Ratings agency Moody’s has downgraded Italian government bonds by three notches to A2 from Aa2 with a negative outlook. 

It cited the following arguments:

- The material increase in long-term funding risks for euro area sovereigns with high levels of public debt, such as Italy, as a result of the sustained and non-cyclical erosion of confidence in the wholesale finance environment for euro sovereigns, due to the current sovereign debt crisis.

- The increased downside risks to economic growth due to macroeconomic structural weaknesses and a weakening global outlook.

- The implementation risks and time needed to achieve the government's fiscal consolidation targets to reverse the adverse trend observed in the public debt, due to economic and political uncertainties.

The size of the downgrade (three notches) “is largely driven by the sustained increase in the country's susceptibility to financial shocks due to a structural shift in market sentiment regarding euro-area countries with high debt burdens,” stated Moody’s.

For indebted countries, their liquidity and solvency is often a matter of confidence.

If investors are confident and keep on lending to them at reasonable rates, they will never default.  If investors doubt and stop lending to them at reasonable rates, they will most likely default.

Moody’s noted that investors are losing confidence in indebted peripheral Eurozone countries, including Italy.

At various points during the European debt crisis, the market stopped lending to Greece, Ireland, and Portugal at reasonable rates, prompting the Eurozone to step in with bailout packages and credit agencies to downgrade their debt.

If the market zeroes in on Italy, it could “transition to substantially lower rating levels,” stated Moody’s.

An Italian debt crisis could be catastrophic for Europe.  Whereas Greece, Ireland, and Portugal were relatively small economies, Italy is the third largest in the Eurozone after Germany and France and likely falls in the category of “too big to bail out.”