This week, a possible downgrade of Italy would sound like a bad omen for the Eurozone. Moody’s believes that the country presents a “substantial credit risk.” The country is currently at the lowest investment-grade level with a negative outlook.

Prime Minister Giorgia Meloni adopted a more flexible budget policy in September, which widened the yield spread between Italian bonds and Germany to 210 basis points for the first time since January. A downgrade in the rating could push the spread back to 250 basis points, a level last seen during the 2022 snap elections that brought Meloni to power.

Any increase in yields could exert increased pressure on the European Central Bank.
While some funds may exclude holding junk bonds, a single assessment could limit the damage, and investors have had time to prepare. However, a seismic reaction cannot be ruled out: Greece’s first downgrade to speculative grade in 2010 exacerbated Europe’s situation.

Moody’s has highlighted three problematic areas. Two concerns are structural reforms and challenges related to energy supply, where the Meloni government could claim progress. But public finances are the biggest concern. According to Moody’s, “There are risks that Italy’s budgetary strength could be further weakened by sluggish growth, higher financing costs, and potentially weaker budget discipline.”

Italy has just narrowly avoided a recession, and the ECB’s interest rate hike has fueled borrowing costs, with Meloni’s 2024 budget described by Moody’s rival, Fitch Ratings, as a “significant loosening.” There is no longer an expected primary surplus next year, where revenues will exceed expenses before interest charges, and the deficit will not return to the European Union’s 3% limit until 2026.
Moody’s tends to focus on debt as a percentage of GDP.

Significantly, Moody’s has a much more pessimistic view than its competitors. Fitch and S&P rate Italy one notch higher with stable outlooks.
Stripping Italian debt of its investment-grade status also appears delicate compared to other G7 economies. Its debt-to-GDP ratio is much lower than Japan’s 255%, which Moody’s rates several notches higher. The UK and France have even better ratings but higher debt ratios and budgetary challenges. However, unlike Italy, the UK or Japan benefit from the flexibility of their currency. This is where the role of the ECB will be crucial: Frankfurt officials have prepared a crisis tool to contain turbulence but would require the Italian government to adhere to foreign policy demands. Such assistance might be necessary if Moody’s were to make downgrades. The fact that a few investors seem not to anticipate a downgrade may amplify volatility.

With borrowing costs at their highest level in over a decade, a downgrade would inevitably spark a new debate about Italy’s ability to honour its debt obligations.