FACTBOX-Iceland crisis: what does "national bankruptcy" mean?

Sun Oct 12, 2008 3:16am EDT

Oct 12 (Reuters) - Iceland's prime minister has raised the spectre of his country being at risk of "national bankruptcy" as a financial crisis took hold.

But what does it mean when a country -- as opposed to a person or an institution -- goes bankrupt?

WHAT IS IT?

Bankruptcy is when an entity is legally declared unable to pay creditors. The phrase "national bankruptcy" itself is not a common economic term with any agreed definition. In essence, it could be read to mean a country cannot pay its debts or raise foreign currency to pay for imports. In economic jargon, it could also be known as a "balance of payments crisis". The balance of payments measures all the payments that flow in and out of a country.

WHAT CAN A COUNTRY DO?

If a country no longer has enough foreign currency to pay for imports, it typically must borrow funds from the International Monetary Fund (IMF) or other countries.

Without that, it would soon not be able to import necessary goods and services -- a particularly troublesome prospect for a country such as Iceland, which relies heavily on imports.

The IMF historically has used its loans with member countries as leverage to push for changes in fiscal and economic policies. Some critics accuse it of being heavy-handed and obsessed with a free-market ideology.

But any country can loan another country money. In the case of Iceland, it plans to begin negotiations next Tuesday with Russia over a loan expected to be about 4 billion euros ($5.5 billion).

WHAT DOES THE IMF DO?

The IMF, unlike an administrator in the event of a corporate bankruptcy, does not take over the assets and liabilities -- which in the case of a country would mean the entire nation and all its debts. The Fund has a variety of "facilities", some of which charge interest at a market-related rate. It also has special facilities for poverty-reduction or shocks to an economy beyond a government's control.

The Fund says on its Web site: "A core responsibility of the IMF is to provide loans to countries experiencing balance of payments problems".

It typically lends money under an "arrangement" which stipulates policies and measures a country agrees to implement to resolve the problem.

The IMF cannot act without the invitation of a government. Once on the ground, IMF staff and authorities discuss what steps and financing are needed.

WILL THE IMF COME TO ICELAND'S RESCUE?

The IMF said on Thursday it has activated emergency plans to provide lending to countries in crisis. The emergency mechanism ensures a quick response by the IMF to clear any lending decision within five to 10 days.

Iceland has said several times that it has not decided whether it will seek assistance. It is open to the possibility but has expressed hope that an IMF bailout will not be necessary.

WHERE DO THE BANK DEBTS FIT IN?

Iceland's problem stems from the huge debts its main banks have taken out. According to Thomson Reuters data, bank leader Kaupthing, together with top banks Landsbanki and Glitnir, owe a combined $62 billion in foreign currency debts.

The banks were frozen out of credit markets in the run-up to this week's crisis and became unable to make good on short-term payments.

By the end of a harrowing four-day period beginning on Monday, the nation had taken control of most of its banking system, abandoned a brief attempt to defend the currency, halted trading in all stocks, found itself embroiled in a diplomatic row with Britain and been forced to seek help from abroad.

The state has taken over the banks under a law passed this week, but Prime Minister Geir Haarde later made clear that Iceland has not yet assumed the banks' assets and obligations. Rather it has given itself the power to dictate what they do.

(Reporting by Adam Cox, additional reporting by Lesley Wroughton)