DUBLIN (Reuters) - Ireland's economy shrank 1.2 percent in the second quarter, crushing forecasts for growth and raising the stakes for Prime Minister Brian Cowen as he seeks to reassure investors the country is not on the verge of financial meltdown.

Ireland is under huge international pressure to tackle the worst budget deficit in the EU, but a fragile domestic economy may prevent Cowen from cutting public spending too zealously, compounding market scepticism about Ireland's ability to shoulder the burden of a disastrous property bubble.

The premium investors demand to hold 10-year Irish government bonds rather than German benchmark bunds hit a fresh euro lifetime high after the gloomy gross domestic product data, the knock-on effect of which will be a weak tax take.

Irish five-year credit default swaps hit a record high of 500 basis points, up 40 bps on the day.

"It's a delicate balance. I honestly don't think there is much alternative for the government but to impose cuts, but it certainly suggests they need to be cautious about being too aggressive," said Austin Hughes, chief economist with KBC Bank.

The contraction in the first three months of the year came despite economists' consensus forecast for growth of 0.5 percent, reflecting consumers' continuing unwillingness to spend in the middle of a state austerity drive.

It also contrasts sharply with the growth logged in most of the rest of the euro zone in the same period, with the notable exception of similarly debt-laden Greece.

Together with a downward revision in first-quarter figures, the data suggests Irish economic growth will be flat this year, analysts said, missing a government forecast for economic growth of around one percent.

Ireland's open economy is heavily reliant on overseas demand, and surveys yesterday showed growth rates in the euro zone's services and manufacturing sectors slowed more than forecast this month.

With borrowing costs now at unsustainable levels over the medium-term, Minister for Finance Brian Lenihan reiterated that Dublin was sticking to its target of getting the public deficit to an EU target of three percent of GDP by 2014.

"A longer timescale for the fiscal plan would denude this country of any credibility in world markets," Lenihan told public radio RTE in an interview.

The International Monetary Fund has previously said Ireland was unlikely to meet this target and investors are concerned that as the economy remains fragile Ireland will have to do more fiscally to get its debt to GDP levels down.

Analysts at Credit Suisse have forecast that Ireland's debt to GDP level could peak above 100 percent. It was 25 percent before the crisis.

"This is probably going to mean a tougher budget," said Stephen Taylor, equity analyst with Dolmen Stockbrokers.

"To be honest, they should probably look to bring the budget forward a little bit to settle bond markets."

But Lenihan has ruled out accelerating his fiscal plans due to be unveiled on December 7.

In Berlin, European Economic and Monetary Affairs Commissioner Olli Rehn said the euro zone should learn from the work of the temporary European Financial Stability Facility before considering setting up a permanent rescue mechanism for countries in fiscal trouble.

Rehn ruled out a debt restructuring for Greece, Ireland or any other country in the euro zone. He said Ireland still faced major challenges but its government had shown determination in consolidating the budget, adding that he was confident it would meet its fiscal targets.

Ireland's budget deficit could hit 25 percent of GDP when the cost of bailing out Anglo Irish Bank is included.