Italy passed a tough market test on Friday as its three-year borrowing costs fell well below 5 percent at an auction hours after Moody's cut the country's rating to two notches above junk status.
The U.S. rating agency surprised markets on Friday by lowering Italy's sovereign debt rating to Baa2 amid persistent worries about Spain's ability to sort out its banking problems, concerns about a Greek exit from the euro and doubts over Italy's long-term resolve to push through much-needed reforms.
Moody's lauded Prime Minister Mario Monti's commitment to fiscal reforms and structural consolidation. But warned it could again cut the country's marks if the next Italian government failed to push through necessary changes.
"The negative outlook reflects our view that risks to implementing these reforms remain substantial. Adding to them is the deteriorating macroeconomic environment, which increases austerity and reform fatigue among the population," it said.
"The political climate, particularly as the spring 2013 elections draw near, is also a source of implementation risk."
Analysts say political uncertainty ahead of elections is the main risk for Italy, where frustration with austerity measures and the country's weak and fragmented party system is stoking anti-European sentiment and has helped the meteoric rise of the populist Five Star Movement, led by comedian Beppe Grillo.
Respected technocrat Monti, who was called in last November to pull back Italy from the edge of the cliff and avoid a Greek-style debt crisis, has said he will stand down next year.
Three-times Prime Minister Silvio Berlusconi, who has kept a low profile since being forced out to leave room for Monti, announced this week he will return to frontline politics as the center-right candidate, further muddling the political outlook.
He has taken an increasingly anti-European tone in recent public comments, criticizing Monti's austerity policies and openly questioning the value of remaining in the euro.
"Berlusconi seems to have picked up on the increased sense of frustration within the Italian society that the sacrifices being made by the country are not being sufficiently recognized by the markets and that part of the blame lies in the slow EU policy response," said BNP Paribas analyst Luigi Speranza.
Opinion polls suggest that a center-left bloc would win the elections and it is not yet clear whether Berlusconi's return to front line politics may alter the picture.
The stark warning from Moody's, which comes as investors are already fretting about Spain's ability to mend its banking sector, knocked the euro down about a quarter of a cent overnight and initially sunk Italian bond futures.
The downgrade prompted angry reactions in Italian political and economic circles, with Italian Industry Minister Corrado Passera calling it "altogether unjustified and misleading."
Italian magistrates are currently investigating overall downgrade actions by the three main international rating agencies, which deny vigorously any wrongdoing.
The Italian bond market however recovered some ground as Italy managed to sell 5.25 billion euros in medium and long-term bonds, its top targeted amount, fetching the lowest yield since May on a new three-year issue.
Yet, the yield difference between 10-year Italian government bonds and their German equivalent remained at around 480 basis points, a high level that is frustrating the government in Rome and that Federico Ghizzoni, who heads of Italy's biggest bank by assets UniCredit, has called 'unsustainable'.
Monti this week did not rule out tapping euro zone bailout funds through a new bond-buying system to help ease Italy's borrowing costs, a move that Moody's says could trigger a further downgrade.
Three-year bond yields had risen to a six-month peak of 5.3 percent in June, ahead of a cliffhanger Greek election that some feared may have forced the country out the euro zone and after an unconvincing initial attempt to bail out Spanish banks.
In its comments, Moody's said the probability of Greece leaving the single currency had increased in recent months as well as the likelihood Spain may require external aid.
"In this environment, Italy's high debt and significant annual funding needs of 415 billion euros, 25 percent of GDP, in 2012-13, as well as its diminished overseas investor base, generate increased liquidity risk," Moody's said.
The country's economy is projected to contract by as much as 2 percent, dimming the prospect of implementing reforms.
Moody's took its ratings for Italy below those from agencies Standard & Poor's and Fitch, potentially triggering further investment outflows from Italy.
Analysts estimate that foreigners hold about one third of Italy's public debt, down from 40 percent a year ago. Data from Italy's banking association ABI also showed that foreign deposits at Italian banks were down 20 percent year on year.
"This is just Moody's opinion. I think our country, and our manufacturing system, is much stronger than the Moody's evaluation suggests," Italian business association head Giorgio Squinzi said.
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