Moody’s Investor Service downgraded Iceland’s debt ratings outlook to negative from stable on Tuesday over concerns about the tiny island nation’s ability to tap the foreign credit it needs to stay afloat.

The ratings agency said that Iceland’s economic recovery is threatened by delays in the resolution of the so-called Icesave dispute - the repayment of $5.3 billion to Britain and the Netherlands to compensate government payments to citizens with accounts in a collapsed Icelandic bank.

Iceland’s government was pushed into a national referendum last month that rejected an agreed deal with Britain and the Netherlands after public anger about the harsh repayment terms.

Moody’s acknowledged Iceland may still achieve a better deal in renewed negotiations, but said the current uncertainty is harmful to the country’s short-term economic and financial prospects.

“The recovery of the Icelandic economy is threatened by the delays in the resolution of the Icesave dispute, which constitutes an obstacle in the resumption of official and private financial flows into the country,” said Kenneth Orchard, Vice-President/Senior Credit Officer in Moody’s Sovereign Risk Group.

After a decade of dizzying economic growth that saw Icelandic banks and companies snap up assets around the world, the global financial crisis wreaked political and economic havoc in the Nordic nation. Iceland’s banks collapsed within a week in October 2008, its krona currency plummeted and protests toppled the government.

Moody’s noted that the economy had performed better than expected in 2009, but added it was likely to underperform forecasts in 2010, perhaps contracting by 5 percent or more.

Orchard said the stalled Icesave negotiations have created some risk that the government might not be able to refinance its December 2011 and May 2012 eurobonds in the international capital markets.

It changed the outlook on the Icelandic government’s Baa3 ratings to negative from stable. The outlooks on the Baa2 foreign currency bond ceiling and Baa3 foreign currency deposit ceiling were also changed to negative from stable.

Icelandic Prime Minister Johanna Sigurdardottir last month pressed the International Monetary Fund to hasten a review to determine the next batch of bailout funding for the nation’s struggling economy.

The IMF has been putting off a decision on whether to release the second tranche of its $2.1 billion bailout funds since last year. Iceland is worried that the money could be held up until it settles the wrangling with Britain and the Netherlands, although the IMF has insisted this wasn’t the case.

The IMF has already paid out about $1 billion to Iceland and said discussions on a second review are ongoing.

Although the body has never explicitly linked delivery of the loan funds to the reaching of an Icesave deal, it is committed to Iceland repaying its international debt. The months taken to reach the original Icesave deal were responsible for holding up the first tranche of IMF funds last year.

Finland, Norway and Denmark agreed to provide a further $2.5 billion to help the country recover from a deep recession.

More In: International | News