The International Monetary Fund has warned Europe its inaction over Irish bank debt could threaten the nation's exit from its bail-out programme by the end of 2013.
The IMF, one arm of Dublin's 'troika' of lenders, which also includes the European Commission and European Central Bank, toughened up its language towards eurozone leaders, who agreed six months ago to improve the conditions of Ireland (OTC BB: IRLD - news) 's bank rescue.
A central issue is the €31bn used to rescue the former Anglo Irish Bank, which at the time was provided in so-called promissory notes - a time-fixed IOU - but which Dublin is pushing the European Central Bank to replace with long term government securities.
The IMF's report will reinforce Dublin's call for the debt to be restructured by March, when the next payment of €3.1bn is due.
The Irish government struck a deal to avoid immediate payment of the €3.1bn owed last March, settling the bill by issuing a 13-year bond, and has indicated it wants a similar deal on the entire debt before March 2013.
"We consider that resolving this issue is an essential part of the whole package that would be needed for a smooth exit to reliance on market funding," said Craig Beaumont, the International Monetary Fund's Ireland mission chief.
"We are strongly encouraging that a resolution of the issue be reached by the end of March."
The eurozone leaders' accord in June helped push Irish bond yields down sharply, allowing Ireland to become the first bailed-out euro country to return to long-term bond markets and begin to pre-fund a sizable chunk of the funding it will need once its €85bn bail-out ends next December.
However, Ireland is not yet in a position to resume monthly bond auctions. The IMF said prospects for durable market access depended greatly on the delivery of European commitments, particularly via a so-called retroactive recapitalisation of viable Irish banks with European rescue funds.
Eurozone creditor countries have proved reluctant to allow Dublin to tap precious rescue funds, while talks with the European Central Bank to secure longer-term funding for its banks have made slow progress.
After cutting its growth forecast for 2013 for the fifth successive review, the IMF also raised the prospect that slower growth might leave the government on the hook to cover even more banking losses if the bank-sovereign loop is not broken.
"In this context, market doubts about debt sustainability could easily re-emerge, undermining the availability of the substantial market financing needed and resulting in prolonged dependence on official support," the IMF said in a statement.
"The most definitive way to forestall such a scenario would be through decisive direct bank recapitalisation by the European Stability Mechanism, which would reduce public debt directly and insulate the sovereign from potential contingent liabilities from the banking sector. The way forward is clear."