Italian bond yields hit eight-month high as risk focus switches from Spain

* Italy's 10-year yield hits highest since February

* Gap over Spanish yields biggest in nearly 4yrs

* Rescue plan for bank MPS seen running out of time (Updates prices)

By Abhinav Ramnarayan

LONDON, Nov 1 (Reuters) - Italy's borrowing costs hit eight-month highs on Tuesday with investors focused on political risks and the country's stuttering banking reforms while anxiety about other lower-rated euro zone nations has eased.

The formation of a minority Spanish government at the weekend after a 10-month political stalemate has prompted markets to throw the spotlight east to Italy instead for what could be a nervy year-end.

The gap (NYSE: GPS - news) between Italian and Spanish 10-year borrowing costs - viewed as a key indicator of political risk - rose on Monday to 41.4 basis points, its highest since 2012. It hovered close to that level at 39 bps on Tuesday.

The country has also overtaken Greece as the country most likely to leave the euro zone, according to investors polled by the Frankfurt-based research group Sentix, albeit with a low probability of 9.9 percent in the next 12 months.

Concern about Italy centres on a referendum on Dec (Shanghai: 600875.SS - news) . 4 in which voters will decide whether to approve Prime Minister Matteo Renzi's programme of constitutional reforms to reduce the role of the Senate and the powers of regional governments.

Polls suggest Renzi may lose the referendum, "and that would be very bad news," said DZ Bank strategist Daniel Lenz.

"Since Portugal passed the DBRS ratings test and Spain now has a minority government, Italy is where the risks lie."

Last month, Portugal came through a DBRS sovereign credit review with its sole investment-grade rating intact. Losing that would have made its debt ineligible for the European Central Bank's bond-buying programme.

With (Other OTC: WWTH - news) the outcome of next week's U.S. presidential election uncertain, the direction of the next ECB policy move on Dec. 8 unclear and a U.S. interest rate rise likely on Dec. 14, the timing of Italy's referendum could magnify market volatility.

All but one of 26 opinion polls published this month have put the "no" camp ahead, with a lead ranging from one to nine percentage points.

Renzi earlier this year said he would step down in the event of a "no". He has stopped making that promise in recent months, but would come under huge pressure should he lose the vote.

In addition, veteran Italian banker and former industry minister Corrado Passera withdrew his rescue plan for Banca Monte dei Paschi (Milan: BMPS.MI - news) di Siena on Tuesday, accusing the bank of obstruction and ignoring the interests of its own shareholders.

Monte dei Paschi said Passera's decision to withdraw his plan was based on "groundless arguments".

Adding to the country's troubles, another powerful earthquake struck over the weekend in the same central regions that have been rocked by repeated tremors over the past two months.

The government recently cited earthquakes and the influx of migrants as reasons for submitting a budget plan to the European Union that would increase Italy's structural deficit.

Italy's 10-year government bond yield rose 8 basis points (bps) to 1.69 percent on Tuesday, the highest since February.

As the session went on, there was a reminder that investors are not blind to continued issues in Spain despite the formation of the government. The country's 10-year bonds rose by a similar amount to 1.30 percent.

"Spain has gained quite a lot on the back of the formation of the government - but it is still a minority government, so it's not out of the woods yet. This is a reflection of that," said Martin van Vliet, rates strategist at ING.

He pointed to the need for Spain to reduce its deficit in 2017 and the economy's external indebtedness as two of the main challenges.

For Reuters new Live Markets blog on European and UK stock markets see reuters://realtime/verb=Open/url=http://emea1.apps.cp.extranet.thomsonreuters.biz/cms/?pageId=livemarkets (Editing by Catherine Evans)