(Reuters) - The European Central Bank has rejected Ireland's preferred solution to a dispute over the cost of servicing money borrowed to rescue a failed bank, EU sources familiar with the talks said on Saturday.
Dublin wants to avoid having to pay 3.1 billion euros a year until 2023 to service a promissory note it issued to underwrite failed Anglo Irish Bank during a meltdown of the main Irish lenders after a real estate bubble burst in 2008.
Irish Finance Minister Michael Noonan had proposed converting the note into long-term government bonds that would be taken up by the Irish Central Bank with the intention of keeping the bonds in its portfolio for a long period.
The sources said the ECB's Governing Council discussed the plan for the first time at a meeting on Wednesday and Thursday and agreed that it amounted to "monetary financing" of the Irish government, banned under article 123 of the EU treaty.
"The ball is now back in the Irish court," one source involved in the deliberations said.
"This is an issue of principle. There is a real concern in the Governing Council because you can create precedents when you do things for one country. Then others may say 'why not for us?'," the source said.
"We must be sure the solution doesn't open a window in terms of monetary financing."
A spokesman for Ireland's finance department declined to comment. Officials from the central bank and government were not immediately available for comment.
Avoiding the hefty interest charge that kicks in with this year's payment would help reduce Ireland's budget deficit, still among the highest in Europe, by more than one percentage point, according to finance department estimates.
The source said everybody involved in Ireland, the European Commission, euro zone finance ministers and the ECB wanted to find a solution by the end of March, when the next payment is due.
Ireland had raised other ideas that were less problematic, he said, declining to go into detail.
Irish Prime Minister Enda Kenny told Reuters Insider television in an interview on Friday that getting relief on the promissory note was a crucial part of his country's path to returning to full market funding this year after its EU-IMF bailout programme expires.
"We've made no secret of the fact that it's unfair. We are the only people who have had to put up with that," Kenny said, calling the talks with the ECB technical and complex.
The aim was to re-engineer, restructure the note and extend the maturity over a much longer period, he said.
Relations between Dublin and the European monetary authority have been tense since the ECB refused during the bailout negotiations to allow Ireland to make senior bondholders of Irish banks take a share of the losses incurred in the rescue.
Kenny said his government remained "confident that we'll have a deal concluded by the end of March when the next payment is due".
Another EU source said one of the outstanding issues was whether the ECB could accept the swapped Irish bonds as collateral in its refinancing operations.
Irish central bank governor Patrick Honohan, who represents Ireland on the ECB's board, described Dublin's proposal last week as a "novel" solution to reach a deal which would not take policymakers too far out of their comfort zone.
Honohan said a solution was not yet "done and dusted" but ministers have been far more confident with Finance Minister Michael Noonan repeating last week that a deal was likely, although he cautioned that significant outstanding matters could derail it.
Dublin postponed last year's 3.1 billion euro cash payment by issuing a 13-year bond and had floated the idea of replacing the rest of the payments with loans backed by euro zone bailout cash, but have concentrated their efforts on settling the issue with a long-term bond.
European Economic and Monetary Affairs Commissioner Olli Rehn told Reuters that euro zone governments were looking at ways to help Ireland back to full market access that could include extending the maturity of the bailout loans it received in late 2010 or possibly extending a precautionary credit line to Dublin from the euro zone's ESM rescue fund.
The latter option could open the way for the European Central Bank to buy short-term Irish bonds on the secondary market to help bring down its borrowing costs under the ECB's Outright Monetary Transactions policy.
However, a source familiar with ECB thinking said the Governing Council would rather hold its OMT weapon in reserve as a deterrent and not use it, noting that Irish borrowing costs had already fallen substantially and the spread over German 10-year bonds reflected market assessment of the credit risk.
He also said he did not expect Spain to request a precautionary credit line to trigger ECB intervention this year since its spread too had fallen to a level that reflected credit risk rather than any market premium due to a perceived risk of the euro zone breaking up or Spain exiting.
Additional reporting by Padraic Halpin; writing by Paul Taylor; editing by Jason Neely