Will Rome Listen to Italy's Downgrade 'Wake-Up Call'

Domes of San Carlo al Corso Church and St. Peter's Basilica
Sylvain Sonnet | Photographer's Choice RF | Getty Images
Domes of San Carlo al Corso Church and St. Peter's Basilica

Italy's credit downgrade should be viewed as a "wake-up call" by the country's fractious government, analysts told CNBC - but they remained divided over whether the announcement would have any impact in Rome.

S&P lowered Italy's sovereign credit rating to BBB from BBB-plus on Tuesday, citing the country's weak economic prospects. The new rating is two notches above "junk" status.

The agency left the country's outlook at "negative" and said there was at least a one-in-three chance the rating would be revised down again this year or next. Italy's FTSEMIB benchmark index fell after markets opened on Wednesday, and was 1.2 percent lower in mid-morning trading.

(Read More: Is Italy on aCollision Course With Europe?)

"This is a wake-up call for Italy and perhaps it will raise the pressure on the government," Derek Halpenny, European head of global currency research at the Bank of Tokyo-Mitsubishi, told CNBC on Wednesday. "This isn't about austerity, this is about structural reform - or the lack of it in Italy. Gradually the risks are rising in Italy."

Halpenny added: "Really, the only potential thing that can shake Italy out of its complacency is the sovereign debt markets."

At a bond auction of 6 and 12-month bills on Wednesday, Italy sold 9.5 billion euros ($12.1 billion) of short-term bonds. Its one-year debt costs hit a four-month high.

Christian Schulz, senior economist at Berenburg Bank, also said the S&P downgrade should resonate in Rome.

"This downgrade might be a health warning to Italy," he told CNBC. "We almost need the ratings agencies to exert some pressure on the government to stay the course of reform and austerity."

The euro tumbled to a three-month low of $1.2756 against the dollar on Tuesday evening, before recovering to $1.2819 on Wednesday morning. The yields on Italy's benchmark ten-year bonds rose following the downgrade, from 4.38 percent to 4.47 percent on Wednesday morning.

Schulz called the downgrade "concerning" but said the absence of pressure from the bond market – given the European Central Bank's (ECB) support for peripheral euro zone countries with its Outright Monetary Transactions (OMT) bond-buying program – meant Italy needed a downgrade to put pressure on the government.

Other economists were not convinced that Rome would heed the warning from S&P's gloomy announcement. Michael Hewson, senior analyst at CMC markets, told CNBC the downgrade was "meaningless."

"Ratings downgrades have lost their capacity to shock. Everyone knows that Spain, Italy, Greece and Portugal are in dire straits and not implementing structural reforms as unemployment rises," he said on Wednesday.

"The Italian government has been weak in trying to implement reforms and - to borrow a phrase from the 'Italian Job' film - the government is like a 'self-preservation society.'"

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He added that, in effect, the ECB and OMT had prevented the Italian government from carrying out more reforms, as it was safe in the knowledge that European officials would do "whatever it takes" to save the euro zone.

"It takes the pressure off these peripheral governments to reform and I think Europe will stumble on in a zombie-like automaton – at least for a while," he said.

S&P is the third ratings agency to downgrade Italy this year. Fitch and Moody's also putting Italy on "negative" outlook and gave the country "BBB " and "Baa2" ratings respectively.

(Read More: Why Italy Could Be the Next 'Bad Boy of Europe')

S&P said it expected the Italian economy to contract by 1.9 percent in 2013, compared with its previous forecast of a 1.4 percent fall. Economists from Daiwa Capital Markets said they expected an even worse contraction - of 2 percent this year – in a note on Wednesday.

"Investors don't need rating agencies to tell them how dire a state Italy's economy is in," Nicholas Spiro, from Spiro Sovereign Strategy, said in a note. "There's nothing new in the latest assessment provided by S&P. Yet it's a further confirmation of the severity of Italy's recession."

Spiro added that, from a sentiment standpoint, the downgrade was "irrelevant," which would be reflected in the country's bond auctions.

"Italy's debt auctions this week are unlikely to be affected, particularly since demand has been lackluster for some time and yields have already been backing up because of tapering fears," he said.

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Italy's government - a fragile coalition led by Prime Minister Enrico Letta - has been under increasing pressure to continue with the reforms instigated by former premier Mario Monti. There are also growing tensions between Letta's party and its coalition partner, led by Silvio Berlusconi, over delayed tax increases.

Commenting on the downgrade on Italian television, Letta said: "It's proof that the situation is still complex and Italy remains under special observation."

- By CNBC's Holly Ellyatt, follow her on Twitter @HollyEllyatt