UPDATE 2-S&P cuts Italy rating, leaves outlook negative
* Rating cut to BBB from BBB+ on low growth outlook
* PM Letta says Italy remains under observation
* Treasury auctioning up to 16 billion euros of bonds this week (Recasts, adds quotes, detail, background)
By Luciana Lopez and Paolo Biondi
NEW YORK/ROME, July 9 (Reuters) - Ratings agency Standard & Poor's cut Italy's sovereign credit rating on Tuesday to BBB from BBB-plus and left its outlook on negative, citing concerns about prospects for an economy stuck in its worst recession since World War Two.
The announcement, which sent the euro lower, came a day before Italy was due to sell 9.5 billion euros of Treasury bills at auction and two days before a planned sale of up to 6.5 billion euros of medium and long term bonds.
"The rating action reflects our view of the effects of further weakening growth on Italy's economic structure and resilience, and its impaired monetary transmission mechanism," S&P said in a statement.
Italy's economy, the euro zone's third largest, has been one of the most sluggish in the world for more than a decade, held back by low competitiveness, a weak political system and a public debt of more than 130 percent of gross domestic product.
S&P noted that economic output fell 8 percent between the final quarter of 2007, on the eve of the global financial crisis, and the first quarter of 2013, and said data pointed to a sharp drop for the year as a whole.
It cut its full-year economic forecast to show a contraction of 1.9 percent, in line with a forecast by the International Monetary Fund last week.
The recession is making it more difficult for Prime Minister Enrico Letta to hit European Union budget targets while meeting demands from his centre-right coalition partners for tax cuts.
"Politically it's not welcome, coming at a time of high tension in the coalition over tax policies," said Erik Jones, professor of European studies at Johns Hopkins School of Advanced International Studies in Bologna.
"The ratings agencies, traditionally behind the curve, have woken up late to the fact that Italy won't meet its deficit target," he said.
Letta himself said the rating cut showed that Italy was still far from overcoming the long slump that took the euro to the brink of collapse in 2011.
"It's proof that the situation is still complex and Italy remains under special observation," he told a talk show on RAI state television on Tuesday.
Helped by European Central Bank pledges of support, Italy's borrowing costs have come down from crisis levels but remain higher than pre-crisis levels, with the yield on 10-year BTPs at around 4.4 percent.
Successive Italian governments have passed a succession of severe tax hikes and spending cuts to keep the deficit under control and Rome has emerged from the EU's special excessive deficit procedure, which Letta hopes will ease budget pressure.
However S&P said the main problem was a lack of structural reform to put the economy on a sustainable path toward growth.
"In our view, the low growth stems in large part from rigidities in Italy's labor and product markets," it said.
It pointed to data from the European Union statistics agency Eurostat which showed that nominal unit labour costs had increased more than in any other major member of the euro zone, underlining a sharp decline in productivity.
With the government at odds over issues ranging from demands to cut an unpopular housing tax to an order for F-35 combat jets and the legal problems of centre-right leader Silvio Berlusconi, prospects of concerted political support for reform appear weak.
Fitch rates Italy BBB-plus with a negative outlook. Moody's rates the country Baa2 with a negative outlook. (Additional reporting by Stephen Jewkes; Writing by James Mackenzie; Editing by Robin Pomeroy)
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