S&P cuts Ireland; Fitch in downgrade threat

Standard & Poor's cut Ireland's debt rating by just one notch and gave the thumbs-up to its bank bill on Friday but rival Fitch's warning of another downgrade and a big drop in growth expectations spelled trouble ahead.

Fears Ireland will not be able to shoulder the burden of one of the world's costliest bank bailouts have overshadowed the government's pledge to recapitalize its financial system by 24 billion euros and draw a line under its banking woes.

A Reuters poll on Friday showed economists have slashed their expectations for Gross Domestic Product (GDP) growth this year to just 0.5 percent from 1.2 percent previously and a fraction of the 1.7 percent growth penciled in by Dublin.

Unless you have tremendous growth, someone will need to pay and I do think that at some point this year, things will get worse before they get better, said Ben Bennett, credit strategist at Legal & General Investment.

Fitch said it could cut its BBB+ rating after the economy shrank sharply in the fourth quarter, marking three years of contraction equivalent to over 12 percent of GDP. It also cited the cost of bailing out the banks.

The premium investors demand to hold Irish debt over German paper widened by 9 basis points after the Reuters poll was released, cancelling out much of the positive reaction from S&P cutting Ireland to just BBB+ and changing its outlook to stable, meaning no further downgrades are in the pipeline.

A weak economic outlook coupled with the fact that the European Central Bank has not provided a formal medium-term liquidity facility for Irish banks means investors still doubt the state can cope with its debt burden.

If our economy goes well, if we get back to growth, get to full employment, then we can pay this easily, central bank Governor Patrick Honohan said in a TV interview. If economic growth is weak, then it won't be so easy.

The ECB said it would give Irish banks continued access to liquidity and said it had suspended collateral requirements for Irish sovereign and Irish guaranteed debt.

The ECB assurance means the Irish banks are still accessing short-term loans, totaling 89 billion euros at the end of last month, and are exposed to future rate hikes.

Analysts said Europe would need to come up with a longer-term liquidity facility for struggling euro zone banks.

If that is everything the ECB does then it would turn into a significant issue, said Holger Schmieding, economist at Berenberg, arguing the result is that the ECB would not be able to withdraw its overall emergency support for banks.

The ECB should really go toward targeted support for specific banks or banking systems, under conditions, he said.

European clearing house LCH.Clearnet meanwhile raised the margin requirement it charges on Irish bonds to 45 percent from 35 percent on Friday, making it more expensive to trade Irish debt.

A SILVER LINING?

S&P, whose rubbishing of a previous final bill for Ireland's banking sector sent the country's debt crisis into overdrive last year, said the assumptions underlying the latest round of stress tests were robust.

It's as positive as a downgrade can be, said Eoin Fahy, economist at Kleinwort Benson Investors.

I would take that as distinctly positive. The fact that they moved us to stable is significant and the language they have used is encouraging. I was worried we would see two or even three notches (cut).

S&P now rates Ireland BBB+, above fellow euro zone strugglers Portugal and Greece. Moody's rates Ireland Baa1 with a negative outlook.

The rationale for the cut was the risk that bond investors could be hit if Ireland needs to borrow from a new European bailout fund, set to be up and running in 2013. S&P believes sovereign debt restructuring is a possible pre-condition to borrowing from this fund.

Ireland is already borrowing from the euro zone's temporary rescue fund and some analysts think Dublin will need to tap the permanent bailout fund despite government ambitions to return to the debt markets, possibly in the second half of 2012.

S&P said it expected the Irish economy would gradually recover after a three-year contraction and its reliance on external trade meant it had better growth prospects than Portugal and Greece.

But Fitch was less upbeat, warning that there was significant uncertainty surrounding the outlook for economic growth this year.

Finance Minister Michael Noonan hopes he can cap the state's part of the 24 billion euro bill at around 17 billion euros, which can be funded out of the 17.5 billion euros Irish government contribution to the 85 billion euros EU-IMF bailout.

The rest would be paid by imposing losses on banks' subordinated bonds, which Noonan said could raise around 5 billion euros, and asset sales.

If Ireland has to pump the full 24 billion euros into the banks, its debt-to-GDP ratio would rise to 111 percent by 2013 from around 100 percent currently, a finance official said.

Shares in Bank of Ireland rose on the government's commitment to make it one of the pillars of a new two-bank system, while the government's retreat from a threat to impose losses on some bondholders pushed senior bank debt higher.

(Additional reporting by Conor Humphries and Steve Slater; editing by Patrick Graham and Stephen Nisbet)