Market jitters over Italy eased on Friday after a successful bond auction despite a ratings downgrade by Moody's, which warned that short-term economic prospects were worse and political risk had increased.
The Italian Treasury raised 3.5 billion euros ($4.3 billion) in three-year bonds at a rate of 4.65 percent from 5.30 percent last month.
The rate on bonds due in 2019 however rose to 5.58 percent from 4.30 percent in March in the sale, which raised the maximum target of 5.25 billion euros.
The auction brought Italy's borrowing costs on the secondary debt market below a crucial 6.0-percent threshold for 10-year government bonds.
The Milan stock exchange also moved towards parity, with the main index showing a dip of 0.08 percent after falling sharply earlier in the session.
Moody's cut Italy's rating overnight by two notches, citing the knock-on effects of a possible Greek exit from the eurozone and Spain's banking woes.
As it reduced the rating to Baa2 from A3, Moody's said Italy was "more likely to experience a further sharp increase in its funding costs or the loss of market access" for borrowing.
"Italy's near-term economic outlook has deteriorated, as manifest in both weaker growth and higher unemployment, which creates risk of failure to meet fiscal consolidation targets," it said.
The move, which left Italy's rating just two notches above junk-bond status, provoked furious reactions from political and business leaders.
"I think our manufacturing country is stronger than the Moody's ratings would have us believe," said Giorgio Squinzi, the head of the main employers' federation, Confindustria.
Economic Development Minister Corrado Passera said the action was "completely unjustified and off the mark."
The European Commission also questioned the "timing" of the downgrade.
"I do think one can legitimately and seriously question the timing of it, whether the timing is appropriate," said commission spokesman Simon O'Connor.
He noted that the downgrade coincided with an "important bond sale" and said Italy's reform agenda over the past few months "has been impressive and it may not be an exaggeration to say it has been unprecedented."
Asked about the downgrade, Japanese Finance Minister Jun Azumi said he could not comment on specific actions by ratings agencies but pointed to the action plan agreed by European Union leaders on June 29.
"Europe can firmly overcome its issues and regain the confidence of the markets," he said.
Analyst Ugo Bertone of the financial news site firstonline.info said the impact would be limited because "there are no foreign buyers any more."
Many foreign banks and investors have reduced exposure to Italian sovereign debt risk while domestic lenders have increased it using cheap ECB loans.
Nicholas Spiro, managing director at Spiro Sovereign Strategy, told Dow Jones Newsires: "Once again, the Treasury was able to get its debt out the door which, right now, is the overriding priority.
"The concession, however, is still hefty and reflects the increasing risks in Italy," he said.
Moody's also underlined Italy's strengths like a primary budget surplus -- when revenues are set against spending before interest payments on the total debt, a diverse economy and a commitment to reforms.
But it cautioned that political risk was increasing ahead of a general election expected in April 2013 where Prime Minister Mario Monti, who leads a cabinet of technocrats, has said he will step down.
Former prime minister Silvio Berlusconi, who resigned in November 2011 following a parliamentary revolt and financial market panic, has meanwhile signalled he wants to return to the fray as candidate for premier.
Moody's noted that any EU bailout mechanism would be stretched to breaking point should Rome require emergency funding of its own.
Monti has said Italy is not planning to resort to EU assistance to help lower its borrowing costs but has not excluded the possibility in the future.
Moody's also said it expected Italy's economy to contract by 2.0 percent this year, "which will put further pressure on the country's ability to meet its fiscal targets", which were already scaled back in April.
The government's current forecast for 2012 is a 1.2-percent contraction.
Fellow eurozone struggler Spain has also been under pressure as the feel-good momentum of an EU plan to stabilise its stricken banks faded with news the lenders were even more dependent on the European Central Bank.
The Bank of Spain said ECB loans to the country's banks hit a record 337.2 billion euros ($411 billion) in June, as they were finding it more difficult to raise money on the financial markets.
