UPDATE 1-Italy PM Letta says borrowing costs at risk as instability continues
* Uncertainty over Berlusconi's political future continues
* Italian bond yields creep up ahead of auction
* Showdown over Senate committee averted
ROME, Sept 11 (Reuters) - Italian Prime Minister Enrico Letta warned on Wednesday that political turmoil was driving up Italy's borrowing costs as uncertainty continued over the future of former premier Silvio Berlusconi.
The fate of the 76-year-old billionaire, who faces expulsion from parliament following a conviction for tax fraud last month, has overshadowed Italian politics for weeks, with his supporters alternating pledges of loyalty with threats to bring down the government if he is forced out.
A cross-party Senate committee that must decide on whether to strip him of his seat has been the focus for the growing tension between the parties but lawmakers averted a decisive showdown during a late night meeting on Tuesday.
Stefania Pessopane, a senator from the centre-left Democratic Party (PD) and deputy chairman of the cross-party senate committee on eligibility, said a final vote should now be expected by mid-October although the timetable for further sittings has not yet been agreed.
Speaking in parliament ahead of an auction of medium term bonds on Thursday, Letta said the impact of the political turmoil was showing up clearly on financial markets, which have sent Spain's borrowing costs below those of Italy for the first time in 18 months.
"I say it particularly today on a day when our interest rates, instead of continuing to go down as they have done over the past few months, are continuing to suffer, because of political instability," he said.
Despite some signs that Italy may be able to look towards emerging from its longest post-war recession, markets have remained on edge and the auction, including a new issue of three year bonds, is expected to see yields rise.
On Wednesday afternoon, three-year bonds maturing in November 2016 were trading at 2.8 percent, compared with the 2.3 percent level at which Italy last sold three year paper in July.
DOVES AND HAWKS
The committee will resume meeting on Thursday but Berlusconi in any case faces the prospect of an exile from frontline politics ordered directly by the court verdict, which sentenced him to prison and banned him from holding public office.
His lawyers appealed against the severity of the five year ban on public office imposed by last month's court verdict and a revised sentence is due to be issued on Oct. 19.
With Berlusconi's centre-right PDL split between "hawks" pressing him for a final showdown and "doves" who see no advantage in a scorched earth policy that could also hurt his business interests, Berlusconi's own attitude remains unclear.
Some allies have even suggested he may prefer to resign of his own accord before the revised verdict and before the Senate committee comes to a vote.
"This would give him the chance of a pardon from the head of state and he could present it as an independent decision which he could use in any subsequent political negotiations," one PDL parliamentarian said, speaking on condition of anonymity.
After a tense day on Tuesday, when it appeared the PDL and the PD were on course for a potentially decisive confrontation, procedural tactics ensured the crisis was averted.
Three PDL motions on legal appeals by Berlusconi which could have delayed the hearings by months were withdrawn in the face of PD opposition. The PDL's main spokesman on the committee, Andrea Augello, will now present a revised proposal later on.