Fear on streets of Reykjavik as country can only go to IMF for financial bailout

Iceland may be the target of British opprobrium right now, but on the streets of Reykjavik, citizens are more concerned about their own increasingly dire situation. The collapse of the country's banking system and, along with it, the economy, is steadily affecting ever more of the 320,000 people who live on the North Atlantic island.

Yesterday, one of the country's few daily national newspapers announced it was shutting its doors, while the country's flag-carrying airline, Icelandair, said it had seen a dramatic slump in demand. No wonder the governor of the country's central bank has been sent home to rest by his doctors.

Such is the parlous state of its finances, economists now believe Iceland will have no choice but to go cap in hand to the International Monetary Fund and ask the world's lender of last resort to bail it out.

Negotiations are due to begin with Russia on Monday over a possible loan of €4bn (£3.15bn) but this will not be enough to get the country through its banking crisis. While such a loan would be worth a quarter of the country's annual GDP, the total liabilities of the Icelandic banks are more like nine times the size of Iceland's economy.

"Iceland is bankrupt," said Arsaell Valfells, a University of Iceland professor. "The Icelandic krona is history. The IMF has to rescue us."

Without help from the IMF, Iceland is almost certain to find itself in the same position as some of its leading financial institutions – bankrupt. The country would simply be unable to service its liabilities and its economy would be plunged yet further into crisis.

The krona, Iceland's currency, has already collapsed in recent months, but bankruptcy would make it worthless on world markets. And without a viable currency the banks can't be rescued, there is no cash to pay for essential imports, and no way of controlling inflation. The result is one with which Zimbabwe is now becoming ever more familiar – soaring prices, a big increase in unemployment and terrible hardship for most of the population.

The IMF now represents Iceland's best bet of getting through this crisis. Not that it is an easy option. The IMF will only intervene in countries on its own terms and Iceland would be expected to accept harsh strictures from the Washington-based organisation.

In the longer term, there will be political fallout from this collapse. Iceland has traditionally been sceptical about the appeal of the European Union, let alone membership of the bloc operating with the single currency. However, the idea of joining the EU – though it would mean putting up with foreign intervention in its fishing, Iceland's one remaining industry of note now banking has failed – may now become more attractive.

Iceland's bankruptcy will also shock the developed world. While other countries have quite recently trodden this path – most notably Thailand and several Latin American states – Iceland is considered a developed market by economists. Indeed, until the credit crisis began just over a year ago, the enterprising skills of the country's bankers had produced one of the best performing economies in the West.

So far, however, Iceland seems to be escaping one other common feature of national bankruptcies – serious civil unrest. Indeed, for now at least, the country seems to be attempting to pull together, with rock stars organising gigs, for example, in an attempt to buoy fellow citizens' spirits.

Nor has Geir Haarde, the country's Prime Minister, yet come under pressure to step down – and in public he is attempting to remain calm. "We are gradually moving through this crisis," he said on Thursday. "There are still a few issues to resolve but that is the nature of these kind of things." A difficult man to ruffle, clearly.

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