Iceland on brink of meltdown

Iceland's credit risk may rise "considerably" as it faces the threat of a shelved emergency bailout and a government collapse, Standard & Poor's said.

"The risk is there that the programme will fall apart and with that, the downside risks would increase very considerably," Moritz Kraemer, S&P's managing director for Europe, the Middle East and Africa, said.

If the outlook for the bailout programme doesn't improve, "it's quite possible" the Government will collapse.

President Olafur R. Grimsson's January 5 decision to block a UK and Dutch depositor accord called into question the continued disbursement of a US$4.6 billion ($6.22 billion) loan from the International Monetary Fund and the Nordic countries that Iceland needs to avert default.

Fitch Ratings cut the island's credit grade to junk the same day and S&P said it may lower its BBB- rating to non-investment grade within a month if the rejection halts bailout flows.

"We were not encouraged by the statement of the President because it also made it clear that predictability of policy implementation in Iceland is not what we thought it would be," Kraemer said. "The political process has turned out to be even more cumbersome than we had anticipated."

The cost of protecting Iceland's sovereign bonds from non-payment increased last week, according to CMA DataVision prices in New York. Credit-default swaps on the nation's debt rose 37 basis points last week to 543.58 basis points. A basis point is 0.01 percentage point.

"The increasing sovereign risk in countries such as Iceland and Greece in Europe will very likely impact the European-based lenders and I could also see it having a spillover effect on some of the US banks," said Brayan Lai, a Hong Kong-based credit analyst at Calyon. "If that's the case, the recovery phase is going to be more protracted than people initially thought."

The so-called Icesave bill, which allows the Government to guarantee a US$5.5 billion loan from the UK and Netherlands to repay depositor claims, is due to be put to a referendum by March 6. Most polls show Icelanders will reject the legislation, which lawmakers passed 33 to 30.

The political strain of any failure of the accord with the UK and Dutch may be too much for the Government to survive, Kraemer said.

Some members of the Left Greens, the junior coalition partner, don't want Iceland to continue its co-operation with the IMF.