Iceland’s defence of its embattled economy from rampant inflation, huge foreign debts and a tumbling currency could send interest rates higher, say bankers on the Nordic island.

Another surge in the cost of borrowing, possibly to 16 per cent, would signal the country’s determination to defend its currency, according to Glitnir, the Icelandic bank.

Geir Haarde, the Prime Minister, accused hedge funds this week of targeting his country’s financial system and he threatened to use “bear traps” to catch speculators “who just want to make profit by hook or by crook. We would like to see these people off our backs and we are considering all the options available.”

The krona experienced some relief yesterday, rising 2 per cent against the euro and dollar, but it has been close to freefall since the beginning of the year, losing 28 per cent of its value against the euro and stoking the fire of inflation.

Iceland, a stubble of volcanoes and glaciers in the North Atlantic, acquired notoriety for its helter-skelter economic expansion. A consumption boom combined with near-full employment pushed up wages and prices, while the aggressive investment spree by companies such as Baugur, which has amassed a big presence on the British high street, left the country with huge foreign borrowings.

Now its banks, which joined in the expansion overseas, are under the cosh as financial markets question their ability to finance their businesses in the credit squeeze. The share price of Kaupthing, one of the three largest commercial banks, has fallen by more than a third since last summer. The country suffered another blow last month when the ratings agencies Fitch and Standard & Poor’s put Iceland’s sovereign debt on watch. Standard & Poor’s expressed concern that the Government might be forced to prop up Kaupthing and the other commercial banking giants Glitnir and Landsbanki.

The situation reached crisis levels last week, when the cost of insuring loans to the trio rocketed amid fears that they would be unable to tap the global credit markets for funds. According to data from Markit, the cost of Glitnir’s credit default swaps - derivatives that offer insurance against a company defaulting on its debt – soared to 1017 basis points from 841 a week earlier as investors panicked that the bank was about to run out of cash. It now costs slightly more than $1 million (£500,000) a year to insure only $10 million of the bank’s debt over five years.

The central bank has responded to the problems by raising interest rates – by 1.25 percentage points to 15 per cent on March 25. Jon Bentsson, an economist at Glitnir, reckons that they will rise further.

“The central bank will want to drive home the message it is not willing to take a bet on inflation,” Mr Bentsson said. “A further hike of 100 basis points is not out of the question.” He believes that there is scope for further intervention as public finances are strong.

With little more than 300,000 people living in a harsh, subarctic environment, Iceland’s extraordinary rise to affluence is difficult to fathom. The country has few resources other than geothermal energy and fish, but it has put them to good use. Abundant supplies of cheap energy from hot springs have attracted resource-based industries, notably aluminium smelters, which require vast amounts of electricity.

Iceland has long privatised and monetised its public assets, even including its fish stocks. Catch quotas are tradeable among fishing companies, creating a capital resource worth a total of about $5 billion that has been used as collateral for investments.

The investment boom in Iceland has created an extremely tight labour market, soaring wage costs and galloping inflation, which in February reached 6.8 per cent.

The resulting high interest rates have made the krona a favourite for currency speculators in the “carry trade”, in which money is borrowed in low-interest currencies, such as the yen, and invested in financial assets in high-yield currencies, such as the krona. However, a loss of confidence has pricked the bubble in the carry trade, causing the krona to tumble.

Corporate and household debt levels have soared and much of the corporate debt is believed to be denominated in foreign currencies, a consequence of the acquisition spree by Iceland’s ambitious companies. The falling value of the krona is likely to put pressure on the ability of these companies to service that debt, creating further problems for the economy.

Leading the march to overseas expansion

Baugur

Investment company that owns outright or has stakes in a raft of high street names, including House of Fraser, Coast, Principles, Debenhams, Oasis, Karen Millen, Iceland and Hamleys, the iconic toy store. The value of its investments in quoted British firms fell by £100 million last year, but that didn’t stop it making a £40 million bid approach to Moss Bros in February

Kaupthing

Iceland’s biggest bank takes deposits from UK savers and has bankrolled large parts of the entrepreneur Robert Tchenguiz’s investments, including substantial stakes in the grocers J Sainsbury and Somerfield and the pub chain Mitchells & Butler. Pretax profit fell to £540 million last year, from £680 million in 2006

Landsbanki

The bank runs the online savings operation Icesave, with more than £5 billion deposited by its British customers

Arev

Investment company focused on retailing that owns all or part of Aspinal of London, the maternity wear specialist Blooming Marvellous, Cruise, Duchamp, Hardy Amies, Ghost, Jones Bootmaker, Limeys, Mountain Warehouse and Unisport. It was founded by Jon Scheving Thorsteinsson, the former right-hand-man of Jon Asgeir Johannesson, who oversaw Baugur’s acquisition of Hamleys

FL Group

Holding company part-owned by Baugur has stakes in House of Fraser and the slot machine maker Inspired Gaming Group

Bjorgolfur Gudmundsson

Iceland’s second billionaire is chairman of West Ham United Football Club and the 799th richest man in the world, according to Forbes. He bought West Ham for £85 million in November 2006 (Catherine Boyle)

Explore Economics

• Pre-Budget Report 2008

• Budget 2009

• World Economic Forum

• The Times MPC

Times Recommends

• Lies and cover-up at MG Rover exposed by report
• High oil prices push manufacturing costs up
• Primark founder steps down as chief executive