* Says government must not ease austerity drive
* Uncertainty over mortgage losses could impact sovereign
* Says deal on Anglo promissory notes would 'boost confidence' (Adds byline, details on promissory notes, background)
By Conor Humphries and Stephen Mangan
DUBLIN, Jan 29 Ireland's central bank warned on Tuesday that mortgage arrears and tough export markets had the potential to throw the country's recovery off track.
An elusive deal with Ireland's international creditors on restructuring bank debt would provide a confidence boost to a country keen to emerge from an EU/IMF bailout, the central bank added as it set out its latest economic forecasts.
Ireland's economy grew an estimated 0.7 percent in 2012, its second year of growth after a 2007 property crash.. But the central bank cut its 2013 forecast to 1.3 percent from 1.7 percent.
As a result the government cannot afford to ease its fiscal adjustment program despite beating its 8.6 percent deficit target last year, the central bank said.
Pressure on the government to ease its austerity drive has increased in recent months as opinion polls show the anti-austerity opposition growing in popularity.
"It would not be appropriate to use the buffer this provides to ease back on the adjustment effort," the central bank report said.
Continuing to beat the targets, it added, would "serve to reduce uncertainty and, through this channel, contribute to a faster domestic recovery."
The weakening medium term outlook will increase the pressure on the government to secure a deal on restructuring 30 billion euros of promissory notes tied to the bailout of Anglo Irish Bank. Last week the European Central Bank rejected Ireland's proposal to convert the notes into long-term bonds to be taken up by the central bank. That would amount to "monetary financing" of the government, the ECB reasoned.
Asked if a deal on the promissory notes would boost the economy, Frisell said: "Hard question if that will help boost growth, I guess it would help boost confidence in the whole program."
He refused to comment on what Irish Central Bank governor Patrick Honohan might offer as a replacement for the rejected proposal, saying that work on a deal was ongoing.
Another threat to Ireland's return to the markets is posed by the failure of the country's banks to adequately deal with mortgage arrears, the central bank's chief economist Lars Frisell told a briefing of journalists.
One in six home loans are not being fully repaid, as Ireland recovers from one of the biggest property bubbles in Europe, with peak to trough falls in average house prices of 50 percent.
While the banks should have enough capital to address any writedowns, the uncertainty about the losses are damaging for the sovereign, Frisell said.
"There's huge uncertainty about this, which may be a problem for Ireland when exiting the program because the capital needs are uncertain," Frisell said, adding that the bank's existing capital should be sufficient.
"We had expected more progress on this than we have seen over the last five years. It's absolutely clear that the central bank is not happy," Frisell said. (Reporting by Conor Humphries; Editing by Ruth Pitchford/Janet McBride)