Standard & Poor's cut its rating outlook for Italy to negative from stable, citing weak growth prospects and increased risks it would fail to slash its debt mountain.

The downward revision, which raises the risk of a downgrade of Italy's sovereign rating, may heighten fears that contagion from Greece's and other European countries' debt crisis could be spreading to the euro zone's third-largest economy.

In our view Italy's current growth prospects are weak, and the political commitment for productivity-enhancing reforms appears to be faltering, Standard & Poor's said in a statement released early on Saturday.

It said the fragility of Prime Minister Silvio Berlusconi's center-right coalition government meant such reforms were unlikely to be pushed through anytime soon.

Potential political gridlock could contribute to fiscal slippage. As a result, we believe Italy's prospects for reducing its general government debt have diminished.

Standard & Poor's affirmed its 'A+' long-term and 'A-1+' short-term sovereign credit ratings on Italy, which is slowly recovering from its worst economic downturn since World War Two and has one of the world's largest public debts.

Its outlook revision implies a one-in-three chance that the ratings could be lowered within 24 months.

S&P has often taken a bleaker view of the state of Italy's economy than other ratings agencies.

Moody's has an Aa2 rating for Italy and Fitch an AA-, so S&P has Italy two notches below Moody's and one below Fitch.

Italy has weathered the financial crisis better than some of its euro zone's peers but it has been one of the bloc's most sluggish economies for more than a decade.

Many analysts say unless it adopts reforms needed to sharply improve its growth potential, it has little chance of meeting its medium-term target to cut debt.

If low economic growth persists, the fiscal outcome will, in our view, likely significantly miss the government's targets and therefore may derail the debt-reduction plan, S&P said.

Italy hardly grew in the first quarter, with gross domestic product (GDP) edging up only 0.1 percent, compared with rises of 1.5 percent in Germany and 1.0 percent in France. Crisis-hit Greece grew 0.8 percent.

POLITICAL PARALYSIS

Italy's Treasury criticized S&P, saying data on economic growth and public accounts had constantly been better than expected.

However, while 1.3 percent growth in 2010 was slightly better than expected, the government last month cut its GDP growth forecasts for 2011, 2012 and 2013 and raised its projections for the public debt.

It kept the budget deficit outlook unchanged after a lower than targeted deficit of 4.6 percent of GDP in 2010.

The economy is now expected to grow by 1.1 percent in 2011 and 1.3 percent in 2012. Public debt is seen hitting 120 percent of GDP this year, falling slightly to 119.4 percent in 2012.

In a statement, the Treasury said the International Monetary Fund, the OECD and the European Commission had recently given very different assessments on Italy from that of S&P.

IMF and OECD analysts said this month that Italy's economy was recovering slowly, but added that it would require major structural reform to boost its growth potential.

They urged efforts to stimulate productivity growth and foreign investment -- but analysts said the government would be reluctant to take such action.

Berlusconi, because of his plunging popularity, is reluctant to take up what would be a very unpopular reform agenda that could result in job losses and falling incomes, said Raj Badiani from IHS Global Insight.

The market has been soft on Italy as it is used to its very low growth numbers and high public debt...(but) if growth slows sharply then people will reexamine Italian public debt levels and start grouping it with Spain, he said.

The Treasury ruled out the risk of political gridlock cited by S&P, saying measures aimed at meeting its target of balancing the budget in 2014 would get parliamentary approval by July.

However, S&P's revision is another blow for Berlusconi, who is embroiled in sex and corruption trials, and suffered a big setback this week in local elections. His coalition faces a risky run-off on May 29-30 in Milan, Italy's business capital.

The only bright note in the S&P assessment was for Italy's banking sector, which was helped by moves to strengthen capital and is in a stronger financial position than six months ago.

However, in a separate statement, S&P said the change in outlook could harm the creditworthiness of some Italian banks whose ratings are the same or higher than the sovereign ratings.

The banks are Intesa Sanpaolo and its core units, investment bank Mediobanca and BNP Paribas units Findomestic Banca and Banca Nazionale del Lavoro.

(additional reporting by Ian Simpson and Catherine Hornby)

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