MILAN (Reuters) - Revenue clawed back from tax evaders could help Italy to limit the damage to its budget deficit target from the intensifying economic contraction that contributed to the country's latest credit downgrade.
Italy, the biggest of the euro zone's problem debtors, has been having to pay rising yields to raise funding in the debt market as the bloc's sovereign debt crisis spreads, adding to its economic troubles.
In cutting Italy's sovereign rating by two notches on Friday, Moody's said a worsening near-term economic outlook put the fiscal targets of the euro zone's third biggest economy at risk. Failure to meet the targets may disrupt market confidence, raising the risk of a sudden stop in funding, the agency said.
Italian Economy Minister Vittorio Grilli forecast a fall of slightly less than 2 percent in 2012 economic output in an interview with an Italian newspaper on Sunday - deeper than the government's latest projection of a 1.2 percent drop.
However, Grilli also said that revenues from anti tax-evasion measures would yield more than 10 billion euros ($12 billion) this year.
While this is a figure broadly in line with the average in recent years, the government has not yet incorporated it into its estimates.
"While on one hand Italy is likely to have cropped the low-hanging fruit, on the other hand it has stepped up the efforts to fight tax evasion," said Fabio Fois at Barclays Capital.
The government is expected to account for the sharper economic contraction when it next updates its budget forecasts in September. In April it forecast the 2012 budget deficit at 1.7 percent of gross domestic product (GDP).
"The government estimates for revenue have been cautious, including a buffer against lower-than-expected growth. If there is an overshoot of the target this year, it should remain limited," said Luigi Speranza, head of fiscal economics at BNP Paribas in London.
"The budget deficit adjustment is remarkable. The problem is the lack of growth."
BNP forecasts an average 2.2 percent contraction in Italian GDP this year, with the deficit at 2 percent.
Fois at Barclays sees Italy's deficit at 2.6 percent of gross domestic product (GDP) this year, with a surplus of between 2.5 and 3.0 percent before interest payments, "a sign that the budget adjustment is taking place."
"While we acknowledge efforts made by the government so far, we think that Italy should keep the reform agenda open in order to further boost its growth prospects over the medium term," he said.
Lowering the debt-to-GDP ratio more quickly would reduce potential contagion risks from the rest of the euro zone periphery, he said.
Italy, whose interest payments soared by 16 percent in the first quarter, plans to spend 84.2 billion euros to service its debt year in 2012, or 5.3 percent of GDP.
With the euro zone debt crisis keeping 10-year bond yields at around 6 percent, Italy's interest bill is running close to that figure and would overstep it if yields rose much further.
Sensitivity analyses run by the government and the central bank show that higher yields, while not a threat in terms of debt sustainability, would slow down its reduction path.
The International Monetary Fund's Chief Economist Olivier Blanchard said on Monday that important steps taken by Italy and Spain would be successful only if the two countries at the fore of the debt crisis could finance themselves at reasonable rates.
Italy's 10-year bond spread against Germany rose to 496 basis points on Monday, its highest since early January.
Based solely on fundamentals, the yield gap should be 200 basis points tighter, the IMF said.
In an update of its Fiscal Monitor released on Monday, the IMF saw Italy achieving a small structural surplus in 2013. However, contributions to the euro zone's rescue funds would lift the debt to 126.4 percent of GDP in 2013, it said.
Additional reporting by Francesca Landini; Editing by Ruth Pitchford