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Iceland Backs Off Icesave Repayment

Iceland will hold a referendum on a depositor accord with the U.K. and Netherlands after President Olafur R. Grimsson blocked the bill in a move that threatens to undermine the island's efforts to repair international relations.

"The constitution is very clear about the need for a referendum in this situation," Prime Minister Johanna Sigurdardottir told reporters in Reykjavik today.

Grimsson vetoed the so-called Icesave accord after more than 60,000 of Iceland's 320,000 inhabitants signed a petition urging him to reject the legislation.

The bill, which polls show about 70 percent of the population opposes, had obliged Iceland to use $5.5 billion in borrowed funds from the U.K. and Netherlands to cover depositor claims from the two countries after the failure of Landsbanki Islands hf in October 2008. The absence of clear cross-border regulatory rules on depositor insurance has allowed settlement of the claims to drag on and left Icelandic taxpayers disgruntled over having to pay for the failure of a private bank.

"The cornerstone of Iceland's constitution is that the nation is the highest judge for the validity of law," Grimsson told reporters at his residence outside the capital today. "Now the nation has the power and the responsibility in its hands."

'Brink of Default'

The decision jeopardizes the continued flow of loan payments from the International Monetary Fund, Danske Bank A/S Chief Analyst Lars Christensen said in an e-mailed note.

If Iceland doesn't cover the depositor claims, "the most likely outcome would be a postponement of the payout of money from the IMF, which could potentially push the Icelandic government to the brink of default," he said. "Iceland's return to international capital markets now seems very distant."

Fitch Ratings lowered the sovereign's rating to BB+, one level below investment grade, after the announcement by Grimsson. The rating carries a negative outlook.

"Today's decision by Iceland's president to refer the Icesave agreement to a referendum creates a renewed wave of domestic political, economic and financial uncertainty," Fitch senior director Paul Rawkins said in a statement. "It also represents a significant setback to Iceland's efforts to restore normal financial relations with the rest of the world."

Sigurdardottir, who told reporters she had "no idea" Grimsson was going to veto the bill until he announced his decision, convened a Cabinet meeting, followed by a meeting of coalition lawmakers to decide how to proceed.

"In light of the serious consequences that the decision may have, the government will now assess matters and the outlook in regards to the reconstruction plan that has so far been pursued with good results," the government said in a statement.

'Very Disappointed'

"The U.K. government does expect Iceland to meet its obligations," U.K. Chancellor of the Exchequer Alistair Darling told reporters in London today. The president's failure to stick to the Icesave accord will "make things a lot more difficult," he said yesterday.

The government of the Netherlands is "very disappointed" by the decision, Dutch Finance Ministry spokesman Ruud Slotboom, said in a phone interview. "We expect an explanation by the Icelandic government on the situation. The Netherlands sticks to its stance that Iceland has the obligation to repay" the depositors.

"We will take as little time as possible," Sigurdardottir said. "We need to dissipate all the uncertainty, as much as we can; however, we are in the midst of an era of uncertainty with the president's decision. We will carry out the tasks that need to be carried out in regards to the national referendum."

Government Outlook

A veto from Grimsson may lead to "the end of this government," Bjorn Valur Gislason, deputy chairman of the budget committee and a lawmaker in the ruling Left Green Party, said in a telephone interview on Jan. 3. Finance Minister Steingrimur Sigfusson said in an interview today there is no indication the government will collapse.

Standard & Poor's on Dec. 31 raised its outlook on Iceland's BBB- rating to stable from negative and said parliament's ratification of the depositor bill is a step "that will contribute significantly to securing crucial external financing throughout 2010." Moody's rates Iceland's debt Baa3, one level above junk.

The presidential veto interrupts a series of settlements needed to rebuild the economy, which was the worst hit in the western world after the credit crisis.

Bill History

The Social Democrat, Left Green coalition of Sigurdardottir, which has been working for the past year to resurrect the island's financial system, said last month it completed a bank recapitalization plan after creditors accepted settlements. Iceland's three biggest lenders collapsed in October 2008, leaving about $80 billion in outstanding claims.

Lawmakers on Dec. 31 voted 33 to 30 to allow the government to provide a state guarantee for the U.K. and Dutch loans to cover the Icesave depositor claims.

Thousands of British and Dutch depositors risked losing their savings when Landsbanki collapsed along with the rest of Iceland's over-leveraged banking system in October 2008. By passing the bill, lawmakers hoped to pave the way for unlocking further disbursements from a $4.6 billion bailout from the International Monetary Fund and Nordic countries.

Earlier Accord

The bill would have allowed Iceland's government to guarantee repayments of as much as 2.35 billion pounds ($3.8 billion) borrowed from the U.K. and 1.2 billion euros ($1.7 billion) borrowed from the Netherlands to repay Icesave depositors.

A tentative agreement on repaying the depositor claims and a state guarantee attached to them was reached on June 6. The agreement had to be ratified by Iceland's parliament, which attached conditions to the state guarantee.

Parliament's conditions linked repayments to economic growth, preserved the island's right to legally challenge its payment obligation, and called for a full suspension in repayments in 2024. Some of the conditions were rejected by the U.K. and Netherlands, sending the three nations back to the negotiating table.

The bill that Grimsson rejected today allowed for some of parliament's original conditions, such as linking payments to economic growth. It also established a mechanism on how to settle any outstanding claims in 2024, for which Iceland bears full responsibility. The Netherlands and U.K. allowed Iceland the right to challenge the agreement, according to a joint statement from the three countries published on Oct. 19.

The failure of Landsbanki, Glitnir Bank hf and Kaupthing Bank hf led to the collapse of the currency and forced Iceland to go to the International Monetary Fund to get a $2.1 billion loan, with a further $2.5 billion pledged by Nordic nations.

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