By Catherine Hornby and James Mackenzie
ROME (Reuters) - The Bank of Italy warned on Tuesday that government plans to cut debt were at risk from weak growth as a lukewarm bond sale threatened to drag the euro zone's third-biggest economy back to the center of the debt crisis.
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Ignazio Visco, deputy director-general of the Italian central bank, said growth was likely to be under 1 percent in 2011 and even weaker in 2012 and warned that market tensions remained high, despite government austerity measures.
"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.
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.
Visco's 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 major test of emergency steps taken to stem the spread of the euro zone debt crisis. Market participants say the ECB has focused on Italy with 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 selloff 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.
The austerity package was passed by parliament in record time as the markets crisis raged earlier this month. But the plans have drawn wide criticism and Prime Minister Silvio Berlusconi has promised changes that are due to be sealed later this month.
However, Italy's record as one of the world's slowest-growing economies over the past decade means that broad skepticism remains over how effective even an amended package will be.
"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 analyst Giada Giani.
"I don't think they'll get a balanced budget, especially because growth is falling sharply. We forecast the economy will contract by 0.3 percent next year," she said.
The latest amendments scrap key parts of the package, including a so-called "solidarity tax" on high earners and some cuts to local authority funding.
No detail has been given on how the changes would be funded apart from vague promises of a crackdown on tax evasion.
The amendments also put back the retirement age of many workers who will no longer be able to count years spent at university or in compulsory military service, even when they have paid contributions for those years.
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 and the uncertainty surrounding the package meant markets would remain suspicious of Rome's ability to control public finances, particularly given the funding gap opened up by the latest amendments.
"There is a question mark against how they are going to make the numbers add up now that they have abolished the solidarity tax and reduced the cuts to local government," said UniCredit economist Chiara Corsa.
Visco's call in the Senate for more measures to boost competitiveness and help 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."
(Additional reporting by Gavin Jones; Editing by Dan Grebler)