More drama has descended on the Republic of Italy's mounting fiscal problems. After the country revised GDP forecasts that breached the fiscal deficit cap imposed by the European Commission, Italy now faces the repercussions from a downward ratings action. Fitch Ratings last week changed its outlook on Italy to negative from stable.

Fitch affirmed the long-term rating at AA' and short-term at F1+ but said last week in a teleconference that the deteriorating scenario could possibly lead to a downgrade unless the country is able to turn around its negative growth prospects and public finances. Standard & Poor's lowered the country's ratings last July to AA-' stable from AA'.

Fitch analyst Nick Eisinger said that the medium term prospects were not looking positive. "The growth story has clearly been a disappointment over the short-term but there are also some serious question marks over medium-term and longer term growth prospects," he said. This year has dealt a series of blows to the Italian economy. The country is in a technical recession, with GDP shrinking 0.3%, said Fitch.

"Most of the key leading indicators have been weak and it's hard to see what is going to save the day in 2005," Eisinger said. The Italian government expects growth to be strong enough in 2006 to heal the fiscal gap, but Fitch says that its forecast of 1% growth will not be enough to offset the widening of the deficit.

Fitch said that its earlier anticipation that the public finance 3% GDP limit would not be breached this year was based on the government's implementing additional one-off measures as it has done in recent years but the agency is no longer factoring these structuring techniques in its GDP forecast outlook. According to Fitch, the government deficit now stands in excess of 4% and is expected to widen next year because of the elimination of one-off fiscal measures equal to 1% of the GDP so far this year.

The situation has deteriorated to the point where certain Italian political parties are rallying for a referendum to pull Italy out of the euro. Eisinger said a withdrawal from the common currency would be disastrous and, in any event, improbable. According to S&P, a return to the lira would mean a likely depreciation of about 25% from the current euro exchange rate levels and thanks to the euro, Italy has benefited from very low interest rates. "The rise in Italy's spread to about 25 basis points (bps) in the past month, while still very modest, provides a first indication of what the market reaction might be to a withdrawal from the euro," said analysts at S&P.

(c) 2005 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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