Anti riot police react during clash with anti-austerity protesters near the Italian Parliament building in downtown Rome, Sept 14, 2011. [Photo/Agencies]

NEW YORK/ROME - Moody's lowered its rating on Italy's bonds by three notches on Tuesday, saying it saw a "material increase" in funding risks for euro zone countries with high levels of debt and warning that further downgrades were possible.

The agency downgraded Italy to A2 from Aa2, a lower rating than it holds on Estonia and on a par with Malta and kept a negative outlook on the rating.

The euro pared gains against the dollar and Japanese yen immediately following the announcement which comes after Moody's rival Standard and Poor's cut its rating on Italy by one notch to A/A-1 on September 19.

The cuts underline growing investor concern about the euro zone's third largest economy, which is now firmly at the center of the debt crisis and dependent on help from the European Central Bank to keep its borrowing costs under control.

"The negative outlook reflects ongoing economic and financial risks in Italy and in the euro area," Moody's said in a statement.

"The uncertain market environment and the risk of further deterioration in investor sentiment could constrain the country's access to the public debt markets," it said.

It added that Italy's rating could "transition to substantially lower rating levels" if there were long term uncertainty over the availability of external sources of liquidity support.

Italy's mix of chronically low growth, a public debt mountain amounting to 120 percent of gross domestic product and a struggling government coalition has caused mounting alarm in financial markets.

Moody's decision came as little surprise after the agency said on September 17 that it would finish a review for possible downgrade of its rating on Italy within a month.

But it highlights the growing vulnerability of the euro zone, which is already struggling to contain the crisis in the far smaller Greek economy and which would be overwhelmed by a crisis of a similar scale in Italy.

"It's not that unexpected but it doesn't help the situation at all," said Robbert Van Batenburg, Head of Equity Research at Louis Capital in New York.

"They have already traded as if there was somewhat of a downgrade in the works, so it will probably force Italian policymakers to embark on more austerity programs. It will put another fiscal strait-jacket on them."