Downgrade threat leaves shrinking pool of investors

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A reduction in the credit rating of heavily indebted countries such as Spain and Italy would substantially curb their ability to borrow much-needed cash – perpetuating a vicious downward spiral in which they are unable to raise all the funds they need to invest their way to growth while paying through the nose for the little they can secure.

As the threat of further downgrades to Spanish and Italian sovereign debt looms larger in the wake of last week's bailout of Greece, the pool of investors willing to lend to them by buying government bonds will become ever smaller. Already institutions such as pension funds are barred from buying bonds from governments such as Spain and Italy because they are only allowed to buy the safest triple-A rated debt.

A move into junk status would accelerate the process dramatically, scaring off another significant chunk of buyers. Rated by Moody's at Aa2, both Spain and Italy are seven notches above junk status, but analysts believe one, if not both, could end up there.

Moody's had Spain on a "negative outlook" and was reviewing Italy's rating even before the Greece deal, which it says makes further downgrades of "non-Aaa sovereigns" more likely. The reluctance among traditional lenders to buy Spanish and Italian debt is underlined by research from Fitch showing US money market funds – a key source of finance – have fled Europe in the past 18 months. At the end of June, US money market funds held just 0.8 per cent of their $1,570bn (£964bn) of assets in Spanish and Italian banks, well down from 6.1 per cent at the end of 2009.

There will always be some investors, such as hedge funds, willing to take on the debt of a high-risk lender – but they will charge crippling interest.