Nov. 20 (Bloomberg) -- Iceland got a $4.6 billion bailout from the International Monetary Fund and four Nordic countries to help resurrect the island's economy after the failure of its biggest banks and the collapse of its currency.

The Washington-based IMF approved a $2.1 billion loan late yesterday. Finland, Sweden, Norway and Denmark will provide a further $2.5 billion, the Finnish Finance Ministry said in a statement today.

``The shock of the economic collapse has already hit Iceland, these loans will just reduce the extent to which the decline will draw out,'' said Lars Christensen, chief analyst at Danske Bank A/S. ``But it is a substantial amount, and it's enough money to recapitalize the country's banks.''

The loan won't be enough to prevent the economy from contracting at least 10 percent next year, Christensen added. Iceland will use the money to stabilize the krona, shore up its banks and restore confidence, the IMF said. The country, which had the fifth-highest per capita income in the world last year, needs the financing to pay for imports and to create enough foreign reserves to support a free-floating currency.

``Iceland is in the midst of a banking crisis of extraordinary proportions,'' said John Lipsky, the first deputy managing director of the IMF, in a statement. It ``is facing a severe recession, given the high debt level in the economy and significant dependence of the private sector on foreign currency and inflation-indexed debt.''

Dragged Out

Approval of the loan dragged out after Iceland was unable to reach agreement with U.K. and Dutch officials on how to cover foreign deposits held at one of the island's bankrupt lenders, Landsbanki Islands hf.

The country struck a deal ending that dispute on Nov. 16. Today's loan won't be used to repay depositors in the Internet unit, known as Icesave, Prime Minister Geir Haarde has said.

The U.K., Dutch and German government ``will work constructively in the continuing discussions with Iceland to conclude agreements on pre-financing that enables Iceland to meet its obligations towards depositors shortly,'' according to a joint statement today.

Icelandic Foreign Minister Ingibjorg Solrun Gisladottir has estimated the deposits at 640 billion kronur ($3.7 billion).

Credibility

The IMF said that $827 million of its loan would be made available immediately and the rest in eight installments of about $155 million, subjected to quarterly reviews.

The agreement ``gives us a solid platform for re-establishing the credibility which will be necessary in restructuring a viable Icelandic economy,'' Gisladottir said.

Haarde originally targeted financial support worth a total of $6 billion. In addition to IMF and Nordic support, Poland has agreed to lend $200 million and the Faroe Island has pledged $50 million. It is in talks to secure funding from Russia, Foreign Minister Alexei Kudrin said yesterday.

Raising foreign reserves will allow the central bank to restore the currency to a free-floating regime, a necessary step to reviving the economy given its reliance on imports and capital inflows, according to Handelsbanken economist Thomas Haugaard.

Imports made up 45 percent of gross domestic product last year, according to the statistics office.

Since the collapse of the banks last month, official trade in the krona has been limited to daily central bank auctions. The krona traded at 176 against the euro at the auction on Nov. 19, according to the central bank's Web site. That compares with an offshore rate of 215 against the euro, according to Handelsbanken.

Free Float

``They'll have to accept that there'll be a pretty significant pressure on the currency when they reintroduce a free float,'' Christensen said.

Defense of the krona, which has lost about two thirds of its value since the beginning of the year, will be a priority for the central bank, the government said on Nov. 17. That means policy makers may raise the benchmark interest rate from the record 18 percent it was lifted to on Oct. 28.

Christensen estimates the krona will trade weaker than 250 against the euro once it's returned to a free float.

``Sedlabanki assumptions of where the currency will stabilize look very optimistic,'' Beat Siegenthaler, chief strategist at TD Securities in London, said yesterday. ``It's the credibility issue that's really, really crucial.''

A free float may ``trigger a massive currency outflow,'' the central bank said on Nov. 3. The bank estimates that foreign investors hold about 400 billion kronur ($2.9 billion) worth of government-backed bonds.

The currency slumped after Kaupthing Bank hf, Landsbanki and Glitnir Bank hf collapsed under the weight of their debt last month. The country isn't guaranteeing foreign investor debt holdings at the banks, Prime Minister Geir Haarde said on Nov. 17.

Since the beginning of October, the benchmark stock index has slumped 80 percent, while the yield on the 7.25 Treasury note due May 2013 has jumped 5 percentage points to 13.65 percent.

To contact the reporters on this story: Tasneem Brogger in Copenhagen at tbrogger@bloomberg.net;

Last Updated: November 20, 2008 06:11 EST