By Liam Moloney and Giovanni Legorano

ROME--The Bank of Italy dealt another blow to hopes of a convincing recovery in the country this year as it slashed its economic growth forecast and warned of "downside risk."

The Bank of Italy said economic growth in the next two years would be modest, something the Italian government is hoping it can change.

The central bank slashed its projection of Italy's gross domestic product growth rate for 2014 to 0.2% from its January forecast of a 0.7% rise, while it raised its 2015 forecast to an increase of 1.3% versus an earlier estimate of 1.0% growth.

The cut in the Bank of Italy's forecast for this year comes after ISTAT, the country's statistical agency, last month lowered its 2014 GDP forecast to a range of between a drop of 0.1% and a gain of 0.3%.

Lack of solid growth could hit the government of Prime Minister Matteo Renzi, who came to power in February on the promise of reforms to boost the economy as a way to trim record unemployment. Italy's economy has been anemic over the last decade. Last year, it contracted 1.9%.

The Italian government estimates GDP will grow 0.8% in 2014, while the European Commission predicts an increase of 0.6%.

While recent surveys by the Bank of Italy show banks are gradually becoming less strict about extending credit, loans to the private sector declined by 2% in the three months ending May, compared with the same period a year earlier. In particular, loans to nonfinancial companies dropped by 3.1%, while those to households fell by 0.4%. In May alone, total Italian lending declined 3.2% on a yearly basis.

New monetary policies at the European level combinedwith an economic recovery should ease credit conditions between the end of this year and next, the Bank of Italy said Friday.

At the beginning of June, the European Central Bank further lowered its reference interest rates to previously unseen levels and said it would make four-year loans available to banks starting in September at a fixed rate of 0.25%, on the condition that these banks then raise their level of funding to the private sector.

The three largest Italian banks, UniCredit SpA, Intesa Sanpaolo SpA and Banca Monte dei Paschi di Siena SpA, are set to borrow up to EUR34 billion ($46 billion) under this program.

Write to Liam Moloney at liam.moloney@wsj.com and Giovanni Legorano at giovanni.legorano@wsj.com

(END) Dow Jones Newswires

July 18, 2014 10:17 ET (14:17 GMT)

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