Could Iceland be the first country to fall victim to the global financial turmoil?

Along with the Baltic state of Latvia, Iceland has ridden the liquidity boom and grown off the back of cheap short-term money, much like the investment banks and financial engineers like Allco. But as a result of the credit crunch, Iceland’s high flying days are numbered and some European financial analysts wonder if the entire country could end up joining the likes of Bear Stearns and Northern Rock.

Iceland’s Central Bank lifted its key interest rate to a knee-trembling 15% yesterday: a rise of 1.25% in an unannounced emergency decision designed to steady the country’s shaky currency and markets.

The bank blamed “deteriorating financial conditions in global markets” for the emergency move. Confidence in the krona, Iceland’s currency, has been shattered this year by fears of economic imbalance and concern the banking sector could fail. The krona has weakened by 22% against the euro so far this year, driving inflation higher: it’s running at 6.8% annually compared to the central bank’s 2.5% target.

The rapid plunge in the krona prompted the central bank to adopt unusually blunt language in its statement when it warned that if the decline in the currency was not reversed Iceland faced “spiralling increases in prices, wages and the price of foreign exchange”.

The rate rise saw the krona gain as much as 6.3% against the US dollar, but it failed to rebound strongly against the euro, and Iceland’s main stockmarket index of the 15-most traded stocks had its biggest gain in more than 15 years, rising 6.2%.

But that rise was driven by the country’s three major banks: Kaupthing, Glitnir and Landsbanki Island hf, which account for more than 70% of the main market index. Iceland’s rapid growth has been substantially driven by these banks and other groups which have borrowed heavily in international markets to expand, particularly into the UK retailing and financial sectors.