Iceland had to borrow about $10bn on Thursday, roughly the size of its entire gross domestic product, to prevent its economy collapsing.

The move underlined the damage wrought by last month’s disintegration of the country’s banking system.

Iceland finally secured a $5.1bn (€4bn, £3.4bn) bail-out for its crisis-stricken economy, comprising $2.1bn from the International Monetary Fund and additional loans of up to $3bn from Denmark, Finland, Norway, Sweden, Russia, Poland and the Faroe Islands.

It also agreed to borrow £2.2bn from the UK government and €1.3bn from the Netherlands government which will be used to compensate depositors in Icesave, the online arm of Landsbanki, the collapsed bank.

The loans will expose 320,000 Icelanders to a brutal recession, soaring inflation and an enormous debt burden that will haunt them for years in the form of taxes, threatening to trigger mass emigration. Up to a third of the population have said they want to flee the island.

The huge rescue package and its damaging domestic effect mark the official end of a 17-year experiment in free market economics that transformed Iceland from a fishing-based backwater to a booming tiger economy and now to the humiliation of an IMF-led bail out.

The £2.2bn owed to the UK has been a source of acute tension between London and Reykjavik since Iceland’s banking system collapsed, triggering the worst breakdown in diplomatic relations between the two states since the cod wars of the 1970s.

UK treasury officials said yesterday that while exact terms of the debt financing agreement would be set over coming weeks, the acceptance of the principle of treating all creditors fairly was a significant step forward.

The IMF-led loans, which will be used to bolster Iceland’s foreign exchange reserves, clear the way for the country to refloat its currency, which is regarded as a crucial next step towards restoring its international credibility.

“It is imperative that the authorities move quickly to stabilise the currency and lay the foundations for economic recovery and a normalisation of financial flows,” said Paul Rawkins, senior director at Fitch Ratings.

The krona has lost about 70 per cent of its value since the crisis. Authorities are braced for a new wave of selling by foreign owners of up to IKr400bn ($3bn, €2.4bn, £2bn) of Icelandic bonds that could push it even lower.

The social and political implications of the crisis and the loans needed to bail the country out will be apparent in the months to come.

The government has already agreed to reverse its long-standing opposition to joining the European Union and adopting the euro as its currency. It hopes to start discussions early next year.

But frequent demonstrations on the streets of Reykjavik by disgruntled citizens against Geir Haarde, prime minister, and David Oddsson, the governor of the central bank, indicate that there could be pressure for political change in the near future.

Copyright The Financial Times Limited 2008