Market jitters over Italy eased today after a successful bond auction despite a ratings downgrade by Moody's.
The Italian Treasury raised €3.5 billion in three-year bonds at a rate of 4.65% from 5.3% last month.
The auction, which raised the maximum target amount of €5.25 billion, also sold bonds due in 2019, 2022 and 2023, the Bank of Italy said.
While the rates on bonds due in 2022 and 2023 were in line with previous sales, the 2019 rate rose sharply to 5.58% from 4.3% in March.
The auction brought Italy's borrowing costs on the secondary debt market below a crucial 6% threshold for 10-year government bonds.
Markets had eased this week after an accord to help Spain's banks. That accord also took some of the pressure off Italy, seen as the next euro zone state most at risk in the debt crisis.
But the Moody's rating action has put Rome back in the firing line.
Moody's cut Italy's rating overnight by two notches, citing the knock-on effects of a possible Greek exit from the euro zone and Spain's banking woes.
In reducing the rating to Baa2 from A3, Moody's said Italy was now "more likely to experience a further sharp increase in its funding costs or the loss of market access" for borrowing.
"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," it said.
The move, which left Italy's rating just two notches above junk-bond status, provoked furious reactions from political and business leaders.
"I think our manufacturing country is stronger than the Moody's ratings would have us believe," said Giorgio Squinzi, the head of the main employers' federation, Confindustria.
Economic Development Minister Corrado Passera said the action was "completely unjustified and off the mark." But analyst Ugo Bertone of the financial news site firstonline.info said the impact would be limited because "there are no foreign buyers any more."
Many foreign banks and investors have reduced exposure to Italian sovereign debt risk while domestic lenders have increased it using cheap ECB loans.
Moody's also stressed that Italy did have some strengths like a primary budget surplus - when revenues are set against spending before interest payments on the total debt, a diverse economy and a commitment to reforms.
But it cautioned that political risk was increasing ahead of a general election expected to be held in April 2013 where Prime Minister Mario Monti, who leads a cabinet of technocrats, has said he will step down. Former prime minister Silvio Berlusconi, who resigned in November 2011 following a parliamentary revolt and financial market panic, has meanwhile signalled he wants to return to the fray as candidate for premier.
Italy's economy is bigger than Spain's, behind only Germany and France in the euro zone, and Moody's noted that any EU bailout mechanism would be stretched to breaking point should Rome require emergency funding of its own.
Monti has said Italy is not planning to resort to EU assistance to help lower its borrowing costs but has not excluded the possibility in the future.
But Moody's said "there is a limit to the extent to which these support mechanisms can be used to backstop such a large, systemically important sovereign" debtor such as Italy.
It said it expected Italy's economy to contract by 2% this year, "which will put further pressure on the country's ability to meet its fiscal targets", which were already scaled back in April. The government's current forecast for 2012 is a 1.2% contraction.
