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The decision to downgrade Italy's rating reflects the following key factors:
Italy is more likely to experience a further sharp increase in its funding costs or the loss of market access than at the time of Moody's rating action five months ago due to increasingly fragile market confidence, contagion risk emanating from Greece and Spain, and signs of an eroding non-domestic investor base. 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.
Italy's near-term economic outlook has deteriorated, as manifest in both weaker growth and higher unemployment, which creates risk of failure to meet fiscal consolidation targets. Failure to meet fiscal targets in turn could weaken market confidence further, raising the risk of a sudden stop in market funding.
At the same time, Moody's notes that the sovereign's current Baa2 rating is supported by significant credit strengths relative to other euro area peripheral economies, including (1) maintenance of a primary surplus, (2) large and diverse economy that can act as an important shock absorber in the current crisis, and (3) substantial progress on the structural reforms which, if sustained in the coming years, could improve the country's competitiveness and growth potential over the medium term.