Italy’s debt rating slashed by Moody’s

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Italy on Tuesday had its credit rating slashed three notches by Moody’s Investors Service, another reminder of how debt woes have spread from Europe’s smallest countries to some of the largest.

Separately, France and Belgium moved to rescue the giant bank Dexia, a major lender to French and Belgian towns.

Moody’s cut Italy’s rating to A2 from Aa2 and kept the outlook negative, a warning that further downgrades may be ahead.

At A2, Italy’s debt still is considered investment-grade in quality. But an A2 rating is five notches below the top Aaa grade still held by Germany, France, the Netherlands and other Northern European countries. Italy’s credit now is on par with that of the island nation of Malta and the African country of Botswana (also both rated A2), and below South Korea and Estonia (both A1).

Moody’s said it downgraded Italy, the Eurozone’s third-largest economy, in part because “the fragile market sentiment that continues to surround euro area sovereigns with high levels of debt implies materially increased financing costs and funding risks for Italy.”

In other words, although the risk of Italy defaulting on its bonds “remains remote,” Moody’s said, investors’ fears of worsening contagion from the continent’s debt crisis has pushed up Italy’s borrowing costs, raising the potential for more damage to an already struggling economy.

The annualized yield on two-year Italian government bonds (charted at left) is at 4.23%, up from 1.65% one year ago but down from a high of 4.69% in early August. Moody’s said one of its main concerns was Italy’s “susceptibility to shocks” if the Eurozone crisis deepens.

Last summer’s plunge in global markets was triggered in part by soaring interest rates on Italian and Spanish government bonds, as investors worried that those countries would be the next dominos to fall after Greece, Ireland and Portugal were forced to seek bailouts from the rest of the Eurozone over the last 18 months.

Standard & Poor’s had beaten Moody’s to the punch, downgrading Italy to A from A+ in mid-September. Both Moody’s and S&P warned that Italy, like much of the Eurozone, faces the prospect that austerity programs aimed at paring budget deficits will undercut the economy, making it more difficult for the government to raise needed tax revenue.

Moody’s announcement came after U.S. markets had closed for the session. Word of the rescue of Dexia bank was credited with helping to pull U.S. share prices up from their lows near the end of trading -- although the Dexia situation may just worsen investors’ concerns about Europe in the short term.

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-- Tom Petruno

Follow me on Twitter: Twitter.com/tpetruno