By Carmel Crimmins and Marius Zaharia
DUBLIN/LONDON (Reuters) - Fears of a Greek default have stalled Ireland's progress toward bond costs that would let it borrow on the open market and yields are likely to keep rising unless the crisis in Athens can be contained.
Once shunned as a major default risk, Ireland's success in separating itself from Greece in the minds of investors has driven yields on its benchmark 10-year paper down from over 14 percent in mid-July to 8 percent in late August.
Yields on two-year paper fell from over 20 percent to around 8.2 percent in the same period.
The Irish government's success in getting cheaper terms from Europe for its 85 billion euros EU-IMF bailout on July 21, its long-running efforts to get twin banking and fiscal crises under control and its export-heavy economy encouraged some investors to take a second-look.
But Europe's debt crisis has entered a more dangerous stage in recent weeks with Greece's repeated failure to meet its fiscal targets and senior politicians in German Chancellor Angela Merkel's center-right coalition talking openly about a Greek default.
"We have separated ourselves from Greece in the eyes of the market but a disorderly default in a European country would clearly create contagion," said Rory Murray of Glas Securities in Dublin.
Irish bond yields have risen around 50 to 100 basis points across the curve in the past two weeks and analysts said the small, illiquid nature of Ireland's debt markets meant that yields could jump sharply if Greece's second bailout started to unravel, raising question marks over Ireland's package.
"Something going wrong in Greece, something going wrong in Europe, means that in a day or two's trade, Irish bond yields could rise by 200 basis points," said Eoin Fahy, economist at Kleinwort Benson Investors.
A Greek default would set a dangerous precedent and revive fears that Irish bonds are a similar risk, sending its yields soaring. However, even if Athens was not an issue, analysts doubt that Ireland's yields should be any lower right now given its still weak financial state.
Even with up to 25 billion euros in spending cuts and tax increases under its belt, equivalent to nearly 16 percent of annual economic output, Ireland's budget deficit is estimated to be around 8.6 percent of Gross Domestic Product (GDP) next year, the second-highest in Europe after Greece.
"Is it realistic to think Irish bond yields can fall another 200 basis points on a three month view? I don't think it is because no matter how good the news domestically or from Europe we are still going to have a deficit of 8-8.5 percent of GDP next year," said Fahy.
A STRONG STOMACH
Ireland needs yields to fall to around 5-6 percent if it is to exit its bailout program, as planned, in 2013 and return to debt markets to fund itself.
That will be a tall order.
The government has said it has enough EU-IMF loans to last it until the end of 2013 but with an 11.9 billion euro bond due to mature in January 2014, the head of Ireland's debt management agency, the NTMA, said Dublin may need to raise up to 15 billion euros before the end of 2013.
John Corrigan told lawmakers last week that the bond repayment in early 2014 was "very challenging."
Further falls in Irish yields will depend on Ireland meeting investor expectations and some officials, most notably the outgoing chief economist of the European Central Bank Juergen Stark, have urged Ireland to beat those expectations by accelerating their austerity measures.
Corrigan told lawmakers that if next year's budget deficit came in below 8.6 percent of GDP it would make it easier for him to secure financing but the government, conscious of the need to protect a tepid economic recovery, has said it is sticking to its current goals.
Finance Minister Michael Noonan has said he does not expect Ireland will have to tap the euro zone's emergency fund again but he told lawmakers this month that he may discuss with European partners whether Dublin could use official loans to help meet its maturing debt in 2014.
The last time Ireland raised long-term debt in September 2010, two months before its banking crisis forced it into an official rescue program, its 10-year yields were trading at around 4.9 percent.
Analysts expect the NTMA to start issuing longer-term debt when 10-year yields are around five or six percent. Before it returns to longer-term paper, the agency is expected to start ramping up its sale of short-term debt in the second half of 2012.
Corrigan said that the agency would likely return to market with a syndicated issue rather than the sort of open tender used by confident issuers with plenty of buyers.
Having gone from an AAA rating to junk or a few notches above it in the space of two years, the NTMA is courting new investors for Irish debt with a greater appetite for risk.
Richard McGuire, rate strategist at Rabobank, said Ireland's fundamentals -- its success in meeting its bailout targets, its focus on relatively recession-hardy exports such as pharmaceuticals and its improving competitiveness -- were all reasons to buy, but the wider environment was a threat.
"I can certainly see the appeal, but I am slightly concerned that if we did get a messy default in Greece or rising speculation there that may trigger a wave of restructuring speculation elsewhere in the periphery, which would drag down those markets which were already bailed out," he said.
"You would have to have a very strong stomach to engage in such a trade."
(Writing by Carmel Crimmins)