By Ingrid Melander
BRUSSELS, Feb 5 (Reuters) - The fate of Iceland's fishing industry -- an issue that strikes to the heart of its national identity -- will be the hardest obstacle to resolve if it applies to join the European Union.
New Prime Minister Johanna Sigurdardottir said on Tuesday that joining the EU and its euro currency was the best option to revive Iceland's economy, crippled by the collapse last year of its debt-laden banks and currency.
EU officials have said an application could progress swiftly, possibly allowing Iceland to join at the same time as Croatia which hopes to enter in 2011.
"The key thing is fisheries, if they sign up on that one it can go quickly," said Daniel Gros, director of the Brussels-based Centre for European Policy Studies.
But signing up to a centralised EU fisheries policy would be hard for a nation which has jealously guarded control of its seas -- rich in cod, haddock, herring and other species -- and waged "Cod War" disputes with Britain in the 1950s and 1970s.
Reluctance to open up its waters to others has deterred Iceland from applying to join the EU before.
"It is in the Icelandic psyche a very important part of our sovereignty and independence, it is in that sense a sensitivity to join the EU, to become part of the common fisheries policy," said Stefan Haukur Johannesson, Iceland's ambassador to the EU.
The EU policy defines annual catch limits for each member country according to species and geographical area. It also sets strict rules on permitted fishing tackle and practices.
PROBLEM AREAS
Ragnar Arnason, professor of economics at the University of Iceland, said fishermen would have to open up some of their waters to EU states, follow new quota rules, give up some of their equipment and allow much more foreign investment in the industry. The EU was also likely to oppose hunting of whales and seals.
"All of these are problems for Iceland and the Icelandic population, especially the population outside of Reykjavik, where fishing is more important," Arnason said.
"That would probably mean the industry would gradually go into foreign hands."
Fishing and processing of fish represents 7 percent of Iceland's economy, according to the latest full year data, but its political significance goes deeper. Fishing is even more important in relative terms since the collapse of the financial sector, ambassador Johannesson said.
Willingness for Reykjavik to open up on this sensitive issue would depend very much on how Icelanders vote in any referendum to start EU negotiations.
One EU diplomat said there would be little room for compromise. "Fisheries ... is a common (EU) policy, the European Commission is very much in charge of it ... The scope for derogations (opt-outs) is quite limited," the diplomat said.
FAST-TRACK
Among other possible difficulties in the talks, one diplomat said the EU would look closely at the stability of Iceland's financial institutions and would not agree to rush any accession to the euro.
Gros, from the Centre for European Policy studies, said another issue could be deposits which EU citizens had put in Icelandic banks before they collapsed, noting that the EU would insist the issue be fully resolved before allowing Iceland in.
Diplomats also noted that France and Germany have said that before enlarging further, the bloc must first revive its stalled Lisbon treaty, meant to streamline its institutions and prepare the bloc to accept more members.
Johannesson said areas in which Iceland did not yet apply EU law included, apart from fisheries, agriculture, regional policy, the budget, and some parts of justice and home affairs. However, it was already applying EU legislation -- a requirement for membership -- in about 75 percent of its laws.
"Out of 35 chapters (negotiating areas) that the EU opens up when negotiating with candidate countries, this means we have largely concluded something like 24 chapters," he said.
Concluding the chapters takes most candidate countries years. Croatia, which started accession talks in 2005, has only concluded seven so far.
European Commission spokeswoman Krisztina Nagy said talks with Iceland would be smoothed by the fact that -- together with the EU, Norway and Liechtenstein -- it is part of the European Economic Area, a single market with free movement of goods, services and capital.
"Their homework is much more limited because it is not like some Balkan countries who need to review their judiciary system from A to Z," Nagy said.
(Additional reporting by Jeremy Smith; Editing by Mark Trevelyan)