09/20/2011 01:23 EDT | Updated 11/20/2011 05:12 EST

S&P downgrade casts shadow over Berlusconi government

MILAN - Standard & Poor's cast more doubt over the stability of both Italy's government and its finances Tuesday, when it downgraded its credit rating and cited political weakness as a key risk for the eurozone's third-largest economy.

The Italian government was quick to criticize the downgrade as politically motivated. It was not the first government to attack a rating agency for its decisions — authorities in the U.S. and across the European Union have done so, angered by what they consider a counterproductive move at a time when they were trying to contain worries about their sovereign debt.

But the S&P downgrade hit Italy at a particularly vulnerable moment. Investors now are less confident about its financial prospects than Spain's — for decades viewed as the weaker economy — and widely consider it to be the next most likely victim of the debt crisis.

"In our view, Italy's economic growth prospects are weakening and we expect that Italy's fragile governing coalition and policy differences within parliament will continue to limit the government's ability to respond decisively to domestic and external macroeconomic challenges," S&P said in its report.

The sensitivity of the issue was apparent in the rapid criticism the agency received for its surprise downgrade of Italian sovereign bonds to A from A+.

The Italian government accused the agency of being more influenced by newspaper reports critical of the government than the reality of a euro54 billion ($70 billion) austerity measures approved last week that aim to balance the budget by 2013.

"The evaluation by the ratings agency seems to be dictated more by behind-the-scenes reports in daily newspapers than reality and appear to be tainted by political considerations," the government said in a statement.

S&P responded with a terse five-line statement saying sovereign debt ratings are "apolitical."

Markets, which were buoyed by hopes that Greece will not be allowed to default, took the events in stride and stocks in Milan closed higher. But the downgrade is likely to reinforce fears that Italy is getting sucked into Europe's debt crisis.

Italy's debt burden is the second highest in the eurozone after Greece. It has carried heavy debts successfully for years because bond investors have always been willing to loan more money as bonds came due.

But bond markets began to look more skeptically at Italy after Greece, Ireland and Portugal needed bailouts and the government has had to pay more to borrow as a result.

S&P said Berlusconi's "fragile" coalition and the political deadlocks that have blocked reforms were a risk.

The agency's managing director, Moritz Kraemer, told investors on a conference call that the rating could be cut again in 12 to 18 months if Italy's debt rises above its current level of around 120 per cent of GDP — one of the highest among the countries rated by S&P's.

The downgrade was precipitated on significantly lower growth forecasts — down to an average of 0.7 per cent annually between now and 2014 from a projection of 1.3 per cent made in May. S&P also expects lower exports, domestic consumption and investment during the period.

Unicredit economists said the S&P's moribund growth forecasts for Italy were largely in line with their own, but disagreed with the agency's assumption that the austerity package will be ineffectual.

"While we have repeatedly argued that much bolder action is needed on the growth if Italy wants to win back market (and rating agencies') confidence, we do not share the view that the recently approved measures to simplify the public administration, increase labour market flexibility and push forward privatizations and service sector liberalization will have zero impact on medium-term GDP prospects," analysts Chiara Corsa and Loredana Federico said in a note.

An important element of the S&P decision was the lack of determined political response to the growing debt crisis. S&P cited the fact that the government, under market pressure, twice expanded the austerity measures and that there was an apparent lack of bipartisan will to fix Italy's economic woes.

While Spain managed to create bipartisan support for a constitutional amendment setting a debt ceiling, there has been no similar commitment in Italy, Kraemer said, noting dissent even within Berlusconi's governing coalition.

The markets have also noted the differences. In recent weeks, Italian borrowing rates have edged higher than Spain's. The benchmark bond yield was at 5.67 per cent on Tuesday, compared with 5.35 per cent in Spain.

Kraemer also said the Italian election cycle does not guarantee that the promised austerity measures will be kept. Berlusconi's mandate ends in 2013, but his main coalition partner Umberto Bossi has recently indicated he is not sure the majority can hold that long.

In addition, many of the austerity measures count on new revenue, and not the kind of structural reform that will promote growth, Kraemer said.

"We consider that the political situation lends itself more easily to a situation of gridlock and delayed policy response than in other countries where the funding costs have gone up," he said.

Despite the downbeat assessment, he said it was unlikely that a country with an A rating would be unable to fund its debt needs — as has been the case with Greece. Italy currently carries a public debt of euro1.9 trillion ($2.6 trillion), a portion of which must be refunded each year through the sale of government bonds.

As borrowing costs rise, so does the cost of carrying that debt. If costs go too high, the risks is a government would default. An Italian default would be a devastating event with wide-ranging ramifications that policy-makers want to avoid.