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Facing Economic Collapse, Iceland Seeks To Borrow 4 Billion Euros From Russia

The government of Iceland is seeking a 4 billion-euro loan from Russia to help strengthen its foreign reserves and support its sinking currency amid the global financial meltdown.

Iceland's prime minister, Geir Haarde, warned this week that the country -- one of Europe's smallest but richest -- could face "national bankruptcy" if its financial problems are not contained.

Haarde said that representatives of the country's Central Bank will be going to Moscow to discuss the terms of the loan. That concluded a day of mixed signals regarding whether or not the loan would be forthcoming.

Earlier on October 7, Iceland's Central Bank said in a statement that "Russia [will] grant" the loan, adding that Russian Prime Minister Vladimir Putin had confirmed Moscow's decision.

But the status of the loan was then thrown into confusion after the Finance Ministry in Moscow said no decision had yet been made.

But all the back-and-forth only underlined the importance of the loan for the small North Atlantic island, which has a population of some 300,000.

In recent years, Iceland has become one of the world's 10 richest countries by turning itself into a financial center that has attracted trillions of dollars worth of foreign currency.

That money, more than Iceland's own domestic economy based on exports of seafood and aluminum, has allowed Iceland's banks and companies, in turn, to invest aggressively in other countries' economies, fueling a positive spiral of growth.

But now, Iceland's prosperity looks in danger of being severely trimmed by the global banking crisis.

The government announced on October 7 that it is taking control of the country's second-biggest bank, Landsbanki, to prevent its collapse. Just last week, the government bought 75 percent of the country's third-largest bank, Glitner, for the same reason.

Drowning In Hot Foreign Currency

Economists say the multibillion-euro loan from Russia is likely to be just one of many that Iceland will need from multiple sources to stabilize its now teetering economy.

"They are basically looking at all possible sources. Russia has considerable foreign-currency reserves so that would make them a reasonable lender. I think the explanation is just as simple as that," says Gylfi Magnusson, a professor at the University of Iceland.

The Russian loan would be used to strengthen Iceland's foreign-currency reserves and thus help stop the slide of the local currency, the krona.

Iceland's currency has lost almost 46 percent of its value against the euro since July 2007, The government has announced it will peg the krona to the euro to help stabilize it.

The severity of Iceland's financial problems became frighteningly clear on October 6 when Haarde said a frank televised address to the nation that "There is a very real danger, fellow citizens, that the Icelandic economy, in the worst case, could be sucked with the banks into the whirlpool and the result could be national bankruptcy."

Economist Magnusson notes that Iceland's banks, like many around the world today, are reeling from a lack of both money and equity. But Iceland also is uniquely vulnerable to the global economic storm because of the sheer size of its banking sector -- which is eight times larger than the country's own gross domestic product.

If the banks fail, there is no way Iceland's government can guarantee their debts -- a frightening prospect for investors. Additionally, most of the money in Icelandic banks is in foreign currencies. Magnusson says that makes it hard for the Central Bank to shore them up even when they are just shaking, because it can't just provide local currency.

Iceland's banks are filled with foreign currency because they offer some of the world's highest interest rates on bank accounts. That makes them very attractive to people in Japan, for example, who are looking for a better return on their savings than they can get from Japanese banks. Banks in Japan offer some of the world's lowest interest rates.

Taken together, all these factors -- a giant banking sector, aggressive investments abroad, a magnetic pull for foreign currency -- once seemed to be the magic formula for Iceland's success.

But today, as banks worldwide find themselves holding trillions of dollars worth of bad debt precisely because of aggressive growth during past boom years, all these same factors seem to be a recipe for disaster.

Unless Iceland can now find the way out, it could well become Europe's first victim -- on a national scale -- of the global economic downturn.

with agency reports