* Upbeat PMI data fans ECB taper expectations
* Italian yields at 3-1/2-week high
* Other euro zone bond yields up 1-5 bps
* German plan to allow euro zone peers to tap ESM - Bild
* Euro zone periphery govt bond yields http://tmsnrt.rs/2ii2Bqr (Recasts)
LONDON, Aug 23 (Reuters) - Euro zone bond yields rose on Wednesday, with Italian yields hitting 3-1/2-week highs, as data showing manufacturing firms in the bloc clocked up their best month of growth in over six years in August fanned expectations for an unwinding of ECB stimulus.
Upbeat business surveys were the latest signs of an economic recovery in the single currency bloc that could encourage the European Central Bank to start scaling back or "tapering" its 2.3 trillion euro ($2.7 trillion) asset-purchase scheme.
As ECB tapering moved back in focus, peripheral bonds that have benefited the most from the scheme were in the firing line.
Portuguese bond yields jumped 5 basis points to 2.83 percent and Spanish yields were up 3 bps at 1.48 percent .
But it was Italy that grabbed the market spotlight for a second straight day.
Italian 10-year yields climbed 6 basis points to a 3-1/2-week high at 2.17 percent, having jumped as much as 9 bps on Tuesday as proposals to introduce a parallel currency in Italy were seen upping the ante for elections due next year.
That pulled the gap over benchmark German bond yields to around 174 bps - its widest in over five weeks.
"Investors are becoming more sensitive to Italian risk, which is what you would expect if you are factoring in tapering and the ECB relinquishing its role as buyer of last resort," said Richard McGuire, head of rates strategy at Rabobank.
There had been some initial relief for Italian bonds early on Wednesday following a report that Germany is working on a scheme to let southern countries tap the euro zone's bailout fund for investment during downturns.
If confirmed, it would mark a major change in policy for German Finance Minister Wolfgang Schaeuble, who has opposed transfers from richer to poorer euro zone states.
"Schaeuble has been the hard man of euro zone finance and all of a sudden he appears to be softening," DZ Bank strategist Andy Cossor said.
"I'm awaiting further developments before taking this proposal seriously, but in theory, if this turns out to be accurate, it could be a constructive factor for peripheral European spreads."
Unconventional monetary policy is a success, but gaps in understanding the relatively new tools remain, ECB President Mario Draghi said on Wednesday, cautioning against hasty policy responses to the new reality. He speaks again at a gathering of central bankers in Jackson Hole, Wyoming, this week.
Elsewhere, Germany sold 2.43 billion euros of 10-year bonds.
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($1 = 0.8490 euros)
(Reporting by John Geddie and Dhara Ranasinghe; Editing by Dale Hudson)