Irish stocks fell Friday, dragged down by weak banking shares while the cost of insuring the country's sovereign debt soared to a new record high after analyst comments brought the former Celtic tiger's banking sector problems back into the limelight.
Shares in Allied Irish Bankstanked more than 8 percent and data from Markit showed that 5-year credit default swaps hit a record high of 425 basis points.
Fears over the health of the Irish banking sector resurfaced after a research note by Barclays Capital released Thursday that suggested that the government should consider sharing the burden of solving the situation of failed banks with holders of debt in banks, including some form of debt-for-equity swap.
The main Dublin index was down 2.8 percent in early afternoon trading and the euro was flat. Dublin later pared some of the losses, trading 0.9 percent down.
"A move to institute some sort of a haircut will no doubt cause further losses in the country’s financial sector and may imperil growth going forward," Boris Schlossberg, director of currency research at FX360, wrote in a market note Friday.
"The unpleasant choice between fiscal consolidation and possible further GDP contraction has roiled the credit markets this morning with Irish 10-year bond spreads widening out to all time highs," Schlossberg added.
Barclays Capital analysts wrote that a default by Ireland is unlikely due to the government's policy track record, the possibility of the country getting help from the European Union if it runs into more problems and the fact that it has completed its financing needs for this year.
"Further fiscal consolidation in the near term would have the trade-off of lower growth, which we expect will remain in negative territory this year," the Barclays Capital report noted.
"However, if concerns about growth leave little room for additional fiscal tightening beyond what has already been done, then there are not many policy options left," it added.
EU, IMF 'Rumors'
The report argues that at this juncture the country does not need to seek an aid package from the European Union and the International Monetary Fund, like Greece and some Central and Eastern European countries did.
"Activating such a package could alarm the markets, which could interpret outside financial help as the Irish authorities' public admission of having run out of options," Barclays Capital analysts wrote.
But, they added, "if macroeconomic conditions deviate from our baseline recovery scenario, then EU-IMF assistance is arguably the best option to (stabilize) markets."
Speculation was rife in the markets on whether the country has already asked for help from the financial institutions.
"There is no truth to the rumor," a Finance Ministry spokesman told CNBC. "It is based on a local misinterpretation of a research report."
An IMF spokesman told Reuters the fund did not foresee a need for Ireland to request assistance.
If real estate and other asset prices fall further, uncertainty about the health of the banking sector continues, medium-term growth is anemic and sovereign yields stay high, then Ireland would get into "a path of low-growth dynamics," Barclays Capital analysts warned.
The panicked market reaction proves that confidence in the euro zone overcoming its debt problems has not returned, Schlossberg added.
"The problem with Ireland underscores the fragile state of affairs in the peripheral economies of the euro zone and demonstrates euro's vulnerability to this issue," he wrote.
- Tessa McCann, assistant producer CNBC in London, contributed to this story