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UPDATE 2-Mexico ruling party narrowly fends off leftist in major state election

election@ (Adds new polling returns, analyst's comments, peso)

MEXICO CITY, June 5 (Reuters) - Mexico's ruling Institutional Revolutionary Party (PRI) held on to a narrow lead on Monday over a leftist party in a key state election, according to the latest returns which propelled the country's peso currency to its strongest level in seven months.

The PRI's projected slim victory in the central State of Mexico, the country's most populous, was a close call for President Enrique Pena Nieto, whose party has governed it for nearly nine decades.

It will not end the aspirations of leftists led by Andres Manuel Lopez Obrador, an early favorite for next year's presidential race as the contender of the MORENA party (National Regeneration Movement.)

In other statewide elections, also held on Sunday, the PRI was heading for a loss in the western Nayarit and was narrowly ahead in Coahuila, which borders the United States.

"The PRI struggled to hold on to the gubernatorial seat in both the State of Mexico and Coahuila, which have traditionally been very favorable electoral battlegrounds, and suffered significant losses in Nayarit and in the municipal election in Veracruz," said Goldman Sachs economist Alberto Ramos.

"This does not bode well for the PRI in the presidential election next year," Ramos added.

Still, markets reacted positively to the news that the PRI was bound to retain power in Mexico State.

The Mexican peso gained nearly 2 percent in Monday morning trade, on the setback for Lopez Obrador, a sign of ongoing market distrust of the leader who has opposed economic liberalization in Mexico.

The PRI is battling widespread anger at corruption and rising violent crime under Pena Nieto as the countdown starts for the July 2018 presidential election.

With 97 percent of returns in from polling booths, PRI candidate Alfredo del Mazo had 33.7 percent of the vote compared with 30.8 percent for MORENA candidate Delfina Gomez.

After an early count projection on Sunday night from the state's electoral institute that showed del Mazo winning, Lopez Obrador called the quick count "a farce" and said he did not accept it, and Gomez insisted she had won the election.

Lopez Obrador has alleged fraud in past elections, and he vowed to scrutinize the results from every voting booth.

"We will never resort to violence, but we are going to firmly defend this country's democracy," he said in a video message.

Prosecutors are probing the circumstances of piles of pig heads dumped on Saturday near MORENA offices and at polling stations in several municipalities.

Also under investigation were telephone threats and fake electoral literature warning of attacks - tactics used to dissuade people from voting.

Encompassing many populous neighborhoods on the edge of Mexico City, the State of Mexico is home to one in eight Mexican voters and it has long been a source of strength and financing for the PRI.

However, del Mazo is projected to have won with barely half the share of vote that the current governor won six years ago with the backing of Pena Nieto, himself a former governor of the state whose own popularity has since plunged.

CORRUPTION

Failing to put a stop to corruption scandals and struggling to tame brutal gang violence has cost the party dearly.

Mexico's attorney general's office said on Sunday a former state governor for the PRI, Roberto Borge, had been arrested at Mexico's request in Panama on corruption charges. Borge, an ex-governor of Quintana Roo, encompassing the resort of Cancun, has previously denied wrongdoing.

In the west of the country, the PRI was headed for a decisive loss to an opposition coalition in Nayarit.

The party was also barely retaining the northern state of Coahuila. One of the PRI's recent governors in the border region is wanted on corruption charges in the United States.

The loss of Nayarit would leave the PRI with six fewer governors than when Pena Nieto took office. Going into Sunday, the PRI and its allies controlled 16 states, or half the regional governments.

Lopez Obrador's State of Mexico campaign was hurt by a failure to ally with others in the opposition and references by rivals to crisis-hit Venezuela, which the PRI argues mirrors his economic model. He denies the accusation.

The silver-haired campaigner has opposed the opening of Mexico's energy sector to private capital, a key reform under Pena Nieto, but no longer vows to reverse it.

Linking Lopez Obrador to former Venezuelan President Hugo Chavez has helped rivals beat him to the top job in two previous bids at the presidency.

Victory for Lopez Obrador in 2018 could push Mexico in a more nationalist direction at a time of tension with the United States, with U.S. President Donald Trump riling Mexicans with threats to tear up the North American Free Trade Agreement and build a border wall. (Additional reporting by Anthony Esposito, Dave Graham, Anahi Rama and David Alire Garcia; Editing by Jeremy Gaunt and W Simon)