Moody's on Friday threatened to cut Italy's credit ratings in the next 90 days on worries that Greece's crisis may drive euro-zone interest rates higher and derail Italy's fragile economic recovery.

The move underlines the risks facing debt-burdened European nations as they struggle to bring their budgets under control and avoid the kind of crisis that has sent Greece's economy into a tailspin.

It also underscores fears of contagion from Greece's debt troubles, with Moody's saying developments in the euro-zone debt crisis could be important determinants in its rating review.

Moody's placed Italy's Aa2 rating on review for downgrade, saying structural weaknesses such as a rigid labor market pose a challenge to growth. It also highlighted concerns about funding conditions of countries with high debt levels.

Italy has had structural impediments to growth for some time. However, today, these challenges coexist with a scenario of rising interest rates and fragile market sentiment, Moody's analyst Alexander Kockerbeck told Reuters in an interview.

The European Central Bank at its last policy meeting earlier this month held interest rates steady at 1.25 percent but signaled that it will raise rates in July.

Borrowing costs of peripheral euro-zone countries have already been rising due to uncertainty about the resolution of the European crisis, said Kockerbeck.

What we are looking at is the overall resolution of the debt crisis, whether the uncertainty around that issue will be cleared, he said.

Moody's said its decision will also take into account Italy's ability to implement the consolidation plans required to reduce the nation's debt and keep it at affordable levels.

Moody's announcement came after European markets had closed for the weekend. In late New York trade, the euro trimmed gains against the U.S. dollar, falling to $1.42770 from about $1.43180 before the news. It was last at $1.42830, still up 0.5 percent on the day.

The Moody's news on Italy reinforces the ECB's concern about the prospect of contagion. And contagion should not happen, said Greg Salvaggio, senior vice president at Tempus Consulting in Washington.

STRUCTURAL WEAKNESS

Italy has one of the heaviest public debt burdens in the world, equivalent to some 120 percent of gross domestic product. That's not far from Greek levels, though Italy has largely avoided the turmoil that has hit countries like Greece and Ireland.

Italy's conservative banking system, high levels of private savings and a tight clamp on public spending have largely shielded it from the euro zone debt crisis, but its chronically sluggish growth has made it impossible to cut the debt.

In its report, Moody's said Italy's economy has long-term structural weaknesses such as low productivity as well as labor and product market rigidities that have impeded growth over the last 10 years.

Italy has so far only recovered a fraction of the nearly seven percentage points in GDP that it lost during the global crisis, despite low interest rates, which are likely to rise in the medium term, Moody's said.

Earlier on Friday, Italian and Greek bonds rose on a tentative agreement by France and Germany on broad steps over how to move forward with a second aid package to Greece.

Greece's 10-year bond yields dropped 95 basis points to 17.53 percent. Italy's 10-year bond spreads narrowed by 9 basis points to 186 basis points over benchmark German bunds.

Unfortunately, the news flows of European downgrades will only increase the volatility (in) the markets, said David Kelly, chief market strategist at J.P. Morgan Funds in New York.

Greece is in the most financial trouble in Europe ... Other countries including Italy clearly have budget issues. This shows that Europe can't wash its hands of the Greece situation. It must isolate the problem with Greece and help other countries to deal with their fiscal issues, he added.

Standard & Poor's rating on Italy's long-term foreign-currency bonds is two notches below Moody's, at A-plus, with a negative outlook. Fitch rates Italy between S&P and Moody's, with an AA-minus rating and stable outlook.

(Additional reporting by Burton Frierson, Pam Niimi, Richard Leong and Gertrude Chavez-Dreyfuss in New York; James Mackenzie in Rome; Editing by Leslie Adler)

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