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UPDATE 2-Relief for European stocks as political tensions ease

Sruthi Shankar

* Italian shares rally as PM unveils cabinet

* Opponents of 'no-deal' Brexit defeat PM Johnson

* FTSE 100 under-performs as pound halts slide

* Hong Kong leader withdraws extradition bill (Updates to close)

Sept 4 (Reuters) - A rally in Italian shares driven by the formation of a new government lifted European stocks on Wednesday, with investors also taking heart from an easing of political tensions in Britain and Hong Kong.

The pan-European STOXX 600 index rose 0.89% at the close, with Milan-listed shares soundly outpacing their European peers after Italian Prime Minister Giuseppe Conte unveiled his new cabinet.

Investors cheered an unlikely coalition uniting rival political parties the 5-Star Movement and the Democratic Party, heading off the risk of an early election and prolonged political instability.

"This is a very clear interpretation by the market that the new government is seen as positive, at least when it comes to approach to the budget policies and interaction with the European Commission," said Marco Valli, Unicredit's head of macro research.

"You have a government that is expected to stick to a pro-European stance, which is important because that is needed for financial stability even if we have a deterioration in the global environment."

Italy's FTSE MIB index rallied about 1.6%, touching a more than one-month high, while the banking index jumped 1.75%.

On the other side of the English Channel, British lawmakers defeated Boris Johnson in parliament on Tuesday in a bid to prevent him from taking Britain out of the EU without a divorce agreement, prompting the prime minister to demand a snap election.

Britain's exporter-heavy FTSE 100 underperformed with a 0.59% rise, weighed down by a steadying of the pound on Tuesday's events at Westminster.

Adding to the upbeat mood was data that showed activity in China's services sector expanded at the fastest pace in three months in August as new orders rose.

Surveys showed euro zone business growth was a touch faster than expected last month but remained in the doldrums as the bloc's dominant service industry only partially offset a slowdown in manufacturing.

Investors will now look ahead to a European Central Bank meeting next week that is widely expected to lower interest rates as policymakers seek to head off a slowdown caused by the protracted U.S.-China trade war.

Trade-sensitive sectors such as miners, automakers and oil and gas companies led the charge on the main STOXX 600 index.

Asia-exposed UK banks HSBC and Prudential boosted the main index and helped drive a 1.24% rise in the banking sector, after Hong Kong leader Carrie Lam withdrew an extradition bill that triggered months of often violent protests so the Chinese-ruled city.

The news also helped luxury stocks - LVMH Moet Hennessy Louis Vuitton SE, Swiss Jewelry company Compagnie Financiere Richemont SA and Gucci owner Kering SA - rise between 2.4% and 3.6%. (Reporting by Sruthi Shankar in Bengaluru)