US ratings agency Moody's downgraded Italy's government bond rating by two notches, citing the knock-on effects of a possible Greek exit from the eurozone and Spain's banking woes.

In reducing the rating to Baa2 from A3, Moody's said Thursday that Italy was now 'more likely to experience a further sharp increase in its funding costs or the loss of market access' for borrowing to service its budget.

The move lowered Italy's rating to two notches above junk-bond status, and came just before the debt-laden country attempts Friday to raise 5.25 billion euros ($6.4 billion) in a medium- and long-term government bond auction.

Earlier Thursday Italy raised 7.5 billion euros in one-year bonds at a sharply lower rate than previously, indicating improved investor confidence.

But in a statement, Moody's Investors Service spelt out the challenges both external and internal that face the eurozone's third-biggest economy.

"The risk of a Greek exit from the euro has risen, the Spanish banking system will experience greater credit losses than anticipated, and Spain's own funding challenges are greater than previously recognized," it said.

"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.''

"Failure to meet fiscal targets in turn could weaken market confidence further, raising the risk of a sudden stop in market funding," it said, reaffirming a negative outlook for Italian debt.

Moody's stressed that Italy did have some strengths: a primary budget surplus not counting interest payments on its cumbersome debt, a diverse economy, and the technocratic government's determination to enact reforms.

But the shorter term picture is clouding across the eurozone with Spain the biggest member yet to receive bailout funding. An EU credit line worth 100 billion euros is now available for its distressed banks.

Italy's economy is bigger still, behind only Germany and France in the eurozone, and Moody's noted that any EU bailout mechanism would be stretched to breaking point should Rome require emergency funding of its own.

On June 29, EU leaders reached an agreement to enable two rescue funds -- the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) -- to assist flailing economies.

But Moody's said, "there is a limit to the extent to which these support mechanisms can be used to backstop such a large, systemically important sovereign" debtor such as Italy.

The US credit risk appraiser said it expected Italy's economy to contract by 2 per cent this year, 'which will put further pressure on the country's ability to meet its fiscal targets' that were already scaled back in April.

The Italian government's own forecast for 2012 is for gross domestic product to shrink by 1.2 per cent.

But Moody's praised the 'strong commitment to structural reforms and fiscal consolidation' shown by the government of Prime Minister Mario Monti, a former EU commissioner who took over amid financial market panic in November 2011.

It noted that Monti's administration had implemented three rounds of fiscal tightening, strengthened the pension system and approved a balanced budget rule effective from 2014, which should all 'materially improve' Italy's prospects.

In early Asian trade Friday, the euro was almost unchanged at $1.2207, from $1.2203 in New York on Thursday afternoon. It fetched 96.85 yen, from 96.75 in New York.

The common currency had on Thursday hit $1.2167 in European trading, its weakest level since late June 2010.