ECB sees rising risks to euro zone financial stability, watching for Italian vote fallout

By Francesco Canepa and Balazs Koranyi FRANKFURT (Reuters) - The European Central Bank sees rising risks to euro zone financial stability and is watching for any fallout from Italy's constitutional referendum next month, ECB Vice President Vitor Constancio said on Thursday. In an unusually downbeat Financial Stability Review, the ECB as a whole also warned that political shifts on both sides of the Atlantic, including a potentially protectionist U.S. administration under Donald Trump, may trigger a surge in government borrowing costs and raise concerns about indebted countries. The ECB's rate setters are due to meet just days after the Dec. 4 referendum - which is designed to streamline Italian government - to decide on the duration of their bond-buying programme. Investors fear that Italy could be plunged into political uncertainty if pro-euro Prime Minister Matteo Renzi fails to get his constitutional reforms through as poll suggest and resigns. Constancio said the ECB would react to any "economic shock" from the vote. "It’s the sort of political uncertainty that will trigger or not an economic shock in financial markets," Constancio told reporters after presenting the ECB's twice yearly report on financial stability. "And depending on the degree of that shock, then we have to see if we have anything to do or not." Sources have told Reuters the ECB's rate setters are all but certain to decide to keep buying bonds beyond their March deadline when they meet on Dec. 8, changing the terms of the programme to ensure they find enough paper to buy. Speaking to Reuters in an interview later, Constancio said he did not think financial markets were pricing in the risk of a break-up in the euro zone despite a recent rise in Italian bond yields. "I don’t see that (break-up) risk still reflected in market prices," Constancio added "(Bond yields) have gone up everywhere, a little bit more in Italy as a result of concerns about the result of the referendum but to levels that are still very low." The difference between Italian and German 10-year bond yields, a key gauge of investor sentiment on Italy, was 184 basis points on Thursday compared with more than 550 basis points at the height of the euro zone's debt crisis in 2011. TRUMP On its report, the ECB expressed concern about potentially rising debt. "Higher political uncertainty may lead to more domestically focused, growth-hindering policy agendas," the ECB said, adding this could delay economic reforms. "In particular, concerns about debt sustainability might re-emerge despite relatively benign financial market conditions." Governments' borrowing costs in the United States and Europe have been rising since Trump's election as investors bet on higher growth and inflation fuelled by U.S. government spending. The ECB said that a continued, sharp rise in bond yields in the euro zone as a result of contagion from the United States would be detrimental and noted a long list of elections, including in France and Germany, meant political uncertainty remained high. "Risks of further asset price corrections remain high and may be amplified by high correlations between asset classes," the ECB 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 (to leave the European Union)." 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 Jeremy Gaunt)