The government of Iceland (yesterday) Tuesday pegged its currency to a basket of foreign currencies, nationalized its second-largest bank, and pleaded with Russia for a $5.4 billion loan – all in a desperate attempt to prop up the island nation’s ailing economy.

Icelandic banks used to draw the vast majority of their funds from domestic savings, but over the past several years the banks became overly reliant on foreign money markets for cash . Now, those markets are frozen and the banks are saddled by huge foreign debt.

Just six years ago, if the 310,000 residents of Iceland were to pay off the foreign debt owed by their banks and companies, it would have cost each Icelander $26,000, BBC News reported. Today every single Icelander would have to come up with roughly $281,240.

Iceland’s three largest banks, Kaupthing Bank, Glitnir Bank, and Landsbanki Islands, are responsible for about 90% of Iceland’s foreign debt. Of the three, only Kaupthing has any chance of remaining independent, as Glitnir was partially nationalized last week and Landsbanki was fully seized by the government yesterday.

“The commercial bank model there has failed,” Sunil Kapadia, an economist at UBS Ltd. (UBS) told Bloomberg. “For such a leveraged economy as Iceland, it was clear this was going to happen, but the pace has been surprising.”

The dramatic collapse of Iceland’s banking sector caused the krona to plummet 35% Tuesday, forcing the central bank to peg the currency to a basket of currencies at a value of 131 per euro. However, this measure has yet to prove effective.

“Given the fact that the Icelandic FX [foreign-exchange] reserve is less than $3 billion, the peg does not look very credible, and we do not expect it to be maintained,” analysts at Danske Bank A/S wrote. “To maintain a credible FX peg the government would have to put forward a credible stabilization package, and there is still no news of such a package.”

Iceland has approached Russia in pursuit of a $5.4 billion (4 billion euros) loan to boost its reserves. The loan was originally announced on the Central Bank of Iceland’s website, in a statement that said the deal was green-lighted by none other than Russian Prime Minister Vladimir Putin himself. However, reports surfaced hours later that the loan had not yet been approved.

David Oddsson, Iceland’s central bank governor, was then forced to concede that the progress on obtaining the loan was “overstated,” and that talks were “ongoing.”

“Negotiations are starting,” Oddsson told Bloomberg Television. “We are optimistic” they will be successful and “we are to blame for the overstatement.” Any aid from Russia would be “very much welcomed,” he added.

Geir Haarde, Iceland’s prime minister, then took the opportunity to vent about the lack of support from his nation’s “friends.”

“We have throughout this year asked many of our friends for swap agreements and for other forms of support in these extraordinary circumstances,” said the prime minister. “We have not received the kind of support that we were requesting from our friends. So in a situation like that one has to look for new friends.”

“In a situation like this it’s turning out to be every man for himself, every country for itself, everybody’s taking care of their best interest and that’s what we are doing,” Prime Minister Haarde added.

Of course, the decision to befriend Russia, particularly after its controversial military action in Georgia, could have significant political consequences for the small island nation.

“I think there will be a lot of eyebrows raised in NATO if Iceland does accept this loan,” Carlo Gallo, a senior Russia analyst at Control Risks, told CNBC. “I think the Icelandic government will need to ask themselves and the Russians a lot of questions before they accept.”

Still, without Western support, Iceland is out of options. Iceland’s economy, which was recently enjoying annual growth of 7% a year, is likely to fall into a crippling recession next year, even if the island nation does manage to stave off bankruptcy. Interest rates are at 15.5% and inflation is above 12%.

In his statement yesterday, Prime Minister Haarde said that there was a “real possibility that the national economy would be sucked into the global banking swell and end in national bankruptcy.”

Source: Iceland’s Economy in Hot Water After Commercial Banking Collapse