Locals call it the shadow district: a strip of waterfront at the bottom of a hill, a short walk from Reykjavik's main shopping street. It used to be largely warehouses but today is home to some of the most expensive real estate in the city.

Towering apartment blocks have sprung up, with views across the bay to snow-capped mountains. Flats cost up to £1.5m apiece. Where a cluster of new blocks is going up, the bright yellow cranes against the dazzling blue Icelandic sky look like a patchwork of Swedish flags flying above the city.

For much of the past decade, Iceland, with its tiny population of little more than 313,000, has been one of the fastest growing economies in Europe, making Icelanders the sixth richest people in the Organisation for Economic Cooperation and Development.

Its big banks, Kaupthing, Landsbanki and Glitnir, have become international players and a new breed of companies has been buying up businesses overseas, led by Baugur, which owns much of Britain's high street, including Warehouse, Whittard of Chelsea and Karen Millen.

Signs of the new wealth in Reykjavik are hard to miss. Expensive four-wheel drives creep down the narrow main street, announced by the crunching sound of metal-studded tyres, for better grip on Iceland's frosty roads. Overhead is the near constant hum of private jets.

There is building work throughout the city. On the harbour, a £50m concert hall will have spectacular views when it is finished this year. For the first time, Iceland has had an influx of foreign workers. House prices have doubled since 2001 and a generation has known nothing but the good times.

But those good times have come to a juddering halt. Iceland has become the latest flashpoint in the global financial crisis. Critics have compared the country to a "toxic hedge fund" built on debt that could be about to go spectacularly wrong.



Unscrupulous

Officials in Iceland argue that the country is under siege by unscrupulous speculators looking for the next quick buck. Despite its size, a meltdown in Iceland has the potential to severely damage confidence in the markets; one economist compares it to the canary in the coalmine.

The concern is that the banks and corporations that have put Iceland on the map expanded too rapidly, borrowing during the years of readily available money. Now they face problems refinancing that debt. The banks in particular have been facing astronomical costs for insuring their debt (credit default swaps or CDSs) as the markets speculate that they could be in deep trouble. Based on recent prices in the credit markets, Kaupthing was seven times more likely to default than the average European bank. The chief worry appears to be whether or not the Icelandic Central Bank would have the muscle to rescue one of the banks if things went wrong. Iceland is facing some unfavourable comparisons. Bear Stearns recently suggested the tiny nation was about as safe an investment as Kazakhstan.

Asgeir Jónsson, chief economist at Kaupthing, sees the spiralling cost of insuring the bank's debt as a modern version of a bank run. "Instead of seeing people queueing in lines you see speculators, hedge funds, betting against the banks in anticipation that the central bank in Iceland would not be able to supply the liquidity support. The Icelandic banks have not experienced any losses, they are extremely well capitalised, but if you see a line in front of a bank, you go and join it."

Risk-averse investors have begun pulling out. Since the beginning of the year, the Icelandic krona, the smallest independent currency in the world, has fallen by 25%. The main stockmarket index has fallen by about 40% from its peak last summer, inflation in the overheated economy is running at 6.8% and interest rates reached 15.5% last week. The country has also been running a large trade deficit, partly because of rampant consumer spending.

But in Reykjavik, people have suddenly stopped spending. A Mercedes-Benz dealership that opened on the outskirts of downtown in 2004, claims to have sold more of the top-of-the-range marque last year than were sold in the whole of Sweden. But sales have ground to a halt. "The prices for a new car have gone up between 25% and 30%," says Leifur Orn Leifsson, general manager of the dealership. "All people are talking about right now is the krona."

Glyfi Magnussen, an economist at the University of Iceland, says: "I think it is fair to call it a crisis. What we have is a country or an economy that has gone a little too far in some respects, especially the banking system. The growth of the banking system was very rapid and until last year the banks didn't really have trouble financing themselves and rolling over their debt at quite favourable rates, but the international financial crisis has hit Iceland very adversely and made this situation very rapidly almost unsustainable."

Iceland has been dramatically transformed in the past 20 years. After financial markets were deregulated and banks privatised in 2003, Icelandic companies that previously had only meagre access to funds were able to expand rapidly.

In a country the size of Iceland, the only option for an ambitious company is to look overseas - the reason so many have appeared in Britain. The banks have moved into foreign markets with their clients, investing alongside them and building investment bank capabilities. Landsbanki bought stockbrokers Teather & Greenwood and Bridgewell in London while Kaupthing bought Singer & Friedlander. The food group Bakkavör owns Geest in Britain. The Icelandic billionaire, Björgólfur Gudmundsson, the chairman of Landsbanki, backed the takeover of West Ham Football Club, where he is also now chairman.

