Moody’s warns it may downgrade Italy

June 17, 2011, 11:47 PM UTC

A whole day without European debt fireworks is too much to ask for, apparently.

Moody’s said Friday that it may downgrade Italy’s debt, thanks to “fragile market sentiment” for deeply indebted European governments. It is the first downgrade warning for one of the stronger European economies since the Greek debt crisis flared up this spring.

Big Italy may be the fragile one

The rating agency said that as investors grow more risk averse, Italy — currently rated Aa2, the second-highest rating — may be unable to sell bonds without offering higher interest rates.

Italian 10-year bonds recently yielded around 4.8%. That is below the 5.6% that Spanish bonds have been trading at lately but up a full point from the Italian rate last fall, when investors were flooding into government bonds amid the latest deflation scare.

Moody’s didn’t say how high it thought those rates might go, but it said there is a risk that government bond yields in heavily indebted economies could rise substantially depending on how European policymakers handle the debt crisis.

The continued stability of market demand for Italy’s debt is uncertain at current yields. Although future policy actions within the euro area could reduce investors’ concerns and stabilize funding costs, the opposite is also possible. In any event, going forward, investors appear likely to differentiate more among euro area sovereign borrowers than they did prior to the financial crisis, to the disadvantage of euro area countries with higher-than-average debt burdens, like Italy.

While Italy has so far mostly managed to avoid being dragged into comparisons with weaker states such as Portugal and Ireland, its low productivity and rigid labor markets will make growing out of its debt problem difficult, Moody’s said.

Italy’s gross government debt is on track to hit 114% by year-end, the International Monetary Fund estimates. A widely cited paper by economists Ken Rogoff and Carmen Reinhart says countries with a ratio above 90% tend to grow more slowly.

That slow growth could complicate things for Italy, Moody’s said, despite the fact that the Italian government is one of the few in the developed world that is running a primary budget surplus – that is, taking in more money than it spends, excluding interest payments.

Italy has so far only recovered a fraction of the nearly seven percentage points in GDP that it lost during the global crisis, despite low interest rates, which are likely to rise in the medium term. Growth prospects for the Italian economy in the coming years will be a crucial factor that will determine the government’s revenues and the achievement of fiscal consolidation targets.

So on a day when the Greek crisis finally cools off a few degrees, we learn that a much bigger debt pot may start soon start boiling.  It figures to be a hot summer, to say the least.