Iceland Backs Off Icesave Repayment

Setting off a diplomatic crisis with the EU and IMF, Iceland's president vetoed a bill to repay Britain and Holland for deposits lost when the island's largest bank failed

By Omar R. Valdimarsson and Tasneem Brogger

(Bloomberg) — 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.

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