Moody's Investors Service on Friday said it would finish reviewing Italy's Aa2 sovereign currency credit rating for possible downgrade within the next month, adding Italy faces a challenging economic and financial environment.

Moody's put Italy's rating on review in June and as the original 90-day review period drew to a close this week, Italian and French bank shares fell sharply on fears of a ratings cut.

The stocks of France's BNP Paribas and Credit Agricole and Italy's UniCredit shed 7.0 percent each on Friday even though the overall market was higher for a fourth straight day. Investors fear a downgrade would hurt banks with large holdings of Italian government debt.

Italy, the euro zone's third largest economy, has been hammered over the past two months by financial markets increasingly concerned by its combination of massive public debt and a stagnant economy.

In light of the increasingly challenging economic and financial environment and fluid political developments in the euro area, Moody's is continuing to evaluate Italy's local and foreign currency bond ratings in the context of the risks identified, the agency said in a statement.

Moody's will strive to conclude the review within the next month, it said.

The original Moody's review in June and a similar review by rival ratings agency Standard and Poor's helped focus market concern over Italy, which has had one of the world's slowest growing economies over the past decade.

Moody's cited structural economic weaknesses such as a rigid labor market, rising debt financing costs and risks to a plan to reduce Italy's overall debt burden.

As well as slow growth, Italy has one of the largest public debt burdens in the world, equivalent to about 120 percent of gross domestic product. After Greece, that is the largest ratio in the 17-country euro zone.

PIECE IN THE PUZZLE

Until last spring, Italy stood largely on the sidelines in the euro zone debt crisis, insulated by a relatively modest budget deficit, a high rate of private savings and a generally conservative financial and banking system.

But while it has not followed Greece, Ireland and Portugal in seeking emergency aid, it has faced sharply increased borrowing costs as debt worries have spurred investors to demand higher returns to buy its government bonds.

It certainly is a piece in a puzzle that has been deteriorating lately and that deterioration has weighed on the euro. Six months ago no one would have thought we would be asking these questions about Italy, said Steven Englander, head of G10 currency strategy at Citigroup, in New York

Perhaps in six months we won't be asking these questions. Given the way growth has declined and the way countries have been struggling to meet their targets and the extent to which a Greek default is now priced into the market, I think that there is a tendency to assume the worst when this kind of news comes out, he said.

Italy's borrowing costs have come under mounting pressure since July when worries about the sustainability of its 1.9 trillion euro debt burden triggered a market selloff that sent bond yields over 6.0 percent.

A fractious political climate that has hindered reform has unnerved investors, too.

Italy's center-right government has struggled to get its finances in order, and the 54 billion euro austerity plan aimed at balancing the budget by 2013 was overhauled four times before being passed in parliament this week.

Only the European Central Bank's intervention to buy Italian bonds has held borrowing costs down but there has been growing concern over how long the central bank can keep providing assistance.

As speculation has increased that Greece may be forced to default, and concern has grown about Italian flip-flopping over budget cuts aimed at balancing the budget by 2013, Italian yields have crept steadily higher.

On Friday, yields on 10 year Italian bonds stood at some 5.5 percent, while the premium investors require to hold Italian bonds over safer German bonds stood at 366 basis points, down from highs of more than 400 points seen earlier this week after more reassuring signs from European policy makers.

The ECB said it bought another 14 billion euros in euro zone government debt last week to hold down countries' borrowing costs and now holds 143 billion euros in Italian, Spanish, Greek, Portuguese and Irish government bonds.

The Bank of Italy is forecasting growth of less than 1.0 percent this year and next. Many private sector economists are even more pessimistic, with several expecting Italy to tip back into recession in 2012.

Standard & Poor's has Italy at A-plus with a negative outlook while Fitch Ratings has it at AA-minus with a stable outlook.

Moody's rating is two notches above S&P and one notch above Fitch. Moody's rating is two notches below the gold-plated Aaa status.

(Additional reporting by Daniel Bases and Burton Frierson in New York; Editing by Clive McKeef)

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