The ratings agency blamed increased liquidity risks for the country amid persistent euro zone woes and an expected deterioration of Italy's already weak economic condition as the main reasons behind its decision.

The downgrade of Italy to just two notches above junk status could raise already-painful borrowing costs for the country and risks undermining Prime Minister Mario Monti's efforts to turn market sentiment through tough fiscal and structural reforms.

The stark warning from Moody's, which comes as investors are already fretting about Spain's ability to mend its banking sector, knocked the euro down about a quarter of a cent and sunk BTP futures 60 ticks down.

"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."

Moody's took its ratings for Italy below those from agencies Standard & Poor's Ratings Services and Fitch Ratings, a move that risks triggering further investment outflows from Italy.

In an interview published on Friday, Peter Bofinger, an economic adviser to German Chancellor Angela Merkel, praised Monti's reform efforts and said Italy's borrowing costs of 6.0-6.5 percent were 'unreasonably high' in view of its structural balance and low deficit.

"It takes time to lower the debt. The key thing now is the deficit," Bofinger said.

BAD TIMING

The timing could not be worse for Italy as it seeks to sell 5.25 billion euros ($6.40 billion) in medium-term bonds later on Friday, including a new three-year issue.

There had been hopes borrowing costs would fall at the auction after signs of progress on a Spanish bank bailout and a sharp improvement in Italy's borrowing costs at a one-year bond auction on Thursday.

"Italian bonds were already giving up ground and the Moody's news is going to chew them a bit further," said a bond trader.

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 2 trillion euro public debt and significant annual borrowing needs of 415 billion euros in 2012-2013, as well as its diminished overseas investor base.

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

Analysts estimate that foreigners hold about one third of Italy's public debt, down from around 40 percent a year ago. Data from Italy's banking association ABI on Thursday also showed that foreign deposits at Italian banks were down 20 percent year on year, confirming a trend of shrinking cross-border financing in the euro zone.

High sovereign borrowing costs are 'unsustainable' for Italian banks as they put massive strain on the cost of bank funding, Federico Ghizzoni, who heads Italy's largest bank by assets UniCredit (CRDI.MI) said on Thursday.

Italian politicians and executives have criticized past rating action by the three top international agencies, saying the downgrades hit the country by forcing up borrowing costs.

Italian magistrates are currently investigating the downgrade action by the three rating agencies, which deny vigorously any wrongdoing.

(This story is correced with date of interview to Friday in paragraph 8)

(Writing by Lisa Jucca and Wayne Cole; Additional reporting by Thuy Ong; Editing by Jeremy Gaunt)

• A Permanent Economic Emergency