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For better or worse, Portugal's chances for clean bailout exit grow

* Bailout exit looming on May 17

* Govt to decide on strategy next month, EU still divided

* Benchmark bond yields around 4 pct, lowest since 2010

* Economy growing again after worst recession since 1970s

LISBON, March 28 (Reuters) - Portugal's chances of making a clean break from its international bailout in May are growing as its economic outlook gradually improves, borrowing costs slide, and some political dividends are seen for the government from going it alone.

But any positive market impact of such an outcome may be limited, analysts say. Some warn that the country's economy is still too fragile and could only benefit from a precautionary credit line after the end of the rescue programme.

Prime Minister Pedro Passos Coelho has said the government will decide on what to do in April. He has not ruled out following the footsteps of Ireland whose decision to dismiss any further support after its EU/IMF bailout ended in December was greeted with enthusiasm and a drop in yields in the markets.

Next week, Passos Coelho's cabinet will start a marathon of meetings to discuss the budget strategy for the next few years that needs to continue the course of deficit cuts, and the bailout exit is likely to be among the themes.

EU economy and finance ministers will also debate Portugal's bailout exit at an informal Ecofin meeting next week in Athens.

With the blessing from Europe's powerhouse Germany, Lisbon could try to leave the rescue programme behind without a formal stand-by agreement in place and see if it can stand on its own in debt markets, analysts and some European officials say.

"The idea in Portugal seems to be skewed towards a clean-ish exit, but knowing that the European support mechanisms are there in case they are needed," said Antonio Costa Pinto, a political scientist at the University of Lisbon.

One senior European Union source told Reuters he saw at least a 70 percent probability of a clean exit for Portugal thanks to benign market conditions, strong cash buffers at Portugal's Treasury and the greater political attractiveness of such an outcome both for Lisbon and the euro zone.

The leader of the main opposition Socialists has said that anything but a clean exit would mean the government's failure as its "obligation, after the heavy sacrifices imposed on the Portuguese, is to create conditions for a return to markets without the need for any support".

"From the point of view of internal politics a precautionary loan would not look so good," Costa Pinto said.

SHORT-SIGHTED?

Gilles Moec, an economist at Deutsche Bank, said a clean exit was more likely as it would be "more palatable in Portugal and Europe, with a spin as another success after Ireland".

"That's not necessarily a good thing though and appears a bit short-sighted. I don't think it will have either positive or negative effect on the market, while a precautionary line with further conditionality would be an additional positive."

Still, a senior euro zone official pointed to existing differences on the matter, saying that while Germany clearly favoured a clean break, most other countries and the European Central Bank "would prefer to see a precautionary line". But the final decision is with the Portuguese, EU officials insist.

Comments by another European official appeared to support the possibility of Lisbon ending its bailout on May 17 without any new programme in place, at least for a while.

"There could very easily be a certain time lapse between an expiring programme and a successor programme ... it's not that the range of options is drastically narrowing down to one" as we approach May 17, he said.

Analysts say any standby loan should be in excess of 10 billion euros to plug any potential funding holes for a year.

Credit ratings agencies also have different views on a precautionary loan. Moody's has said it will not make much of a difference on its rating. But Fitch has said that a precautionary loan would be more supportive for its rating.

A one notch upgrade by Fitch could help Portugal back into its investment territory.

Some of the arguments for a safety cushion are that Portugal's bond yields still exceed Ireland's by around a percentage point, that Portugal's economy is structurally weaker and that its debt and financing needs are higher.

But there have been tangible improvements on practically on all these fronts, especially in terms of 10-year benchmark bond yields, that on Friday touched just below 4 percent for the first time in four years.

That is a level Ireland, whose yield is now at 3 percent, saw three months before the end of its bailout.

The Bank of Portugal on Wednesday upgraded its economic outlook for 2014 and beyond, expecting a gradual recovery in consumption and investment to stoke growth through 2016. In a change from its previous warnings of downside domestic risks, it now sees some potential for positive surprises.

"Portugal's outlook is improving significantly," said Lefteris Farmakis, an economist at Nomura Securities in London.

"They expect to be pre-funded for 2015 at the end of this year. At 6 percent borrowing costs you need both pre-funding and a precautionary loan, but current yields allow to think in the direction of a clean exit."

(Additional reporting by Paul Taylor, Jan Strupczewski and Martin Santa; Editing by Alison Williams)