Irish borrowing costs shot up to new lifetime highs on Thursday and European Commission President Jose Manuel Barroso signaled the bloc was ready to act should the humbled former "Celtic Tiger" require a rescue.
European officials said they were monitoring developments in Ireland closely, with the Handelsblatt newspaper quoting a German government source as saying aid could be unlocked "very quickly" if needed.
Ireland's fragile government is battling to prove it does not need a Greek-style rescue to help it reduce the worst budget deficit in Europe, but markets are skeptical about its ability to pass the first of four austerity budgets next month.
Compounding the pressure on Ireland and other euro zone countries like Portugal have been European plans to create a permanent rescue mechanism under which private debt holders would help shoulder the cost of future euro zone bailouts.
Although Germany has made clear the new mechanism would not apply to existing debt, the plan has spooked markets, raising fears of a domino-effect on peripheral euro members that only weeks ago appeared to have weathered the worst crisis in the single currency's bloc's 11-year history.
"What is important to know is that we have all the essential instruments in place in the European Union and euro zone to act if necessary, but I am not going to make any speculation," Barroso said at a G-20 summit in Seoul, when asked whether Brussels would need to act to support Ireland.
Irish bank shares were down sharply on Wednesday, reflecting renewed jitters about their exposure to the country's wrecked property market, with Allied Irish Banks shedding 5.6 percent and Bank of Ireland off 8.9 percent.
U.K. banks with a large exposure to Ireland, including Royal Bank of Scotland, also slid.
The cost of insuring Irish, Portuguese and Spanish debt against default pushed up to record highs as well, and the spread between Irish 10-year bond yields and those of German benchmarks rose above 680 basis points, hitting a new high for the ninth straight session.
"It's the same trend we've been seeing," said Gavan Nolan, an analyst at Markit. "The market is very nervy."
NO CALL FOR AID
Irish, European Union and International Monetary Fund officials all said on Wednesday that Dublin had not requested financial aid under a new rescue mechanism known as the European Financial Stability Facility (EFSF), which the bloc set up in May to stem contagion from Greece's meltdown.
The Irish government is fully funded until mid-2011, meaning a liquidity crisis like the one that shocked Greece earlier in the year is not imminent.
The IMF has said markets are overestimating the risks of default in a number of countries. A recent report said that of the 36 instances in the last two decades where a country's yield spreads rose above 1,000 basis points, only seven resulted in default.
In the other 29 cases, spreads eventually fell back with no default.
But most analysts seem to agree that Ireland could be forced to seek a rescue if its borrowing costs do not stabilize soon.
With liquidity in the bond market drying up, some are now openly speculating the country may also have to restructure its debt, particularly if its banks suffer more losses.
Prime Minister Brian Cowen's unpopular government has pledged to outline a four-year plan later this month to bring the ballooning budget deficit under control, and to push through 6 billion euros ($8.21 billion) in savings in the 2011 budget on Dec. 7.
However, with a parliamentary by-election due which is likely to cut the government's majority to just two seats, analysts increasingly say only an early general election that produces a new government with a stronger popular mandate to implement painful spending cuts and tax rises may convince investors that Ireland is able to overcome its debt crisis.
Should Ireland fall, concerns about Portugal and probably Spain could rise, creating a vicious spiral that could drag the euro zone into another deep crisis with global implications.
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