UPDATE 2-Itally borrowing costs rise as uncertainty continues
* Three yields hit highest level since October
* Political wrangling clouds auction results
* Senate committee continues to debate Berlusconi future
(Recasts to add more quotes on political outlook, details)
MILAN, Sept 12 (Reuters) - Italian borrowing costs edged higher on Thursday, with yields on three-year bonds reaching their highest level in almost a year as the wrangling over Silvio Berlusconi's political future continued to overshadow the government.
However the Treasury had no difficulty in selling its full allotment of paper as an improving outlook in China and the United States fuelled an appetite for risk that has helped Italian assets and outweighed political concerns.
With the future of Prime Minister's Enrico Letta's fragile coalition in doubt following threats by Berlusconi's centre-right party to withdraw its support over moves to strip him of his seat in parliament, the auction was seen as a test of investor nerves.
As well as the tension in Rome, the auction came against a backdrop of bad economic news and a move by clearing house LCH Clearnet to drop a guarantee on repurchase transactions on Italian government bonds, potentially threatening an important funding channel for Italian banks.
Italian yields have gone above Spanish equivalents for the first time in 18 months this week but despite the turmoil, the Treasury was able to shift a total of 7.5 billion euros in four bonds, attracting demand worth 11.6 billion euros.
"We have seen an impressive comeback of foreign investors on Italian assets, first on equity market and then on bonds," said Sergio Capaldi, fixed income strategist at Intesa Sanpaolo.
The Treasury sold 4 billion euros of a new three-year bond, the maximum planned amount, at an average 2.7 percent yield.
That was up from 2.3 percent at a previous mid-July auction and the highest since last October, but there has been little sign of the fear which gripped markets a year ago when the future of the last government, led by Mario Monti was in doubt and yields hit more than 5 percent.
The European Central Bank's pledge to step in to prevent bond market turmoil has shored up investor sentiment.
But weeks of conflicting comments from Berlusconi's party, which has alternated threats to bring down the government with pledges of support for Letta may also have taken the edge off fears of a government crisis.
"Some investors may have underestimated the risk of a government collapse in Italy," Capaldi said.
Political tensions have eased slightly since the beginning of the week when Berlusconi's People of Freedom (PDL) party warned the government was on the brink of collapse over a Senate committee meeting to decide on the future of the 76 year old billionaire.
The cross-party panel, which must decide whether to expel Berlusconi following his conviction for tax fraud last month, has been the focus of growing tensions between the PDL and the centre-left Democratic Party (PD), the other main party in Letta's coalition.
Analysts estimate Italy's borrowing costs would jump to 5 percent on the ten-year maturity in case of a fully-fledged government crisis but markets would then calm down as the budget situation would not change radically in Italy.
"The price of political instability on Italian bonds could be estimated in 50 basis points," said Gianluca Garbi, head of Banca Sistema.
What could really unsettle investors would be a new election, with the risk of an anti-euro coalition, able to sever all the links that keep Rome well attached to the euro zone partners.
The wider threat to Italy, still mired in recession after more than two years, was underlined on Thursday by data which showed industrial production falling 1.1 percent in July, much worse than most analysts had expected.
The European Central Bank also warned that gloomy economic prospects were putting efforts to keep the deficit within EU limits at risk and threatening one of the few areas where Italy has relatively solid record of success in public finance.
Italy plans to raise the ceiling on 2013 net debt issuance by more than a fifth to 98 billion euros and higher debt costs would balance savings the Treasury made in recent months when debt costs fell on the back of loose monetary policy from central banks around the world.
Analysts see early elections as unlikely but say a government reshuffle is possible. It would come at a time when Italy is due to draft next year's budget, seeking to contain a public debt already projected at 130 percent of output.
(Reporting by Valentina Za and Lisa Jucca; editing by Ron Askew)