Credit ratings agency Moody's Investors Service has downgraded Italy's government bond rating two notches on concern that deteriorating financial conditions in Europe will lead to a sharp rise in borrowing costs.

The agency lowered the rating to Baa2 from A3 because it says fragile market confidence and risk of contagion from financial problems in Greece and Spain have increased the risks Italy faces.

Moody's also said it's worried about a diminished willingness among overseas investors to buy the country's bonds. The new rating is two notches above junk status.

The downgrade is another blow to a European economy that is flailing from the effects of austerity measures brought on by high government debt.

Moody's says Italy's short-term economic outlook has deteriorated, as evidenced by weaker growth and rising unemployment.

It was the second downgrade in five months for Italy. Moody's downgraded the country, along with Spain and Portugal, in February.

Moody's said the Italian economy is worsening, and that is also hurting the government's financial position. The agency projects the country's economy to shrink by 2% this year, which would make it harder for Italy to meet fiscal targets.

Among risks from outside the country, Moody's cited the possibility of a Greek exit from the euro currency union and a worsening crisis among Spanish banks. Earlier this week, European financial ministers agreed to a 30 billion euro bailout for Spain's banks. That deal is expected to be finalised on July 20.