By Valentina Za and Luca Trogni

MILAN (Reuters) - Italy must show political stability and convincing signs of an economic recovery to secure foreign demand for its debt in 2014, when domestic banks are expected to slow their purchases of the country's bonds.

The Treasury is confident foreign buyers will take up the slack to help it sell an estimated 460-470 billion euros ($632-$645 bln) of gross debt next year, but analysts warn external demand will be more conditional and sensitive to risks.

High Italian bond yields should lure buyers from abroad, they say, but investors will want proof the government is making good on its promise to end a recession and tackle issues such as 40 percent youth unemployment and shrinking disposable income.

Foreign holdings of Italian bonds have fallen to roughly a third of the total from nearly half before Italy took centre-stage in the sovereign debt crisis in July 2011.

Domestic banks have been the bulwark of demand since, reassured by the European Central Bank's pledge to buy Italy's debt if Rome sought its help and often using the cheap loans doled out by the ECB two years ago to fund their purchases.

An asset review of the banking sector by the euro zone's central bank has turned the spotlight onto lenders' sovereign exposure, however, and Italy's head of debt Maria Cannata said last month domestic banks were likely to curb their holdings.

The banks have already sold a net 11 billion euros of Italian bonds between July and October.

Since then, regulatory pressure to strip sovereign debt of its risk-free status when assessing bank assets has increased, while banks have stepped up repayments of the ECB's loans.

That makes foreign investor support more important, and they have gradually increased their presence as a bout of political turmoil in Rome eases and Italy's long recession bottoms out.

But some fear foreign buying may not fully offset the impact of weaker domestic demand, especially for maturities of up to five years, where domestic purchases are typically concentrated.

"I think the effect of Italian lenders buying less will be visible at the short end of the curve, where there could be some upwards pressure on yields," said Alessandro Tentori, head of global rates strategy at Citi. "We don't rule out a flattening of the yield curve between two and five years."

JPMorgan estimated in a research note last month that foreigners could buy a net 25 billion euros in Italian bonds next year, roughly tripling the 2013 figure.

ELECTORAL LAW

ING strategist Alessandro Giansanti also said he expected higher demand from abroad next year but warned it will be "more volatile and selective" than from domestic buyers.

"Investors will keep a close watch on Italy and may even demand higher risk premia," he said.

Investors will want to see the country pass a long-promised new electoral law that can finally ensure stable government, as well as economic reforms to improve the potential of what has been the euro zone's most sluggish economy for over a decade.

Without growth Italy has no hope of cutting its public debt, which has climbed steadily in recent years to a record 133 percent of output, second only to Greece's in the euro zone. Italy's bond market is one of the world's biggest.

Prime Minister Enrico Letta beat off an attempt last month to bring him down by centre-right leader Silvio Berlusconi, who quit the ruling coalition, and investors will want proof that Letta's new, smaller majority is now more cohesive than before.

The economy has still not emerged from a contraction that began two and a half years ago and if recent tentative signs of recovery should peter out, foreign investors could take fright.

Italy's 2014 funding target is only fractionally lower than the amount sold this year and in 2012, when domestic lenders gave crucial support to its borrowing efforts.

Italian banks bought a net 150 billion euros in domestic bonds from January 2012 through September this year, according to the Bank of Italy.

In the last part of 2013, debt chief Cannata has travelled extensively to meet investors around the globe.

A Treasury source said there were no concerns about next year and that there were signs of returning interest from U. S. and Scandinavian investors as well some modest buying from Japan, the Mediterranean and the Baltics. ($1 = 0.7283 euros)

(Editing by Gavin Jones and Catherine Evans)

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