UPDATE 1-Euro zone faces debt, stability risk from political upheaval: ECB

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FRANKFURT, Nov 24 (Reuters) - Political upheaval on both sides of the Atlantic is raising financial stability risk across the euro zone, potentially raising concern about some countries’ ability to finance their debt, the ECB said on Friday.

Elections and referendums could fundamentally shift the political landscape, triggering sudden capital flows and market volatility, compounding difficulties for a bloc already weighed down by weak growth and vulnerabilities to rising interest rates and yields, the European Central Bank said in an unusually downbeat report.

The U.S. presidential election and Britain’s vote to leave the European Union have both triggered bouts of market volatility while Italy’s Dec 4 constitutional referendum could reignite capital flight, particularly if the ‘no’ vote prevails and topples Prime Minister Matteo Renzi’s government.

Elections in France and Germany are also coming up next year with populist, anti-Europe parties gaining strength, raising the risk that governments will counter the threat with protectionist and nationalist policies.

“Higher political uncertainty may lead to more domestically focused, growth-hindering policy agendas,” the ECB said in a regular stability review.

“This, in turn, could delay much-needed fiscal and structural reforms and could in a worst-case scenario reignite pressures on more vulnerable sovereigns,” it added. “In particular, concerns about debt sustainability might re-emerge despite relatively benign financial market conditions.”

The warning suggests that governments are far from heeding the ECB’s repeated calls for deeper structural reforms, keeping the pressure on the bank to drive economic growth, even as it has warned that member states may be expecting too much from monetary policy.

The ECB has provided unprecedented stimulus for several years and will have to decide next month whether to extend its 1.74 trillion euro asset buys beyond next March to drive growth and inflation.

Though an extension is priced in, critics argue that the benefits of asset buys are diminishing while side effects rise.

Still, ECB Vice President Vitor Constancio said the bank was maintaining its economic projections with the baseline forecast indicating slow but steady growth in the coming years.

He added that the ECB would continue to act as a stabiliser in preserving favourable financing conditions.

“Risks of further asset price corrections remain high and may be amplified by high correlations between asset classes,” the ECB said.

Ten-year Italian yields have nearly doubled since early September and yields are also sharply higher in Spain and Portugal, suggesting political risk contagion on the periphery, Constancio said.

“Political uncertainty continued to rise not only at the national level given busy electoral calendars in 2017 in major euro area countries, but also at the EU level in the aftermath of the UK referendum,” the ECB report said.

Adding to the bloc’s stability risk, robust price increases have been noted in some real estate markets and signs of overvaluation have emerged for residential property in some countries. Furthermore, prime commercial property valuations also appear to be high, the ECB said. (Editing by Tom Heneghan)