Standard and Poor's has cut its unsolicited ratings on Italy by one notch, putting further pressure on the eurozone as it struggles to deal with the wider debt crisis.
In a move that took markets by surprise, the ratings agency downgraded the Italian rating to A/A-1 from A+/A-1+ and kept its outlook on negative.
It warned of a deteriorating growth outlook and damaging political uncertainty in the country, sending the euro more than half a cent lower against the dollar.
S&P, which had put Italy on review for downgrade in May, said the outlook for growth was worsening and there was little sign that Prime Minister Silvio Berlusconi's fractious centre-right government could respond effectively.
European markets opened weaker this morning after the downgrade, but quickly reversed their losses.
Shares in Italy rose by over 1%, while markets in Frankfurt rose by 0.8% and Paris added 0.3%. Shares in London were up 0.3% while Irish shares were flat.
In response to the decision, Mr Berlusconi said that Standard & Poor's decision did not reflect reality and said his government was already preparing measures to spur growth.
"The assessments by Standard & Poor’s seem dictated more by newspaper stories than by reality and appear to be negatively influenced by political considerations," Mr Berlusconi said in a statement.
He added that his government had already approved measures to balance the budget in 2013 and was preparing growth boosting measures that aimed to bear fruit in the short to medium term.
A European Commission spokesman declined to comment on the decision however Amadeu Altafaj, spokesman for EU Commissioner Olli Rehn, said his position was that "bold reforms were needed" in Italy to tackle what he termed "deep rooted problems."
Mr Altafaj said it was a "matter of urgency" that Italy requires a "national consensus" to introduce the measures which would return the country to growth.
He said the austerity programme passed by the Italian parliament went further than what Brussels had been recommending.
Mr Berlusconi’s government has been under mounting pressure to cut its €1.9 trillion debt pile and pushed a €59.8bn austerity plan through parliament last week, pledging a balanced budget by 2013.
However there has been little confidence that the much-revised package of tax hikes and spending cuts, agreed only after repeated chopping and changing, will do anything to address Italy's underlying problem of persistent stagnant growth.
Budgetary savings may not be possible because the government is relying heavily on revenue increases in a country that already has a high tax burden and is facing weakening economic growth prospects, S&P said.
In addition, market interest rates are expected to rise, it said.
Mr Berlusconi's coalition has been plagued by infighting and policy disagreements and the prime minister himself has been battling a widening prostitution scandal which has distracted the government and badly damaged his personal credibility.
Yesterday Italian sources said the government was preparing to cut its growth forecast for 2011 to 0.7% from a previous forecast of 1.1%; it was also expected to cut its 2012 forecast to "1% or below."
Italy, the eurozone's third largest economy, has been dragged to the centre of the debt crisis over the past three months as concern has grown over a debt burden equal to some 120% of its gross domestic product.
Only the European Central Bank, which has been buying Italian bonds to prop up the market, has kept Rome's borrowing costs from spiralling out of control.
Despite this yields have crept back up steadily since the ECB stepped into the market in August.
Yesterday yields on Italian 10-year bonds stood at 5.59%, within sight of the point they had reached just before the ECB intervention.
That intervention has caused growing strain within the central bank, causing Chief Economist Juergen Stark to announce his resignation and prompting open opposition from the Bundesbank.
Greece continues talks with Troika
The Greek finance minister, Evangelos Venizelos, has held another conference call with international lenders in an attempt to persuade them to authorise the next instalment of a bailout loan.
Afterwards the European Commission said the talks, which included the IMF and the European Central Bank, had made good progress.
It said debt inspectors would return to Greece early next week to review the situation.
Greece is under pressure to plug a budget hole of more than €2bn under the terms of a €110bn EU-IMF bailout contracted last year.
