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 in the euro zone's third-largest economy sank 0.2 percent from the previous three months, hit by a fall in domestic demand. It was up just 0.2 percent year-on-year, national statistics bureau ISTAT reported on Wednesday.

The data was weaker than expected and points to an economy deeply troubled even before tough austerity measures were adopted in recent months to try to cap soaring borrowing costs.

Italian bonds have in recent months yielded more than 7 percent, a level widely considered unsustainable. They were at 6.7 percent 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 percent 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 percent GDP contraction in 2012.

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

Earlier this month, he presented 34 billion euros 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 percent 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.

REFORM CHALLENGE

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 percent 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 percent in 2012, but employers' lobby Confindustria expects a 1.6 percent drop. Stefano Micossi, the head of Assonime, the association of quoted Italian companies, said last week the economy would contract by 2 percent if we are lucky.

Italy's third-quarter data compared with a euro zone average of 0.2 percent quarterly growth in the same period, leaving the country in its customary position as one of the region's most sluggish economies.

Its larger euro zone neighbours, Germany and France, grew by 0.5 percent and 0.4 percent respectively. Italian banks, finding it hard to raise funds on interbank markets, are increasingly unable to lend to companies, one of the factors seen weighing on growth.

More than a dozen Italian banks tapped at least 49 billion euros of ultra-cheap three year loans offered for the first time on Wednesday by the European Central Bank, with many using state-guaranteed bonds as collateral. Italy released its third quarter GDP figures much later than the rest of the euro zone due to methodological changes adopted by ISTAT which delayed its normal data schedule.

The breakdown of the data showed quarterly declines in all the main components of GDP except exports, which rose 1.6 percent. Consumer spending fell 0.2 percent, investments shed 0.8 percent and imports were down 1.1 percent.