Italy's huge budget deficit and debt along with delays in spending post-COVID EU funds could erode investor confidence, the International Monetary Fund warned on Monday.

In its annual Article IV report on the Italian economy, the IMF urged the government to reach a primary surplus - net of debt servicing costs - of around 3% of output to ensure a gradually declining debt-to-GDP ratio.

Italy plans to bring the deficit below the European Union's 3% threshold in 2026 while the debt, the second largest in the euro zone as a proportion of output, will follow a rising trend towards 140% of GDP through 2026.

This year the government forecasts a primary deficit of 0.4% of GDP, narrowing from a primary deficit of 3.4% in 2023.

"Domestic factors could weaken growth, including an inability to complete the post-pandemic spending and effectively implement reforms, while still large fiscal deficits could erode investor confidence, further weakening public finances," the IMF said.

Rome should also raise the effective retirement age to streamline its expensive pension bill.

Italian GDP is seen by the IMF rising by 0.7% in 2024 and 2025 as the expansionary effect stemming from the EU funds is expected to largely offset the phasing out of costly incentives for home renovations, the so-called Superbonus.

However, a "faster than planned fiscal adjustment is warranted to lower the debt ratio with high confidence and reduce financing risks."

The Italian banking system remains sound according to the IMF, but stability risks could rise as monetary policy becomes less restrictive and the effects of exceptional support measures wane.

"The current increase in bank profits should be used to reinforce resilience to potential future shocks while funding should be adequately diversified," the report said, adding any scheme allowing borrowers to buy back previously-sold non performing loans (NPLs) risks undermining the secondary market for bad loans.

Last year a growing number of lawmakers from both ruling and opposition parties backed proposals to amend bad-loan rules to help borrowers - both individuals and small- and medium-sized businesses - stoking uncertainty in the sector that buys up bad loans, which is already facing a dearth of activity.

(Reporting by Giuseppe Fonte; Editing by Susan Fenton)