* Iceland GDP shrinks 3.9 percent year-on-year
* GDP contracts 3.6 percent quarter-on-quarter
* Govt deficit at 6.9 percent of GDP in Q1-stats office
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By Niklas Pollard and Veronica Ek
STOCKHOLM, June 8 (Reuters) - Iceland moved deeper into recession in the first quarter with the economy shrinking at an annual pace of 3.9 percent as the collapse of the North Atlantic island's main banks last year reverberated through the economy.
Gross domestic product (GDP) shrank 3.6 percent in the first quarter from the fourth, the statistics office said in a statement. The annual fall in the fourth quarter was revised to 1.5 percent from an initially reported 1.3 percent decrease.
Iceland is in the clutches of what is expected to be its worst ever recession following the collapse of its oversized commercial banks and of its currency in October last year.
The government is forecasting the economy will contract at a rate of more than 10 percent this year while the unemployment rate, which stood at virtually zero ahead of the crisis, is seen climbing to nearly as much amid mounting corporate bankruptcies.
Considering the scale of the island's financial meltdown, the GDP figures were rather upbeat, an analyst said.
"That's actually not that bad, relative to what has happened in Iceland," Danske Bank economist Lars Christensen.
"It is a reletively good number, in terms of what we're seeing in other meltdown economies."
By comparison, the economies in the Baltic region have suffered far greater contractions due to the global downturn with Latvian gross domestic product tumbling a full 18 percent year-on-year in the first three months of the year.
But Iceland's public finances bore greater evidence of the financial collapse with the government running a deficit of 6.9 percent of GDP in the first quarter compared to a 5.5 percent surplus a year ago, the statistics office said separately.
The financial implosion left the volcanic island's economy dependent on a multi-billion dollar bailout tailored by the International Monetary Fund and painful budget cuts are in store in order to slash the surging government deficits.
Iceland took a step toward cleaning up the mess left by the downfall of its banks at the weekend, striking a deal to reimburse Britain and the Netherlands for billions of pounds and euros owed to savers with Icelandic accounts.
The central bank has also carried out a string of rate cuts in recent months, despite IMF warnings against premature easing of monetary policy, and said that capital controls introduced last year might be loosened late this year. (Additional reporting by Mia Shanley and Victoria Klesty; editing by Stephen Nisbet)