By Gavin Jones
ROME (Reuters) - Italian Prime Minister Mario Monti declared on Wednesday that reviving economic growth now had to take priority over belt tightening that could plunge the country deeper into recession.
Monti delayed by a year his technocrat government's goal of balancing the budget in 2013 but market reaction was muted, in contrast to fellow euro zone struggler Spain which has sent its borrowing costs soaring by relaxing its deficit targets.
"Everything, everything, everything that we are doing now is aimed towards helping growth," Monti told a news conference after a cabinet meeting.
Monti's strategy, announced only two days after one of his ministers said the government still aimed to balance the budget next year, contrasts with those of other euro zone governments that plan more tough austerity to reduce their deficits.
His cabinet approved new economic targets projecting a much deeper recession than originally forecast and raising the deficit goals from 2012 until 2014, when the government now aims to balance the budget.
Italian bond yields rose on Wednesday but only modestly. This reflected the continuing credibility that Monti, a former European Commissioner, holds on markets and investors' belief that Italy's main problem is its chronically weak economy, not fiscal slippage.
Italy's budget deficit is one of the lowest in the euro zone as a proportion of output, whereas Spain's is one of the highest and its new Prime Minister Mariano Rajoy has yet to earn the levels of investors' confidence that Monti enjoys.
Markets have been tougher on Spain, which last month raised its deficit target for this year, though some economists say investors are in fact also more concerned about the effects of more austerity being imposed on the Spanish economy.
Italy's new forecasts raise the 2012 deficit target marginally to 1.7 percent of gross domestic product from 1.6 percent, while the 2013 goal is raised to 0.5 percent from 0.1 percent. An almost balanced budget, with a 0.1 percent deficit, is now targeted in 2014.
International bodies and Italy's European Union partners have remained fully supportive of Monti even as it became increasingly clear that he was unlikely to balance the budget next year as targeted.
The International Monetary Fund said on Tuesday that Italy would not balance its budget before 2017 but urged Monti not to adopt more austerity measures that would weaken an economy it forecast would contract this year by a hefty 1.9 percent.
U.S. Treasury Secretary Timothy Geithner also said on Wednesday it that debt-stricken European nations should avoid moving too sharply with immediate budget cuts and higher taxes.
"It's very important to get that balance right between ... growth and austerity," he told an event at the Brookings Institution. Geithner called for "gradually phased in medium-term plans for reform".
"To try to do it all up front, the risk is ... you're undermining the prospects for some stability in growth," he said.
Monti said the new target was in line with the requirements of the EU's recently approved Fiscal Compact, which says that deficits should be adjusted for the business cycle, though it is not yet in force.
After factoring in the effects of recession, Italy will post a budget surplus of 0.6 percent of GDP in 2013, Monti said, emphasizing the damage that recession was inflicting on southern European countries.
Banca Intesa said in a note to clients that the deficit slippage was not only due to the weaker economic outlook, but also "the only partial effectiveness of some of (the government's) austerity measures".
The bank said the deficit goal was being revised up even though a fall in bond yields since Italy set its previous targets in December would save it about 14 billion euros this year.
The economy is forecast to contract 1.2 percent this year, according to the government forecast, compared with a 0.4 percent decline in GDP which it projected in December.
A 30-billion euro austerity plan that Monti rushed through at the end of last year, made up largely of tax increases, is partly to blame for this year's recession which has in turn worsened the outlook for public finances.
This austerity-recession-austerity chain is common to other peripheral euro zone countries from Greece to Portugal, and is exactly the vicious circle that Monti is trying to break, with growing support from economists.
Spain has seen its bond yields rise sharply since it tried last month to raise its deficit goal for this year to 5.8 percent from 4.4 percent and then compromised with its EU partners on a 5.3 percent goal.
Yet many economists believe investors are less anxious about austerity than growth.
"The markets are more worried now by Spain slamming on the fiscal brakes harder," said Nicholas Spiro of Spiro Sovereign Strategy. "The lesson now is that bond market credibility is at least as much to do with getting these economies off the ground and moving as (it is) with fiscal discipline."
One problem for Monti is that even his new growth projection is more optimistic than those of most independent forecasters, who expect a contraction of around 1.5 percent.
The government plan forecasts that Italy's public debt, the second highest in the euro zone as a proportion of output after Greece, will rise this year to 123.4 percent of GDP from 120.1 percent in 2011, and fall in 2013 to 121.6 percent.
Monti, who is facing increasing resistance to his reforms and falling popularity ratings, expressed sympathy for the suffering of ordinary Italians in the economic crisis.
But he said things would be much worse if his government, which took power in November, had not averted the immediate threat of a Greek-style debt crisis.
Under the previous government of scandal-plagued premier Silvio Berlusconi, the euro zone's third biggest economy tottered close to default as markets lost faith in its ability to reform the economy.
(Editing by Barry Moody and David Stamp)