Standard and Poor's has cut its ratings on Italy by one notch, warning of a deteriorating growth outlook and damaging political uncertainty, in a move that took markets by surprise and added to pressure on the debt-stressed euro zone.
S&P's downgraded its unsolicited ratings on Italy to A/A-1 from A+/A-1+ and kept its outlook on negative, sending the euro more than half a cent lower against the dollar.
The agency, which put Italy on review for downgrade in May, said that the outlook for growth was worsening and there was little sign that Prime Minister Silvio Berlusconi's fractious centre-right government could respond effectively.
But Berlusconi said this morning that Standard & Poor's decision did not reflect reality and said his government was already preparing measures to spur growth.
"The assessments by Standard & Poors seem dictated more by newspaper stories than by reality and appear to be negatively influenced by political considerations," 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.
Under mounting pressure to cut its €1.9 trillion debt pile, the government pushed a €59.8 billion austerity plan through parliament last week, pledging a balanced budget by 2013.
But 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.
"We believe the reduced pace of Italy's economic activity to date will make the government's revised fiscal targets difficult to achieve," S&P's said in a statement.
"Furthermore, what we view as the Italian government's tentative policy response to recent market pressures suggests continuing future political uncertainty about the means of addressing Italy's economic challenges," it said.
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.
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.
Italian sources said yesterday that the government was preparing to cut its growth forecast to 0.7% in 2011 from a previous forecast of 1.1% and cut its 2012 forecast to "1% or below."
Italy, the euro zone'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.
But the move from S&P was a surprise because the market had thought Moody's was more likely to downgrade Italy first. Moody's last week said it would take another month to decide on its action.
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, but yields have crept back up steadily since the ECB stepped into the market in August.
Yields on Italian 10-year bonds stood at 5.66% this evening, within sight of above 6% they had reached just before the ECB intervention. The 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.
The S&P downgrade, which came as Greece struggles to meet demands from lenders for yet more austerity measures, underlined the mounting seriousness of the euro zone crisis, which has rattled global markets.
Meanwhile, a European Commission spokesman has declined to comment on the S&P decision. But 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 required a "national consensus" to introduce the measures which would return the country to growth.
