May 16 (Bloomberg) -- Iceland was offered an emergency loan by the central banks of Denmark, Sweden and Norway to shore up the krona and avert an economic collapse.

The currency rallied 3.7 percent against the euro after the banks agreed to provide 1.5 billion euros ($2.3 billion), which would double the Atlantic island's foreign currency reserves.

The krona has dropped as much as 26 percent against the euro this year on concern Iceland's commercial banks have taken on too much foreign debt, prompting speculation the central bank may have to step in.

The offer of aid from neighbors ``will help stabilize the financial markets, but not the basic imbalances of the Icelandic economy,'' said Lars Christensen, senior emerging markets strategist at Danske Bank A/S in Copenhagen.

Support for the currency may enable policy makers to halt a series of interest rate increases that Sedlabanki forecasts will lead the economy to contract 2.5 percent next year and 1.5 percent in 2010. Inflation accelerated to 11.8 percent in April, the fastest pace in 18 years, even after the key rate increased to a record 15.5 percent.

Iceland's foreign currency reserves totaled 206.8 billion kronur ($2.8 billion) at the end of April, insufficient to bail out any bank weakened by the global credit crunch.

The country's three biggest banks have combined assets of 11.4 trillion kronur, or nine times the size of the economy. At the biggest lender, Kaupthing Bank Hf, foreign currency holdings make up 87 percent of assets.

More to Come

``People have been speculating on whether we were capable of doing something if the unexpected happens, so this will hopefully relieve any doubts,'' Icelandic Finance Minister Arni Mathiesen said in a telephone interview from Reykjavki.

The central bank plans to further raise its reserves through other loan facilities or government bond sales, said Sturla Palsson, director of Sedlabanki's international and market operations department.

``It's definitely important to bolster the reserves further,'' Palsson said. ``The bank will announce what it has decided to do after further agreements have been signed.''

The timing of any new loans ``will depend on the situation,'' Mathiesen said.

``This is a step in the right direction and helps to reassure the markets that the government is in a much better position to give assistance to the banks should they need it,'' said Paul Rawkins, a senior director at Fitch Ratings Ltd. in London. ``There still remain uncertainties with the banks.''

`Hands Off'

The loan facility announced today won't be used immediately to buy krona on the open market.

``We're not likely, and have no intentions, to draw on this facility at this stage,'' said Palsson. ``The central bank has a hands-off policy when it comes to intervention in the forex market.''

The krona fell to as low as 128.002 to the euro on March 19, six days before an emergency 1.25 percentage point increase in the benchmark rate to 15 percent at an emergency meeting of the Monetary Policy Committee. Two weeks later it raised rates again. The increases failed to reverse the slump in the krona.

The krona rallied to 116.091 to the euro as of 2:32 p.m., the strongest in more than two weeks.

``Of course if there's a strengthening of the currency this has a direct impact on inflation,'' Palsson said. ``The short-term effect is of course very positive.''

Sedlabanki makes its next announcement on interest rates on May 22.

Recession

As the economy goes into recession next year, inflation will slow to 5.9 percent and 2.8 percent in 2010, Sedlabanki forecasts.

``In times of uncertainty and turmoil the central banks have a responsibility to cooperate,'' Sweden's Riksbank Governor Stefan Ingves said in a statement. ``The swap agreement is aimed at supporting Sedlabanki in its task of safeguarding macroeconomic and financial stability.'' The 500 million euros Sweden offered represents 3 percent of its foreign currency reserves.

In 2007, 22 percent of all Iceland's imports were from Norway, Denmark and Sweden, and 7.8 percent of all its exports went to the same three countries.

Denmark's central bank unexpectedly raised its benchmark interest rate by 0.1 percentage point to 4.35 percent today, lifting the return on the krone versus the euro, as the liquidity crisis forces the bank to defend its currency.

To contact the reporter on this story: Robin Wigglesworth in Oslo at wigglesworth@bloomberg.net

Last Updated: May 16, 2008 12:25 EDT