By Catherine Hornby and James Mackenzie
ROME (Reuters) - Italy's central bank warned on Tuesday government efforts to cut debt were at risk from weak growth as a tepid bond sale threatened to drag the euro zone's third biggest economy back to the center of the debt crisis.
Ignazio Visco, deputy director-general of the Italian 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, despite government austerity measures.
Many analysts expect close to zero growth next year, when austerity will bite in a country seen as too big to bail out if issuing bonds to cope with a 1.9 trillion euro debt burden becomes prohibitively expensive.
At the same time, the government's 45.5 billion euro ($65.97 billion) austerity package to balance the budget by 2013 has drawn widespread criticism for a lack of detail and a virtual absence of reforms to improve growth potential
"The problems of economic growth are perceived as a strong limit to the ability to rebalance the finances of our country," Visco told a hearing of the Senate budget 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.
The 7.74 billion euro bond auction had been seen as a crucial test of emergency steps taken to stem the spread of the euro zone debt crisis. Market participants say the ECB has focused on Italy in around 43 billion euros worth of debt purchases since it reactivated its bond buying program earlier this month to halt the spread of the crisis to Italy and Spain.
Italy slid dangerously close to a Greek-style meltdown last month as a market sell off sent yields on its 10-year bonds soaring to unsustainable levels of more than 6 percent.
The ECB's recent intervention has calmed immediate fears of a crisis that could overwhelm the euro zone and brought yields back down to just over 5 percent, but Tuesday's weak auction result showed how fragile the situation remains.
Visco said the overall austerity package was consistent with recommendations from the European Central Bank for balancing the budget but the final plan must include measures to help growth in Italy, which has one of the world's most sluggish economies.
"Balancing the budget has to be combined with economic policy aimed at reviving prospects for growth in our economy," he said.
The letter from the ECB outlining its recommendations has not been published despite investor nervousness about it and repeated calls for this from the center-left opposition.
The austerity plan was agreed after heavy pressure from the ECB, 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.
GROWTH WORRIES
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 he said left the overall size of the package unchanged.
However analysts said a lack of detail in the plans and the overall uncertainty surrounding the package meant markets would 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.
With prospects for growth in the United States looking shaky and the International Monetary Fund worried about Europe's banking sector, the outlook for the Italian economy is extremely uncertain, which in turn threatens budget plans.
Visco warned that the drive to squeeze deficits would inevitably hold back economic expansion and said 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.
Many private economists are even more pessimistic, with some large banks including Citigroup and Morgan Stanley predicting that the economy will contract in 2012.
Visco's call for more measures to boost competitiveness and create a more favorable environment for business reflect concerns about growth expressed by other groups, including Italy's main employers federation, Confindustria.
But his remarks also 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 Stephen Nisbet)