Iceland's centre-right Progressives to form new government

Progressive leader Sigmundur Gunnlaugsson, who could become one of Iceland's youngest leaders at 38, has pledged an end to austerity and to return to growth five years after a spectacular banking collapse plunged the north Atlantic island into crisis.

"I will now talk to the leader of all the parties elected to parliament and only after that will I decide who would be invited for formal coalition talks," he said after receiving his mandate from President Olafur Ragnar Grimsson on Tuesday.

His Progressives presided over much of Iceland's dizzying economic rise, when home owners took on huge mortgages, the country attracted billions of dollars of Dutch and British savings with its relatively high rates, and banks grew to more than 10 time its gross domestic product.

The Independents, coalition partners of the Progressives in many past governments, were in power when the banks collapsed in a matter of days in late 2008, sending its currency into freefall and tripling unemployment virtually overnight.

Although the outgoing Social Democrat government stabilised the economy and Iceland has returned to modest growth, capital controls remain, real wages are far below their pre-crisis level and household debt remains crippling, as inflation indexed loans keep growing despite earlier government relief.

Voters punished the Social Democrats on Saturday, handing the biggest defeat to any ruling party since independence from Denmark in 1944 and offering the two centre-right parties a chance to rule again.

Although a coalition the most likely scenario, some of the promises made by the Progressives could be an obstacle.

"There is a very strong tradition of two party government in Iceland as it is accepted this would be the most stable," said Thorolfur Matthiasson, an economy professor at Oslo University.

"But Sigmundur David (Gunnlaugsson) is young, new to the game, and if he sticks too hard to his principles, he might run into trouble, turning off potential allies," Matthiasson said.

Gunnlaugsson has promised to reduce household debt through write offs and the abolition of inflation indexed mortgages. He said he would pay for this by asking foreign creditors of its failed banks to take a large write down.

Gunnlaugsson, an EU sceptic, also said Europe's economic turbulence showed the bloc was not the way to go for Iceland and he would support breaking off already stalled entry talks.

"The relief has to come, I lost all my savings," Reykjavik resident Haukur Geirsson said. "I had my retirement savings in stocks and it's gone. My son would help, but his mortgage has gone from 25 million crowns in 2008 to 39 million crowns ($333,000) now."

Gunnlaugsson Progressive Party earned 19 seats in parliament, the same as the Independence Party and more than twice as much as the Social Democrats.

(Reporting by Robert Roberson; Writing by Balazs Koranyi; Editing by Alison Williams)