There has been little evidence of the banks experiencing trouble so far. An Icelandic investment firm, Gnúpur - a big shareholder in Kaupthing - was forced to announce an emergency refinancing earlier this year. Another, FL Group, a big investor in Glitnir and the owner of House of Fraser, has also been liquidating assets, including the sale of an 8% stake in American Airlines. But while profits at the three big banks are down, none has taken the kind of hits that the big US and European banks have suffered during the credit crunch.

Analysts who think the current fear is unwarranted argue that the mini-crisis that struck Iceland in 2006 was a timely wake up call that has cushioned the banks from the wider international crisis. At the time, the Icelandic banks shifted much of their financing from short to long term, broadened the markets they borrowed from, unravelled some of their cross-holdings and increased deposits, partly, in the case of Kaupthing and Landsbanki, by trawling for UK savers. The banks all claim to have enough liquidity to refinance debts for at least a year and have passed stress tests devised by Icelandic regulators.

"It was a wake-up call," says Magnusson. "I am sure if they hadn't done that they would be in much deeper trouble than they are now. We would probably be seeing a real financial crisis with a non-functioning institution if they hadn't done what they did."

Gudjón Rúnarsson, at the Icelandic Financial Services Association, says: "The banks have ample liquidity. Our belief is these problems will clear out this year. For the Icelandic banks to get into real difficulties, that would only happen if these conditions continue for a long, long time and then you will not be focused on the Icelandic banks, then you will just have deep, deep problems all around."

The government has blamed the crisis variously on the media, a lack of understanding among international investors and the scourge of speculators and hedge funds attacking Iceland in pursuit of a quick profit. The prime minister, Geir Haarde, has gone on a charm offensive and was in New York at the end of last month to steady investors' nerves while the financial supervisory authority in Iceland has launched an investigation into whether certain hedge funds are spreading misinformation in an effort to drive Icelandic markets down.



Vegas

"There are always people out there who are looking out for an opportunity to make a profit, and they are scouting for something like this," says the minister of finance, Arni Mathiesen. "Some of these financial transactions that are going on sound more like they are betting at a table in Las Vegas than operating financial institutions."

Mathiesen insists the government would be able to bail out its banking system if the worst happened. The state, he points out, is virtually debt-free.

Still doubts persist. "The banks need better backing," says a senior Icelandic banker. "If these were UK banks or Norwegian banks in their current position, there would not be an issue. It is more a political macro issue than a banking operational issue. If we solve this crisis it will be only short term because the banks will continue to grow."

Ten years ago, Iceland would have been at the tail end of a global downturn. Today, with its companies and banks locked into world markets, it has become a lead indicator and questions are being asked about whether it can maintain its economic independence.

"This crisis will be solved - there is no question that the sovereign could recapitalise the banks," says Jónsson. "But in the future this will be an issue. There are several things that could be done: joining the euro would put much more stability into the system - I think a lot of our problems now can be tied to being a part of such a small currency area. Looking further into the future some of the Icelandic banks could move their headquarters. That wouldn't be very good for Iceland but that might very well happen."

In the past week or so the krona has gained a little, CDS spreads have narrowed and the stockmarket come off its lows. For ordinary Icelanders, these remain worrying times. Truck drivers have been striking and blocking roads and last week they met the minister of finance to protest at the cost of fuel. "The price of oil is so high we are trying to make a point," says one of the drivers, Sturla Jónsson. "It is very tough. Your salary is not moving anywhere and inflation is much higher than the government is saying."

Hylnur Thór Audunsson, 33, is a dentist in Reykjavik, and like many had taken foreign currency loans to avoid punitive Icelandic interest rates, but he has been hammered by the falling krona. He bought an Infiniti four-wheel drive in January using Japanese yen and Swiss francs and his monthly payments have risen by around 30%. His mortgage is also partly financed with foreign currency loans. He has already cancelled a holiday in May and will work instead. "This is a typical story," he says. "My best friend is in a worse position, he just bought a company using yen and Swiss francs. I will manage because I have a flexible job, but I don't know how people on fixed incomes will cope."

He says that he has noticed an increasing number of people cancelling appointments in the past three weeks . "This is a new experience for people of my age. People just want to join the euro now. They want more stability. This is pretty tiring."

In numbers

25%

Fall in the Icelandic krona since the beginning of the year

40%

Fall in the Icelandic stockmarket from its peak last summer

6.8%

Inflation - but people say the official rate is lower than the real situation

15.5%

Interest rates last week - many have resorted to foreign currency loans