The International Monetary Fund urged Rome to be decisive on cutting its deficit as investors dumped Italian bonds and the country's leaders rushed to pass a massive austerity plan.
Amid worries that Italy could follow Greece and Portugal into a financial maelstrom and require a bailout, the IMF praised Italy's reform program that has already cut its current deficit to 4.5 percent of GDP, down from 5.3 percent, in the past two years.
It also said the country had moved well to force banks to boost their capital strength.
But it said the government needs to move firmly to "rationalize" expenditures to set better priorities and make cuts even as growth has plummeted to a stagnant 0.1 percent per quarter on the back of low domestic demand and rising unemployment.
"While the economy has strengths, the public debt is high and growth is expected to remain constrained because of long-standing structural bottlenecks," the Fund said.
In its periodic review of the Italian economy, the IMF board called the government's recent medium-term fiscal plan "an important step" toward cutting its deficit to below 3 percent of GDP by 2012 and almost zero by 2014.
But it suggested there was little room for error given the testiness of markets for eurozone debt.
"The main downside risk comes from market turmoil in the euro area periphery," the IMF said.
"Another decade of stagnation also poses a major risk."
The Italian government earlier this month announced a four-year austerity budget worth 40 billion euros ($56.5 billion) in a bid to slash its deficit, as it faced worries about its ability to service a debt load that amounts to an extremely high 119 percent of GDP.
"Decisive implementation of the package is key," the IMF said, suggesting that some accelerated spending measures might help quell the worries in the markets.
"The main policy goals should be to continue pursuing fiscal consolidation to reduce the large public debt, maintain financial sector stability, and boost growth potential through structural reforms."
The report came as Italian bonds fell under attack in the markets and Italian stocks plummeted, with investors worried the government's heavy debt burden would push Europe's third largest economy down the path of Greece, Portugal and Ireland, and pull struggling Spain with it.
Earlier Tuesday Rome scrambled to adopt the ambitious plan for budget cuts in a bid to douse a spreading eurozone market turmoil.
"We are on the frontlines in this battle," Prime Minister Silvio Berlusconi said, as parliament moved to adopt the new austerity plan by the end of the week.
"The crisis is pushing us to accelerate the process of austerity in a very short time frame, to strengthen its content and to define further measures following the achievement of budget balance in 2014," he added.