Italy suffers rating downgrade by Moody's

Italy's debt rating has been downgraded by Moody's because of the risk of contagion from crisis-hit Spain and Greece, a worsening economic outlook, and the potential loss of market access as borrowing costs soar.

The rating agency cut Italy's credit score by two notches to Baa2 from A3 and assigned it a negative outlook, meaning further downgrades could follow. It leaves the Italian rating just two notches above junk status. Moody's action seemed to have little impact on investor confidence today, though, as Italy sold €5.25bn of medium and long-term bonds at lower average yields than at the previous auction.

In a statement published overnight, Moody's said Italy could experience a sharp increase in its funding costs and even the loss of market access due to fragile confidence and the effect of the Greek and Spanish crises. "The risk of a Greek exit from the euro has risen, the Spanish banking system will experience greater credit losses than anticipated, and Spain own funding challenges are greater than previously recognised," it said.

Last month European Union leaders suggested that the eurozone's bail-out funds – the European Financial Stability Facility and its permanent replacement the European Stability Mechanism – could be used to stabilise sovereign bond markets. But Moody's cautioned that there was a "limit to the extent to which these support mechanisms can be used to backstop such a large, systemically important sovereign" such as Italy.

Meanwhile Italy's own economic outlook has deteriorated, the rating agency said. It warned that weaker growth and higher unemployment would make it harder for Prime Minister Mario Monti's government to meet its fiscal targets. "Failure to meet fiscal targets could weaken market confidence further, raising the risk of a sudden stop in market funding," the statement said. Predicting that gross domestic product would contract 2 per cent this year, it said achieving deficit reduction goals would be "challenging".

However, the American rating agency also acknowledged that Italy had "significant credit strengths" compared with some other eurozone countries, including a primary surplus, a large and diverse economy that could "act as an important shock absorber", and the Monti government's "substantial" progress in implementing structural reforms to make the country more competitive. Nevertheless Moody's rating for Italy is now lower than that of the other two big agencies, Standard & Poor's and Fitch.

Italy's commitment to structural reforms and deficit reduction will be tested next year when Monti's mandate ends and elections are held. In recent days it has been reported that former prime minister Silvio Berlusconi has decided to attempt a comeback and lead his People of Freedom party into the election. Berlusconi resigned last November after losing his parliamentary majority, and was replaced by Monti's technocratic administration.