Moody's cut Ireland's credit rating on Monday, warning the country still faces a slow climb out of recession after nearly two years of austerity as the cost of rescuing its banking sector mounts.

The rating agency's one-notch drop to Aa2 came a day ahead of a scheduled sale of up to 1.5 billion euros of Irish debt, putting Moody's on par with rival agency Standard and Poor's AA rating and still one grade above Fitch.

The downgrade, which a minister said provided no surprises but which briefly weakened the euro against the dollar and hit European stocks, prefaced a sale of six- and 10-year bonds worth between 1 billion and 1.5 billion euros at Ireland's regular monthly auction.

Moody's also changed its outlook to stable from negative, and much of the hit to Irish bond markets was short-lived.

The spread of Irish 10-year bonds against their German equivalent widened 10 basis points on Monday from Friday to 301 basis points, their highest since July 2, before narrowing to 295 bps.

The timing isn't great, given the bond auction tomorrow and certainly this will add to the premium that will need to be paid to raise money, Alan McQuaid, chief economist at Bloxham, said.

Dietmar Hornung, Moody's lead analyst for Ireland, said the downgrade was primarily driven by the Irish government's gradual but significant loss of financial strength.

FISCAL DISCIPLINE

Some of the euro zone's toughest spending cuts last year gave Ireland respite from the market assault on other peripheral euro zone countries such as Greece, Spain and Portugal.

But Dublin's fiscal discipline has been all but overshadowed by fresh rounds of bad news from the banks.

The cost of bailing out nationalized Anglo Irish Bank last year gave Ireland a budget deficit of 14 percent of gross domestic product, the highest in Europe, and this could rise to 20 percent this year, the state-funded Economic and Social Research Institute (ESRI) said last week.

Germany's Bundesbank said on Monday economic imbalances in peripheral euro-zone countries pose risks to the bloc as a whole and made it clear they should not look to Germany to get them out of the mess.

With Ireland having emerged from the euro zone's longest running recession in the first quarter, Moody's said it expected economic growth of 2-3 percent per year from 2011, below the 4 percent forecast built into the government's fiscal program.

Moody's said banking and real estate -- engines of growth in the years preceding the country's crisis -- would not contribute meaningfully to Irish growth in the coming years.

It's really not telling us anything that we don't know already, said Martin Mansergh, Ireland's minister of state for finance. We all know that banking and real estate are not going to be sources of growth.

The IMF last week said Dublin would not meet a European Union-agreed deadline to reduce its budget deficit to 3 percent of gross domestic product (GDP) by 2014, also citing threats to Ireland's growth target.

RATINGS FLOOR?

While the Irish public has so far grudgingly accepted fiscal tightening, a senior official in Prime Minister Brian Cowen's governing coalition said on Sunday voters might not be ready to accept all the further cuts on the way.

Dan Boyle, chairman of the smaller governing party, the Greens, also said he expected the state to increase its minority holding in Allied Irish Banks to up to 70 percent.

Allied Irish and Bank of Ireland are among the lenders whose financial health will be laid bare this week in European stress tests, though they have already met similar criteria at home to prepare them for participation in the National Asset Management Agency (NAMA), a bad bank scheme.

Central Bank Governor Patrick Honohan said on Friday the Irish tests were tougher than those by the Committee of European Banking Supervisors, though Allied must still raise 7.4 billion euros to meet Honohan's new capital demands.

On the positive side, Ireland does not face any major bond redemptions this year and it has raised enough bonds to see it through to the first quarter of 2011 regardless of the outcome of upcoming monthly auctions, officials say.

Moody's action also suggested that Ireland was close to hitting its ratings floor and that should help support its markets, analysts and investors said.

They ... stabilized the outlook, which might indicate that we're much closer to a bottom in ratings. ...This is something which in the end should turn out to be supportive for Irish bonds and (euro zone) peripherals as well, said David Schnautz, strategist at Commerzbank in London.

If there were multiple downgrades then that really would unnerve bond investors, added Gerard Fitzpatrick, who manages $5 billion of fixed income assets at Russell Investments.

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