Rome: Italy’s economy shrank in the third quarter, setting the country on course for what is expected to be a prolonged recession hampered by a debt burden demanding harsh austerity.

Gross domestic product (GDP) in the euro zone’s third largest economy sank 0.2% from the previous three months, hit by a fall in domestic demand. It was up just 0.2% year-on-year, national statistics bureau ISTAT reported on Wednesday.

File photo of a customer waits to pay at a supermarket in downtown Rome 20 Dec 2011 (Reuters)

Italian bonds have in recent months yielded more than 7%, a level widely considered unsustainable. They were at 6.7% on Wednesday.

There has been a range of pointers to Italy’s declining prospects. Purchasing managers’ surveys and industrial output data suggest a steeper fall than the Q3 data—of at least 0.6% in the fourth quarter.

Industry groups are expecting worse.

“A flurry of poor economic data and the intense financial contagion hitting Italy from the euro zone debt crisis point to a painful and prolonged recession which is expected to prevail until the final quarter of 2012," said IHS Global Insight’s Raj Badiani, who forecast a 1.5% GDP contraction in 2012.

This will make new, technocrat Prime Minister Mario Monti’s task even harder.

Earlier this month, he presented €34 billion of tax hikes and spending cuts, saying Italy’s third austerity package since the summer was needed because of a deteriorating growth outlook.

Monti forecast GDP would contract by 0.4% next year, but most analysts say that is already looking optimistic, raising the prospect of yet more cuts in a grim spiral of austerity, recession, and yet more austerity.

Monti now faces the even tougher challenge of tackling structural reforms to raise the potential of an economy that has grown by an average of 0.4% per year over the last decade. His plans to ease firing restrictions for salaried workers already face fierce trade union resistance.

The association of Italian banks on Wednesday forecast a GDP fall of 0.7% in 2012, but employers’ lobby Confindustria expects a 1.6% drop.

Stefano Micossi, the head of Assonime, the association of quoted Italian companies, said last week the economy would contract by 2% “if we are lucky".

Italy’s third quarter data compared with a euro zone average of 0.2% quarterly growth in the same period, leaving the country in its customary position as one of the region’s most sluggish economies. The breakdown of the data showed quarterly declines in all the main components of GDP except exports, which rose 1.6%. Consumer spending fell 0.2%, investments shed 0.8% and imports were down 1.1%.

Its larger euro zone neighbours, Germany and France, grew by 0.5% and 0.4%, respectively.