* Bond guarantee left out of U.S. spending bill

* Iraq seeks bond issue to fill $10 bln budget deficit

* Economic instability could threaten gains vs Islamic State

By Hadeel Al Sayegh and Patricia Zengerle

DUBAI/WASHINGTON, Oct 1 (Reuters) - Iraq's plans to raise $2 billion on international debt markets to help fill a budget gap caused by low oil prices were thwarted this week by the U.S. Congress' refusal to guarantee half the bonds' value.

As part of a 2017 budget endorsed by the International Monetary Fund, Baghdad said it would seek to issue a $1 billion bond fully guaranteed by the United States in order to lower borrowing costs before issuing another $1 billion.

Those funds would complement a three-year $5.34 billion standby loan, which the IMF approved in July in exchange for economic reforms. Baghdad hopes the IMF deal will unlock more than $12 billion in additional aid from sources such as the World Bank and the Group of Seven leading industrialised nations.

Western allies have acknowledged the need to guard major OPEC producer Iraq's fragile economy from a collapse that would risk undermining military gains against Islamic State by a U.S.-led coalition and local forces that are looking to retake the militant stronghold of Mosul later this month.

While the Obama administration requested the guarantee be included in a "continuing resolution" - stopgap legislation that keeps the U.S. government running while more permanent spending decisions are agreed - it did not end up in the final version passed by Congress on Wednesday.

Lawmakers said they had tried to keep side issues out of the spending bill in order to ensure it would go into effect before the new fiscal year began on Oct. 1.

Iraqi Prime Minister Haider al-Abadi's financial advisor, Mudher Salih, who has worked closely on the bond issue, and a source familiar with the matter told Reuters the guarantee had been held up by Republicans in Congress, without providing details.

Republicans have majorities in both the House and Senate, but it was unclear if they had a particular objection to putting up more funding for Iraq, which has already received billions of dollars in military, economic and humanitarian aid from Washington since the U.S.-led invasion that toppled Saddam Hussein in 2003.

Many members of Congress are frustrated with Iraq's government. They worry that the United States has sent far too much money to Baghdad, with too few results, due to corruption and incompetence.

Many also view the Iraqi government as being too close to Iran, and are angry with its Shi'ite leaders for alienating minority Sunni Muslims.

The Iraq loan guarantee could still be included in spending legislation that must pass in order to keep the government open past Dec. 9, when the temporary spending bill expires.

Salih told Reuters on Thursday that Iraq was likely to delay the bond issuance until at least early 2017, in part because of the lack of a U.S. guarantee.

Baghdad's latest budget proposal for 2017 forecasts expenditures of 90.224 trillion Iraqi dinars ($77.6 billion) with a shortfall of around 12 trillion dinars. ($1 = 1,162.7000 Iraqi dinars)

(Additional reporting and writing by Stephen Kalin; Editing by Robin Pomeroy) ((stephen.kalin@thomsonreuters.com; +964 790 191 7023; Reuters Messaging: stephen.kalin.thomsonreuters.com@reuters.net))