Treasurer Bill Lockyer warned last week that a downgrade to BBB+, which is one grade higher than California’s new BBB, could cost $7.5 billion in interest over a 30-year period. California last had a BBB rating between December 2003 and September 2004, when the state was also grappling with a significant budget deficit.

Lockyer spokesman Tom Dresslar said California will pay higher costs the next time it tries to borrow money for public works projects.

Read more here: California’s borrowing costs may rise after Fitch downgrades state bonds