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03/18/2010 05:12 am ET | Updated May 25, 2011

Iceland Faces New Crisis After Bill To Repay Britain Is Vetoed

LONDON (AP) -- A diplomatic deep freeze set in Wednesday between Britain and Iceland, a day after the Icelandic president blocked the repayment of a $5.7 billion loan -- a move that threatened to plunge the tiny island nation back into another financial crisis.

Icelanders are already struggling with high interest rates, soaring unemployment and a virtually valueless currency, but President Olafur R. Grimsson's decision Tuesday jeopardized the country's bid to join the European Union and its access to vital aid.

Some British newspaper editorials compared the current dispute to the Cod Wars of the 1970s when British naval boats challenged Icelandic fishing vessels in a dispute over fishing rights in the North Atlantic.

British Financial Services Minister Paul Myners, meanwhile, said Iceland risked pariah status if a national referendum next month on the loan repayment -- triggered by Grimsson's decision -- cemented a "no" vote.

Iceland, a small nation of around 320,000 people, has been surviving on emergency funds from the IMF. The help, along with revenues from its fishing industry, has allowed it to slowly start rebuilding its economy.

While $1.9 billion of the loan repayment is due to the Netherlands, Icelanders are more livid with Britain after it used anti-terrorist legislation at the height of the credit crisis to freeze Icelandic assets in an attempt to protect its own citizens.

Grimsson has said his decision to veto the bill and put the loan repayment issue before a national referendum -- only the second time in the country's history a president has vetoed a bill -- was determined by overwhelming public opinion.

Almost a quarter of Iceland's tiny population signed a petition calling for the referendum, tentatively scheduled for Feb. 20.

Analysts believe if most people vote "no," it will come down to lobbyists telling the electorate that the deal would saddle every person on the island with an extra $16,000 in debt.

"We cannot bear that," said Johannes Skulason, the spokesman for the InDefence group, which launched the referendum petition. "But for the British public, the amount of money being asked for is peanuts. There is bitter resentment towards the British."

Icelanders are also angry that the previous government had allowed the transformation of Iceland from a solid fishing-based industry to essentially a giant unbalanced hedge fund under the auspices of just a handful of so-called "venture Vikings."

The deregulation of the domestic financial market in the 1990s fueled a stock market boom that underpinned an acquisition spree across Europe by cash-rich Icelandic banks and companies. But the burgeoning banking sector grew to dwarf the rest of the economy, maxing out at assets at nine times annual gross domestic product of $19 billion, leaving Iceland heavily exposed to the global credit squeeze.

"A lot of people feel they are being unfairly punished," said Silja Bara Omarsdottir, a politics professor at the University of Iceland in Reykjavik.

The irony is that the people's push for a referendum threatens to worsen their situation.

International credit ratings agency Fitch reacted to Tuesday's veto by slashing Iceland's credit rating to junk status.

Britain, which is already heavily weighed down with its own debt from the credit crisis, has joined with the Netherlands in warning they both hold veto power to Iceland's entry to the EU -- a key step in the country's economic recovery.

The EU, which is drafting an opinion about Iceland's July membership request, said Wednesday that it was monitoring the situation "very, very closely."

Also at risk is a $4.6 billion bailout from the International Monetary Fund and Nordic countries. The IMF has said that payment is not a condition of the rescue package so long as the economic program worked out as part of its loan is fully financed, but the Nordic countries have explicitly linked the two, potentially delaying the whole program.

Skulason said those repercussions would be an overly harsh response to a referendum that refers to the rejigged terms of a loan repayment package that was narrowly passed by the Icelandic parliament in December -- and does not dispute the repayment of the loan itself.

The December bill included stricter terms imposed by Iceland and the Hague on the Icelandic government's original plan to repay Britain and the Netherlands for the money they used to compensate their citizens who had accounts with online bank Icesave, a subsidiary of Icelandic bank Landsbanki that was available only in Britain and the Netherlands.

A "no" vote in the referendum would have the effect of reverting to the August bill as law, likely leading to further talks between all three countries to reach a mutually acceptable deal.

Britain's Treasury office said Wednesday it believed the revised terms were fair and that it was "too soon to discuss having different terms."

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