STOCKHOLM (Reuters) - Iceland is now staring at twin crises, one economic and the other political, after it failed to strike a new deal on repaying debts to Britain and the Netherlands.

As long as the so-called Icesave dispute hangs over the island, it can expect the economy to be starved of cash. Add to that the chance of political instability as the government has to take responsibility for a mess which will leave Icelandic taxpayers with a huge bill for years to come.

“Nobody dares invest anything in Iceland until this issue is resolved,” said Danske Bank senior analyst Lars Christensen.

Talks collapsed this week on a new deal to replace one agreed late last year, which proved to be deeply unpopular on the island. Britain and the Netherlands say Iceland owes them more than $5 billion after they compensated savers who lost money in Icelandic “Icesave” deposit accounts.

A referendum has been scheduled for March 6 on the old accord, and it is expected to be soundly rejected. Angry Icelanders believe the terms are unduly harsh.

Had a new agreement been forged, Reykjavik might have been able to get financial aid flowing again.

But now, Iceland will be unable to prop up its sagging economy, which contracted around 7.7 percent last year and is likely to shrink again this year.

In the longer term, Iceland faces the risk of default on its foreign debt, the bulk of which falls due in 2011, extending the country’s exclusion from overseas financial markets and prolonging the current recession.

“If this is not solved by then (2011) the risk of default would increase, but that’s a long time from now,” said Mats Olausson, chief emerging markets strategist at Swedish bank SEB.

Iceland’s banking system and currency collapsed in late 2008, plunging the country into recession and leaving it dependent on international aid.

Repeated attempts to solve the spat with the British and the Dutch have failed and foreign capital has dried up as a result.

Rating agencies have already downgraded Iceland’s foreign currency rating sharply and Moody’s Investors Service warned on Friday that Iceland’s ratings were under pressure following the breakdown of talks.

Fitch already rates Iceland paper as “junk.”

Foreign currency borrowing totals around 355 billion crowns ($2.78 billion), according to the central bank’s website, though this does not include the debt to Britain and the Netherlands, nor money from the IMF aid package.

BLAME GAME

Icelandic Prime Minister Johanna Sigurdardottir held out hope on Friday that a deal might still be reached.

But time is running out ahead of the referendum. Analysts say that vote could bring down Iceland’s ruling coalition, sparking a political crisis.

“If there is a ‘no’ vote on March 6, it’s not a necessity that the government would step down, but their position would be seriously damaged. And I don’t think there is an immediately viable alternative,” SEB’s Olausson said.

The largest opposition group, the Independence party, is widely blamed for the 2008 crash, while the popularity of the Social Democrats and Left-Green government has taken a beating over the handling of the Icesave issue.

Political uncertainty is also rife in Britain and the Netherlands. The Dutch government collapsed last week and British Prime Minister Gordon Brown is widely expected to lose a general election to be held before June.

Despite all the difficulties, however, analysts expect a deal to be reached before Iceland runs out of cash.

Britain and the Netherlands want their money and are sensitive to accusations of bullying. For Iceland, a new deal is a must, though it is likely to be a bitter pill to swallow whatever the final terms.

“There is only one way forward for Iceland here, and that’s extreme austerity,” Danske’s Christensen said.

Britain has already warned the country it faces financial isolation unless it accepts its Icesave responsibilities.

What a deal would acceptable to all three would look like, however, no one knows.