By Barry Moody
ROME (Reuters) - Italian Prime Minister Silvio Berlusconi faces possible defeat in local elections on Sunday and Monday that could cause serious political instability and even provoke challenges to his own leadership.
A stunning setback in the first round of the polls in his stronghold of Milan on May 15-16 caused turmoil in Berlusconi's center-right alliance and for the first time undermined the political dominance he has enjoyed for nearly two decades.
Amid increasing pessimism in the center right about winning the run-offs in Milan and a major contest in Naples, analysts say suggestions are starting to circulate in the ruling coalition about dumping Berlusconi -- unthinkable even a few months ago.
The flamboyant prime minister has been the unchallenged leader of Italy's dominant conservative voting bloc since first storming to power in 1994, but he has been seriously weakened by a lurid sex scandal, three corruption trials and his failure to revive a stagnant economy.
The ratings agency Standard & Poors lowered its outlook on Italy at the weekend in a direct swipe at its failure to reduce one of the highest public debts in the world and to stimulate growth in an economy that has been nearly static for a decade.
Although the first sale of government debt since the S&P move went well on Thursday, there is deep concern about the economy, including among Berlusconi's core voters who have suffered a significant decline in living standards.
BUSINESS LEADERS SLAM BERLUSCONI
The Italian business association Confindustria on Thursday slammed the government for the second time this month for failing to encourage growth. "We cannot hide our disappointment. More incisive steps are needed," Confindustria President Emma Marcegaglia told its annual congress.
The vote on Sunday and Monday is in 90 towns and six provinces where no outright winner emerged in the first round, plus a first round of voting in Sicily. About 5.5 million Italians are eligible to vote.
The most crucial contest is in Milan, the city where Berlusconi made his business fortune and a stronghold of the center right for nearly two decades.
In a shock first-round result, leftwinger Giuliano Pisapia took 48 percent of the vote against 41.6 percent for center-right mayor Letizia Moratti.
The result sent Berlusconi into a stunned silence for nearly a week before he returned to the fray with increasingly vituperative attacks on Pisapia, saying he would turn Milan into Italy's Stalingrad, an Islamic city or a gypsy metropolis.
In his latest outburst, Berlusconi distanced himself from both Moratti and his candidate in Naples, Gianni Lettieri, in what appeared to be a preparation for defeat there too.
He branded both opposition candidates extremists and said they would win only if voters "left their brains at home."
Berlusconi is facing four concurrent trials, three for fraud or corruption and the sensational "Rubygate" case where he is charged with paying for sex with an underage prostitute and then using his position to cover it up.
Before the first round, which he turned into a personal vote, Berlusconi constantly railed against magistrates who he said were hounding him to pervert the democratic process. But he has kept silent about them since -- indicating that he realizes even his own voters are turned off by the accusations.
Both his miscalculations in the first round and squabbles within the center-right alliance since then suggest Berlusconi may already be seen in some quarters as a liability.
The pro-devolution Northern League, which is vital to the government's survival, has distanced itself from Berlusconi on several issues, including the war in Libya, and forced the premier to deny that two ministries would be moved to Milan.
Both President Giorgio Napolitano and Italy's bishops have called for calm because of the tense political atmosphere which has left Italy even less able to carry out vital economic reforms.
Michele Ainis, a commentator in the Corriere della Sera newspaper, said there was a total logjam in parliament with 22 draft laws stuck for months in the upper house. "No democracy in the world can work when parliament is crippled," he wrote.
(Editing by Tim Pearce)