By Nick Mann | 13 July 2012

Moody’s has downgraded Italy’s credit status and warned that that the rating could be cut again within months unless it continues to implement structural reforms and fiscal consolidation.

The ratings agency announced this morning that it had moved Italy’s government bond status down two notches from A3 to Baa2. This leaves Italy just two steps above a junk rating and is likely to increase the country’s cost of borrowing.

In a statement, Moody’s said the chances of Italy not being able to access funding on the bond markets had increased over the past five months as a result of fragile market confidence and the risk of contagion from both Greece and Spain.

‘The risk of a Greek exit from the euro has risen, the Spanish banking system will experience greater credit losses than anticipated, and Spain's own funding challenges are greater than previously recognised,’ it said.

Italy’s own near-term economic outlook has deteriorated with both weaker growth and higher unemployment. Together, Moody’s warned these created the risk of Italy failing to meet its fiscal consolidation goals, which could weaken market confidence further.

Moody’s acknowledged measures taken by the Italian government had moderated the downward pressure on the country’s credit rating. The country is legislating a reform programme which ‘has the potential to materially improve Italy's longer-term growth and fiscal prospects’.

These reforms include a structural balanced budget rule and further spending cuts which are being introduced in place of a VAT increase previously planned for October – steps which were welcomed by the International Monetary Fund in an assessment of Italy’s economy this week.

But Moody’s warned that the risks to implementing this programme were ‘substantial’ and placed the country’s rating on a negative outlook, meaning it could be downgraded further. ‘Adding to them is the deteriorating macroeconomic environment, which increases austerity and reform fatigue among the population. The political climate, particularly as the spring 2013 elections draw near, is also a source of implementation risk,’ it added.

In the event of Italy having to access bailout funds, Moody’s said the country’s sovereign rating could be downgraded to ‘substantially lower’ ratings levels.

Alternatively, successful implementation of the country’s economic reforms and fiscal measures could strengthen the Italian economy and government balance sheet, leading to a stable outlook.

If the country’s public finances become less vulnerable to volatile funding conditions and public debt starts to shrink, ‘upward pressure’ on Italy’s rating could develop, Moody’s said.