Could Italy Follow Greece Into Trouble?

S&P cut its outlook on Italian debt at the weekend, citing fear over its growth record, weak reform process and the likely impact of reducing its high government debt.

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As the euro zone’s third largest economy, Italy matters but analysts believe it remains to be seen if the highly indebted country will fall foul of the bond vigilantes.

“While we remain negative on the ratings for peripheral euro zone, we don't think a downgrade of Italy by S&P is clearly warranted,” Win Thin, the global head of emerging market strategy at Brown Brothers Harman in New York, wrote in a research note following the S&P downgrade.

“Italy’s numbers have always been bad, and have in fact stayed remarkably stable during this crisis even as the rest of the periphery blew up,” Thin added.

The market remains on high alert about losses on Greek government debt and the likely impact on the balance sheets of the euro zone banks and the European Central Bank. Since the bailout of Portugal though, the euro zone’s major economies have avoided trouble from the ratings agencies or short sellers.

“Clearly, the downgrade story will remain in play for the periphery for much of 2011. Other weak euro zone credits to watch out for are Belgium and France, with both facing some mild downgrade pressures,” Thin added.

Analysts at Societe Generale expect investors to start pricing in more risk on Italy and Spain.

“Sovereign default is not a zero probability risk. One year since the first Greek bail-out and the European sovereign debt crisis is still not resolved. Unless market conditions improve dramatically, the situation could even deteriorate,” said Claudia Panseri from the European equity strategy team at Societe Generale.

”While Greek, Irish and Portuguese defaults are considered very likely in the short term, Italy and Spain defaults are not considered an imminent risk,” Panseri added.