Portugal's political crisis sends its borrowing costs soaring
* Portuguese yields top 8 percent
* Cost of insuring Portuguese debt against default soars
* Sell-off spreads to Italian, Spanish and Irish markets
LONDON, July 3 (Reuters) - Portuguese borrowing costs surged on Wednesday as rising political tension in the bailed-out country prompted investors to dump riskier assets on concerns the euro zone debt crisis could be set to flare again.
The resignation of two key ministers, including Finance Minister Vitor Gaspar who was the architect of its austerity programme, tipped Portugal into a crisis that could derail its plan to exit its bailout next year.
Portuguese bond yields surged to levels near which it was forced to seek international aid two years ago. The sell-off spread to other riskier markets like Italian and Spanish debt and European equities.
Short-dated borrowing costs rose faster than longer-dated ones and the cost of insuring Portuguese debt against default soared, suggesting growing concern about Lisbon's ability to service its debt.
"This could quickly bring Portugal into a situation where there will have to be decisions about whether there is another extension of the support programme," Elwin de Groot, senior market economist at Rabobank said.
"It will also bring back discussion on whether the ECB has any interest in trying to prevent further increases in Portuguese yields and whether or not it will be willing to do so."
Ten-year Portuguese government bond yields surged to 8.2 percent - their highest since November 2012, while two-year yields jumped 185 basis points to 5.47 percent.
Spanish, Italian and Irish borrowing costs also rose sharply but stayed below 5 percent. Ten-year Spanish yields rose 14 bps to 4.71 percent and the Italian equivalent jumped 13 bps to 4.54 percent.
Analysts remained relatively sanguine about the long-term impact of Portugal's political crisis on the region at large, arguing even a change in government - if it came to that - was unlikely to derail Portugal from its austerity path. They also said Spain and Italy were relatively insulated by the European Central Bank's conditional bond-buying promise.
"The risk for a dramatic change in economic policy is very limited," Patrick Jacq, European rate strategist at BNP Paribas said. "I don't think that this will lead to significant, persistent strong pressures on peripherals and back to a crisis situation."
But higher borrowing costs for longer could hurt Portugal's chances of exiting its bailout without further support and could make markets more prone to testing the ECB's resolve.
Bond markets have stabilised over the past year after the ECB backstop brought borrowing costs across peripheral markets down sharply, but the programme has never been activated.
As the political crisis in Portugal unfolds, analysts say the way euro zone officials deal with the latest flare-up in the currency bloc could be key to whether contagion spreads or is contained.
Against this backdrop, investors will scour ECB President Mario Draghi's news conference after a monetary policy meeting on Thursday for reassurances that the ECB has the region's back.
"Portugal looks very wobbly ... we think there is a highly increased (chance) of second bailout being required," one trader said. "High-beta periphery is back in focus. Presumably this means the ECB is going to be dovish tomorrow."
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