ROME/MILAN (Reuters) - Italy's stuttering economy showed further weakness on Monday as a slide in industrial output and a badly received Treasury bill auction added to signs that flagging growth is hampering efforts to reduce its debt.
Output in the euro zone's third largest member fell 0.7 percent on the month, its third monthly decline in a row and following a downwardly revised 0.8 percent drop in June, figures from statistics agency ISTAT showed.
The data came ahead of an auction of Treasury bills which saw the government's cost of borrowing over 12 months surge to a three-year high, with traders citing concern that the country may be headed for a credit rating downgrade.
Rating agency Moody's said on June 17 it might cut Italy's Aa2 sovereign rating following a review to be completed within 90 days.
Italy's mix of chronically weak growth and a debt equivalent to 120 percent of gross domestic product has dragged it to the centre of the euro zone crisis, dependent on support from the European Central Bank to keep its borrowing costs under control.
But doubts over whether the ECB will continue to hold yields down by buying Italian bonds in the market have rattled investor confidence following the announcement on Friday that ECB board member Juergen Stark was leaving his job over the issue.
The one-year rate shot above 4 percent on Monday, surpassing levels seen before the ECB started intervening on August 8. Yields on 10-year BTPs were at 5.5 percent while the 10-year spread over benchmark German Bunds stood at 378 basis points, having risen above 380 points in early trading.
"There is very little to be done. It is hard to expect better auctions for the issuer given what's happened over the past couple of days," said Alessandro Tentori, a fixed income strategist at BNP Paribas in London.
"There has been a lot of disappointment around the ECB."
The lower house of parliament will begin debating a 54 billion euro austerity package aimed at balancing the budget by 2013 but Monday's industrial output report from ISTAT underlined the mounting threat to Italy from its stagnant economy.
"Italy is lagging its external competitors, exports are not growing as fast as in Germany. Then it's weak in terms of domestic demand so industrial activity is not picking up in any meaningful way," said Citigroup economist Giada Giani.
Monday's output data was weaker than expected and contrasted with better than expected growth of 1.5 percent in French industrial output. Germany, the euro zone's largest economy, saw output jump unexpectedly by 4.0 percent thanks to strength in durable goods.
Germany, France and Italy make up at least two thirds of the euro zone's economic output.
The Bank of Italy said last month that Italy's economy would grow less than 1 percent this year and next, and some banks are now forecasting the economy will contract in 2012, threatening government plans for a balanced budget by 2013.
In Italy, production of consumer goods tumbled 3.2 percent on the month while the energy and intermediate goods sectors also declined, although investment goods rose by 1.8 percent.
Declining production in July was in line with recent survey-based indicators in Italy, which point to slowing momentum in the second half of the year after a slight acceleration in economic growth in the second quarter.
Consumer and business morale surveys have been generally weak in recent months due to concerns about the economy while purchasing managers surveys show activity in the manufacturing and services sector is contracting.
"There were already signs that the third quarter would see a loss of momentum due to slowing global growth," said Loredana Federico from Unicredit.
"Aside from that, the uncertainty surrounding the Italian government's austerity measures and their possible impact is weighing on Italian companies," she said.
Aggregate output data for the euro zone in July is due on Wednesday. The median forecast of a Reuters survey conducted prior to the most recent national data pointed to a 1.5 percent rise on the month and a 4.6 percent increase on the year.
Editing by Catherine Evans