Moody's cuts Italy credit rating by three notches

Demonstrators stand outside Milan's Stock Exchange Palace during a demonstration in Milan, September 6, 2011.

NEW YORK/ROME (Reuters) - Moody's Investors Service cut Italy's bond ratings by three notches on Tuesday, saying it saw a "material increase" in funding risks for euro zone countries with high levels of debt.

Moody's downgraded Italy's ratings to A2 from Aa2, a lower rating than that of Estonia, and kept a negative outlook on the rating, a sign that further downgrades are possible within the next few years.

The move comes after Standard and Poor's cut its rating on Italy to A/A-1 from A+/A-1+ on September 19 and underlines growing investor uncertainty about the euro zone's third largest economy, which is now firmly at the center of the debt crisis.

"The negative outlook reflects ongoing economic and financial risks in Italy and in the euro area," Moody's said in a statement.

"The uncertain market environment and the risk of further deterioration in investor sentiment could constrain the country's access to the public debt markets," it said.

Moody's also said that Italy's rating could "transition to substantially lower rating levels" if there were long-term uncertainty over the availability of external sources of liquidity support.

Italy's mix of chronically low growth, a huge public debt amounting to 120 percent of gross domestic product and a struggling government coalition has caused mounting alarm in financial markets.

The Moody's decision came as little surprise after the agency said on September 17 that it would finish a review for possible downgrade of its rating on Italy within a month.

"It's not that it was unexpected, but it doesn't help the situation at all," said Robbert Van Batenburg, Head of Equity Research, at Louis Capital in New York.

"They have already traded as if there was somewhat of a downgrade in the works, so it will probably force Italian policymakers to embark on more austerity programs. It will put another fiscal straitjacket on them," he said.

Moody's said the likelihood of a default by Italy was "remote," but the overall shift in sentiment on the euro area funding market implied a greater vulnerability to a loss of market access at affordable interest rates.

Italy's borrowing costs have soared over the past three months and have only been kept under control by the European Central Bank's purchase of its government bonds on secondary markets.

An auction of long-term bonds last month saw yields on 10 year BTPs rise to 5.86 percent, their highest level since the introduction of the euro more than a decade ago.

The center-right government of Prime Minister Silvio Berlusconi has been under heavy pressure over its handling of the escalating crisis and recently cut its growth forecasts through 2013.

It is now expecting the economy to expand by just 0.6 percent next year, down from a previous projection of 1.3 percent.

The government last month pushed through a 60 billion euro austerity package -- bringing forward by one year to 2013 a goal to balance its budget -- in return for support for its battered government bonds from the ECB.

(Reporting by Walter Brandimarte and Daniel Bases In New York, Catherine Hornby and James Mackenzie in Rome; Editing by Gary Crosse)