Can Ireland escape Europe’s debt crisis?

October 13, 2011, 10:14 PM UTC

FORTUNE — Despite all the upheaval surrounding bank funding and debt problems in Greece and Italy, investors are betting that one country is seeing better days: Ireland.

The Celtic Tiger, among the eurozone’s peripheral economies rescued to avoid the likelihood of defaulting on soaring debts, is seeing better-than-expected growth. Its economy expanded 1.6% in the second quarter after growing 1.9% during the previous quarter.

Investors have taken note: Irish 10-year bond yields have plunged 637 basis points to 7.7% since this year’s peak of about 14% on July 18, according to The Financial Times, making it “the best performing government debt market of the main eurozone economies and one of the best performing in the world over that period.”

Irish 10-year yields slipped below 10% last month for the first time since Portugal’s rescue, according to Bloomberg. Portugal’s 10-year borrowing costs have been 10% or higher since June 8, while Greek securities of similar maturities yield 22.84%.

Investors’ renewed faith in Ireland has prompted some to wonder if the country’s path is something others should follow. It was less than a year ago that the tiny island nation was on the brink of default and forced to take a bailout with deep austerity measures attached. And already, it is showing signs of stability.

Will the momentum last? Ireland is something to watch closely as Europe’s long and slogging debt crisis continues to roil global markets. The country could either serve as somewhat of a how-to for ailing economies struggling to come off huge debt problems or proof that even the best of them can’t escape the wrath of Europe’s debt crisis.

In 2008, the country was one of the first to enter into recession in the eurozone. Though the downturn was much more severe than in Portugal, Ireland’s recovery has been stronger, according to a note to clients by Deutsche Bank strategist Mohit Kumar . Whereas Ireland’s real GDP is about 12% below its peak, it’s only 2.5% below peak in Portugal. Yet Ireland has shown positive growth this year, while Portugal is still in negative territory.

In many ways, Ireland’s recent performance is rooted in its previous record of attracting foreign investors eyeing the country’s relatively young and well educated population, as well as its low corporate tax rate. Until Ireland fell into recession at the start of 2008, it was known as a destination for foreign investors wanting to tap deeper into the European market. Cisco (CSCO), Intel (INTC) Microsoft (MSFT) and other big corporate names have large offices in Ireland. So its economy is unlike Greece.

But growth for Ireland could prove challenging in the year ahead as Europe’s debt crisis stands to deteriorate growth across the globe. Exports have driven Ireland’s growth this year. “In particular the reliance on the EU, U.S. and Canada as destinations for exports highlights the potential risks of the deteriorating economic outlook in these countries for Ireland,” Kumar notes.

Ireland’s consumers won’t likely be able to offset any potential decline in exports. Similar to the U.S., they’re weighed down with heavy debts from a housing market that went bust only a few years ago.

Indeed, Ireland’s Gross National Product, which better reflects domestic demand, grew 1.1% during the second quarter – the highest increase in economic productivity in a long time. But such growth comes on top of a decline of 4.3% during the previous quarter.

“Taken together, Ireland remains in deeply negative domestic growth for the year,” says Sean Kay, professor at Ohio Wesleyan University and author of Celtic Revival? The Rise, Fall and Renewal of Global Ireland. What’s more, this summer, Moody’s international rating agency downgraded Ireland to “junk” status. Kay notes the move wasn’t based on the economy’s performance but because it remains so deeply in debt that default seems likely without ongoing financial help from the European Union.

Indeed, Ireland has much going for it. No doubt this has helped the Celtic Tiger purr again. But like most other economies across the globe, the risk of financial contagion may be hard for Ireland to escape.