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Iceland said on Saturday it would launch a mortgage debt relief program worth about 150 billion krona ($1.26 billion), in a move that could hurt its credit ratings and which critics say could scare off foreign investors.

Iceland is slowly recovering from its deepest ever financial crisis, but many households are saddled with mortgages they cannot afford to repay, squeezing consumer spending and economic growth.

"The plan will assist over 100,000 households," Prime Minister Sigmundur Gunnlaugsson said. "This will be the beginning of an economic renaissance."

Debt relief will apply to some 1.36 trillion krona in mortgages linked to inflation, with a maximum limit of 4 million krona per household and totalling around 80 billion krona over the four-year period of the programme.

Mortgage holders will also be given tax breaks to encourage them to use pension savings to pay down their borrowing, a measure worth about 70 billion krona.

A centre-right coalition of the Progressive Party and the Independence Party won an election earlier this year on a promise to reduce the financial burden on households after years of austerity.

The government said it would finance the measure through tax hikes on financial institutions and a haircut on around $4 billion in debts owed to overseas investors in Iceland's failed banks, which collapsed in late 2008.

Those debts are now mainly held by hedge funds, which bought them at a deep discount.

"The net impact on the Treasury is expected to be insignificant each year during the period 2014-2017," the government said.

Iceland's financial system and currency collapsed in late 2008 and it was bailed out by international lenders. It exited that programme earlier this year, but growth remains sluggish and inflation well above the central bank's target.

Households, corporations and the government are saddled with heavy debts, and capital controls, imposed at the height of the crisis, are crimping investment.

Writedowns of mortgages linked to foreign currencies and other measures have already cut household debt levels by around 200 billion krona - nearly 12 percent of 2012 GDP - and the new measure will be worth an additional 9 percent of output.

However, rating agencies and the IMF have warned that with Iceland's economy still sluggish and government finances weak, there was little room for new debt relief measures.

Rating agency Fitch estimated that the government will run a deficit of around 3 pct of gross domestic product this year.

In July, S&P said it could downgrade Iceland's BBB- rating if debt relief weighed heavily on government finances.

S&P also said a haircut imposed on foreign creditors could damage the willingness of investors to put money in Iceland.

Such a move, however, would be a further step towards the removal of capital controls, reducing the possible outflow of krona when the controls are eventually lifted.