UPDATE 2-Bank of Italy warns weak growth could hit debt plan

Tue Aug 30, 2011 8:03am EDT

* Bank of Italy says growth may be under 1 pct in 2011, 2012

* Central bank urges structural measures in austerity plan

* Market tensions still high, bond auction disappointing

(Rewrites, adds quotes, detail, background)

By Catherine Hornby and James Mackenzie

ROME, Aug 30 (Reuters) - Italy's central bank said a weak economy threatens government efforts to contain the country's debt mountain, while rising bond yields after a lukewarm auction on Tuesday put it back in the front line of the euro crisis.

Ignazio Visco, deputy director-general of the central bank, said growth was likely to be under one percent in 2011 and even weaker in 2012 and warned that market tensions remained high.

"We risk a phase of stagnation, which would slow the decrease in the debt burden," Visco told a Senate committee.

His remarks came as the European Central Bank returned to the market to buy Italian bonds after an auction of long term BTPs drew a poor response that sent the spread over 10 year German bonds above the symbolically important 300 basis points.

Visco said changes to a 45.5 billion euro ($66 billion) austerity package aimed at balancing the budget by 2013 must include measures to boost growth in the euro zone's third largest economy.

"Balancing the budget has to be combined with economic policy aimed at reviving prospects for growth in our economy."

Prime Minister Silvio Berlusconi's government approved the austerity plan earlier this month after weeks of market turbulence hammered Italy's government bonds and dragged it close to a Greek-style financial crisis.

The plan was agreed after heavy pressure from the European Central Bank, but the government has since dropped parts of the plan including a proposed levy on high earners and also promised to ease funding cuts to local governments.

Berlusconi, who risked a split with his Northern League coalition partners over the mix of tax hikes and spending cuts, said he was pleased with amendments agreed on Monday, which left the overall size of the package unchanged.

However analysts said the uncertainty surrounding the package meant that markets would continue to remain suspicious of Rome's ability to control public finances.

"The continuous changing of the measures is not a good signal because it shows there is division and indecision in the government and it transmits uncertainty to the markets," said Citigroup economist Giada Giani.

NO ALTERNATIVE

Visco said there were increasing signs of weakness in the world economy and that growth in the euro area in the second half of the year was likely to be less than half the level seen in the first half.

"Considering these factors, in an environment which remains extremely uncertain, growth in GDP could be below a percentage point in the current year and even weaker in 2012," he said.

"This would inevitably have an effect on public accounts making the aim of balancing the budget more difficult and slowing down the reversal of the weight of public debt."

In July, the Bank of Italy had forecast growth of 1 percent in 2011 and 1.1 percent in 2012. On Tuesday, the head of statistics agency ISTAT said 2011 growth was unlikely to be much more than 0.7 percent.

Italy's public debt burden of more than 120 percent of gross domestic product is one of the heaviest in the world and its chronically sluggish economy has been one of the world's slowest growing over the past decade.

Visco said more measures were needed to boost competitiveness and create a more favourable environment for business but his remarks underlined how hard it will be to control the deficit while encouraging growth.

"Restoring public finances, aimed at balancing the budget by 2013, will slow growth but there are no alternatives," Visco told the Senate committee. "Any other scenario would lead to more traumatic results for our country."

(Editing by Ruth Pitchford)

($1 = 0.688 Euros)