Italy has come under renewed pressure from the European Commission to take "decisive action" on economic reform or face fines, just weeks after the country's new prime minister Matteo Renzi took office.
The European Commission has launched a formal probe into Italy's economy which will see "specific monitoring" of whether the euro zone's third-largest economy is implementing reforms recommended to them.
High public debt levels and failure to implement structural reform will be the focus of the Commission's monitoring mission.
"Italy has to address the very high level of public debt and weak external competitiveness; both are ultimately rooted in the protracted sluggish productivity growth and demand urgent policy attention," the Commission said in the report.
"The need for decisive action to reduce the risk of adverse effects on the functioning of the Italian economy and of the euro area, is particularly important given the size of the Italian economy."
Italy along with Slovenia and Croatia were deemed to have "excessive macroeconomic imbalances" such as high current account deficits or unsustainable levels of debt. The Commission's investigation is made possible as part of powers granted to the European Union's executive arm two years ago to help oversee economic stabilization in the euro zone during the crisis.
If Italy fails to "deliver a sufficient corrective action plan" it could face financial sanctions.
The damning verdict on Italy's economy comes days after Olli Rehn, the European commissioner for economic and monetary affairs, said the country's economy would grow a meager 0.6 percent this year compared with 1.2 percent in the euro zone.
(Read more: Italy's new leader Renzi already in the soup)
Italy has been criticized over the past few years for a stagnant reform process and frustrating politics. Last month, Matteo Renzi became Italy's third unelected prime minister in three years taking over the reins from Enrico Letta, but faces huge problems to turn the economy around.
"It is clear that the new Italian government is going to have to create a situation where they post surpluses on both the budget and current account above the norm for Italy and that is clearly a huge challenge. It is quite a damning indictment and not a great opening for the Italian government," Raoul Ruparel, head of economic research at Open Europe told CNBC in a phone interview.
France budget miss
Rehn also warned that France would miss its agreed budget reduction deficit target if it did not take action, despite last year being given extra time to bring its budget deficit in line with EU rules, creating a risk to the euro zone economy.
"Despite measures taken to reduce the government deficit since 2010, public debt has continued to increase. This increases France's risk of exposure to financial market turbulence which would spill over to the real economy, but also to the rest of the euro area," the Commission said.
Spain has made a "significant adjustment" to its economy, the Commission said, adding to optimism over the one of the worst-hit countries during the crisis, which a year ago was deemed to have "excessive imbalances". But risks including high private and public debt as well as crippling unemployment still remain.
Rhetoric towards Germany's economy also calmed. The euro zone's largest economy came under fire from the U.S. last year for relying too heavily on exports. Germany's current account surplus has been above 6 percent of its gross domestic product since 2007.
The Commission recognized this surplus reflects "strong competitiveness", but warned that it needs to be monitored.
"Although the current account surplus does not raise risks similar to large deficits, the size and persistence of the current account surplus deserve very close attention," the report said.
—By CNBC's Arjun Kharpal: Follow him on Twitter @ArjunKharpal