Italy's Sharp Rating Cut as One More EU Economy Is Dragged Under

Italy is at the mid-point of economic expansion, or lack of it, among European nations. The fates of Greece, Portugal and Spain are set and depressed, probably for years. France, Germany and northern European nations have dodged the worst of the downturn, at least for now. But Italy is on the cusp. Its gross domestic product is the third largest in Europe, at $2.1 trillion. Its prospects are mixed, even with new austerity plans in place. Italy’s future will signal how badly the overall prospects of the European Union have been, or will be, damaged. That, in turn, will be a sign of whether the confederacy can stay together. The alliance probably cannot afford to rescue a nation as large at Italy.

Unlike the economically weakest countries in Europe, Italy has a large manufacturing economy. But like them, it has a large debt-to-GDP ratio — about 120%. Italy’s prime minister, Mario Monti, has set a number of austerity plans and also a plan to increase the VAT. These plans did not keep Moody’s from a sharp cut in Italy’s debt today. In a note about its decision, the ratings agency remarked as it downgraded Italy’s government bond rating to Baa2 from A3, with the outlook remaining negative:

1. 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 our 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 recognized.

2. 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.

In other words, despite Italy’s relatively more diverse and stronger economy, compared to others in the area, the problem of a recession marks its debt as too risky to carry anything other than the equivalent of a “junk” sovereign rating. Concerns about high taxes and no stimulus plans have spread to the outlook of the Italian economic future.

If Italy is on the cusp of the EU’s economic future, then that future looks worse by the moment.

Douglas A. McIntyre