Moody’s has downgraded Italy’s government bond rating by two notches to Baa2 and warned it could cut it further.

The rating agency said Friday’s downgrade would not affect Italy’s Prime-2 short-term rating, but the move surprised markets and piled on pressure just hours before the eurozone third-largest economy launches its latest bond sale.

Moody’s said the downgrade was prompted by increased liquidity risks for the country amid persistent eurozone woes and an expected deterioration of Italy’s already weak economic condition.

The downgrade, which leaves Italy to just two notches above junk status, could raise already-painful borrowing costs and risks undermining Prime Minister Mario Monti’s efforts to turn market sentiment through tough fiscal and structural reforms.

The stark warning from Moody’s knocked the euro down about a quarter of a cent – not far from the two-year low of $1.2166 that was reached on Thursday – and sunk BTP futures 60 ticks down.

The long-term cost of borrowing for Italy also rose sharply, with the Italian benchmark 10-year government bond at 6.013 per cent, back above the key 6.0 per cent and up from 5.897 percent on Thursday.

Any yield – the rate of return earned by investors – above 6.0 per cent on long-term bonds is widely considered unsustainable.

Struggling banking sector

Moody’s warning comes as investors are already fretting about Spain’s ability to mend its banking sector.

“Italy’s government debt rating could be downgraded further in the event there is additional material deterioration in the country’s economic prospects or difficulties in implementing reform,” the agency warned.

“Should Italy’s access to public debt markets become more constrained and the country were to require external assistance, then Italy’s sovereign rating could transition to substantially lower rating levels.”

Moody’s took its ratings for Italy below those from agencies Standard & Poor’s Ratings Services and Fitch Ratings, a move that risks triggering further investment outflows from Italy.

In an interview published on Thursday, Peter Bofinger, an economic adviser to German Chancellor Angela Merkel, praised Monti’s reform efforts and said Italy’s borrowing costs of 6.0-6.5 per cent were “unreasonably high” in view of its structural balance and low deficit.

“It takes time to lower the debt. The key thing now is the deficit,” Bofinger said.

The timing could not be worse for Italy as it seeks to sell $6.40bn in medium-term bonds later on Friday, including a new three-year issue.

Bad timing

There had been hopes borrowing costs would fall at the auction after signs of progress on a Spanish bank bailout and a sharp improvement in Italy’s borrowing costs at a one-year bond auction on Thursday.

“Italian bonds were already giving up ground and the Moody’s news is going to chew them a bit further,” said a bond trader.

Moody’s said the downgrade was also driven by Italy’s increased susceptibility to political event risk, such as a Greek exit from the eurozone or Spain requiring further aid.

The agency said the country faced growing funding problems given its 2 trillion euro (US $2,402,400,11418.13) public debt and significant annual borrowing needs of 415 billion euros ($506,415,088,270.53) in 2012-2013, as well as its diminished overseas investor base.

On the other hand, a successful implementation of economic reform and fiscal measures that effectively strengthen the growth prospects of the Italian economy and the government’s balance sheet would be credit positive and could lead to a stable outlook, Moody’s said

Analysts estimate that foreigners hold about one third of Italy’s public debt, down from around 40 per cent a year ago. Data from Italy’s banking association ABI on Thursday also showed that foreign deposits at Italian banks were down 20 per cent year on year, confirming a trend of shrinking cross-border financing in the eurozone.

High sovereign borrowing costs are ‘unsustainable’ for Italian banks as they put massive strain on the cost of bank funding, Federico Ghizzoni, who heads Italy’s largest bank by assets UniCredit, said on Thursday.

Italian politicians and executives have criticised past rating action by the three top international agencies, saying the downgrades hit the country by forcing up borrowing costs.

Italian magistrates are currently investigating the downgrade action by the three rating agencies, which deny vigorously any wrongdoing.