(Reuters) -- Moody's Investors Service on Friday downgraded Italy's government bond rating by two notches to Baa2 from A3 and warned it could cut it much further if the country were to lose access to debt markets.
The move left Italy's rating just two notches above junk status and could raise its borrowing costs ahead of a bond sale due later on Friday. The news knocked the euro down around a quarter of a cent to $1.2190 in Asian trade.
Moody's new rating was also below the latest ratings for Italy from agencies Standard & Poor's Ratings Services and Fitch Ratings.
It was the second downgrade in five months for Italy. Moody's downgraded the country, along with Spain and Portugal, in February.
"Italy's government debt rating could be downgraded further in the event there is additional material deterioration in the country's economic prospects or difficulties in implementing reform," the agency warned.
"Should Italy's access to public debt markets become more constrained and the country were to require external assistance, then Italy's sovereign rating could transition to substantially lower rating levels."
"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," Moody's added. "Failure to meet fiscal targets in turn could weaken market confidence further, raising the risk of a sudden stop in market funding."
A further deterioration in funding conditions as a result of new, substantial domestic economic and financial shocks from the euro area crisis would also place downward pressure on Italy's rating, it added.
On the other hand, a successful implementation of economic reform and fiscal measures that effectively strengthen the growth prospects of the Italian economy and the government's balance sheet would be credit-positive and could lead to a stable outlook, Moody's said.
The agency also lowered the maximum rating that can be assigned to a domestic issuer in Italy to A2 from Aaa. The lower ceiling reflects the increased risk of economic and financial dislocations, it said.
Moody's said the downgrade was driven by Italy's increased susceptibility to political event risk, such as a Greek exit from the euro zone or Spain requiring further aid.
The agency said the country faced growing funding problems given its high debt levels and significant annual borrowing needs of 415 billion euros in 2012-2013, as well as its diminished overseas investor base.
Moody's also warned of a further deterioration in the Italian economy, which it now expects to contract by 2 percent in 2012, putting pressure on the country's ability to meet its fiscal targets.
(Reporting by Wayne Cole; Editing by Edmund Klamann)