By Jan Strupczewski and Francesco Guarascio
BRUSSELS (Reuters) - Italy's incoming government should aim to cut its heavy public debt, the European Commission said on Wednesday, warning of a risk that financial instability in Rome could spill over into the whole euro zone.
"Given its systemic importance, Italy is a source of potentially significant spillovers to the rest of the euro area," the EU executive said in an annual set of economic policy recommendations to Italy and the other EU member states.
Negotiations in Rome to set up a new government of anti-establishment and eurosceptic parties have raised concerns in Brussels and the rest of the Union about future policy in the euro zone's third-ranked economy -- and the impact that could have on a currency area still licking its wounds after a decade of sovereign debt crises in Greece and other smaller members.
The report rammed home already existing concerns about the state of the Italian economy, although senior Commission officials told reporters they had no plan to institute euro zone penalty procedures over Italy's high public sector debts.
Valdis Dombrovskis, the Commission's vice president for the euro, said the country had to continue reducing its debt and recommended a cut in the structural budget deficit next year of 0.6 percentage points -- an austerity plan unlikely to find favour with the parties trying to form a government this week.
The League and the 5-Star movement both performed well in an election in March on promises to spend more and tax less.
While EU officials, and the annual report itself, have been at pains to avoid explicitly commenting on their plans but Economics Commissioner Pierre Moscovici said it was important that Italy, an EU founder member, have a credible debt policy.
Markus Ferber, a German conservative member of the European Parliament whose views generally reflect hawkish sentiment in Berlin over the financial problems of Mediterranean euro zone states, said the Commission must challenge a League-5-Star government head on and not let it breach the bloc's discipline.
The League and 5-Star were planning "an open attack on ... the EU system of economic governance", he said. "The Commission must find a credible answer for once. Laissez-faire and business as usual will just not do the trick any more."
In the annual recommendations, the Commission said "medium-term sustainability risks remain high as structural primary surplus is insufficient to bring about a rapid decrease in public debt".
"Long-term fiscal sustainability is weakening too due to recent policy measures and adverse demographic trends," it added, warning that any reversal of pension reforms would lead to an increase in debt.
An imminent tighten of the European Central Bank's loose monetary policy could also be costly for Rome: "Risks may emerge if the current accommodative monetary policy stance were to be reversed," the Commission said.
"Italy is a major source of trade and financial spillovers," the report added. "Moreover, Italy's economy maintains strong financial linkages to other euro area countries. In particular, French banks remain in the lead."
(Additional reporting by Philip Blenkinsop; Writing by Alastair Macdonald)
