ROME/MILAN (Reuters) - Italy’s prime minister-designate labored to finalize his cabinet team on Friday, as markets tumbled and ratings agency Moody’s threatened a sovereign debt downgrade on fears the incoming government will embark on a spending spree.

Italy's newly appointed Prime Minister Giuseppe Conte leaves at the end of a round of consultations with political parties at the Lower House in Rome, Italy, May 24, 2018. REUTERS/Tony Gentile

Giuseppe Conte, a political novice with no managerial or administrative experience, was given a mandate on Wednesday to form a government made up of the anti-establishment 5-Star Movement and the far right League, following inconclusive elections in March.

The two parties have agreed a program that includes slashing taxes and ramping up spending, which prompted Moody’s late on Friday to place Italy’s ‘Baa2’ debt rating - two notches above junk status - under review for a possible downgrade.

The rating agency’s move may exacerbate tensions on markets, which have already slid on fears that the incoming eurosceptic government will undermine fragile state finances.

Markets are particularly on edge over the League’s insistence on giving the pivotal role of economy minister to 81-year-old economist Paolo Savona, who has questioned Italy’s membership of the euro.

“I’m very angry,” League leader Matteo Salvini said on Facebook on Friday evening, in an apparent reference to the dispute over Savona’s position.

“Nobody should fear change,” he said earlier in the day, adding that he was working on a government that would make Italy “a protagonist in Europe and in the world”.

The gap between Italian and German bond yields, a key measure of euro zone stress, surged to 216 basis points, its widest for four years, while Italy’s bank stock index hit an 11-month low.

Italy’s 2.3 trillion euro ($2.7 trillion) debt - the world’s third-largest and equivalent to more than 1.3 times the domestic output - makes the country vulnerable.

Moody’s cited a risk that the new government may fail to reduce public debt as key to its decision to review Italy’s rating.

“Far from offering the prospect of further fiscal consolidation, the ‘contract’ for government signed by the two parties includes potentially costly tax and spending measures, without any clear proposals on how to fund those,” the agency said.

Moody’s said it would wait to see whether the new government followed through on pledges to boost spending and scrap a 2011 pension overhaul which raised the retirement age.

Italy will test investor demand for its debt next week, offering bonds at auction.

Despite the recent surge, Italian yields are well below the peaks they reached during the euro zone crisis of 2011-2012, thanks mainly to the shield provided by the European Central Bank’s bond buying program.

At the height of that crisis the spread between Italian and German 10-year bonds stood above 550 basis points.

STUMBLING BLOCK

Conte is expected to present his cabinet team in the next few days and will then face confidence votes in both houses of the parliament.

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However, Savona remains a major stumbling block.

He has decades of experience in academia, banking and government but has alarmed markets with his eurosceptic views. One former economy minister has called him “suicidally anti-German”.

In his latest book he calls for a “plan B” to be drawn up to allow Italy to leave the euro zone with as little damage as possible should that prove necessary.

League leader Salvini and 5-Star chief Luigi Di Maio look certain to enter the cabinet as interior minister and labor minister respectively.

Ministers from the caretaker center-left government cleared out their offices on Friday in preparation for the new incumbents and outgoing Economy Minister Pier Carlo Padoan warned Conte not to misjudge the power of the markets.

“The most worrying aspect of the programme which this government is working on is its underestimation of the consequences of certain choices,” Padoan said in an interview published in Il Sole 24 Ore newspaper.

($1 = 0.8584 euros)