Cyprus was all the indication the markets needed that 'bailout frenzy' is far from over in Europe. Slovenia appears to be next. The country has long been hailed as a success story of the EU enlargement process, entering the Union in 2004 in robust fiscal health. Rising productivity and industrial output at the time allowed it to replace its currency -- the Tolar -- with the Euro, just three years later, and in 2007 Slovenia joined the Eurozone as its thirteenth member.
Success was short lived, however. By 2008 the price of its high sustained growth rate became apparent. The absence of labor and pension reforms, a failure to meaningfully privatize the substantial state-owned sector, and a large drop in exports resulted in perpetually high deficits over the past 5 years, driving its public debt up from 22% in 2008 to more than 53% in just over 4 years. This week Moody's issued a double downgrade of Slovenia, to junk status, making it the most likely next in line for a Troika bailout (from the ECB, European Commission and IMF).
The country faces dual sets of challenges: fiscal and financial imbalances along with an ailing banking sector, and a state of political impasse that prevents responsible political governance. The two have combined to create a major obstacle to meaningful recovery. Slovenia appears to be destined to meet its fate as a result of its paralysis, unless it can quickly pull a rabbit out of a hat, which is questionable.
If it is to avoid a bailout, the Slovenian government must extract itself from the fiscal burden associated with having to prop up its state-owned banks (beleaguered with over €7 billion in bad debt), reduce state holdings outside the banking sector, and enact necessary austerity measures to resolve the persistent fiscal discrepancies causing high budget deficits. Without addressing any of the three quickly and in a meaningful fashion, Slovenia will not last past the end of summer without needing to request assistance. If all three are addressed in unison, it is possible, though not likely, that Slovenia may still avoid becoming the "next one" and find a path to growth that has been absent since the onset of the financial crisis. However, given the ongoing sorry state of affairs in Europe, this does not appear likely.
The government's laggard privatization program failed to divest the state's holdings in the undercapitalized lenders that dominate Slovenia's banking sector. While a sale of substantial state holdings in various industries would give the Slovenian government some fiscal breathing space to enact the necessary reforms, previous governments steered clear of privatizing any significant state holdings as GDP growth slowed.
Given that an ailing bank sector was the primary cause of Cyprus' downfall, there appears to be little reason to believe why the same will not prove to be true in Slovenia. The banking sector's bad debts will require €1 billion of fresh capital this year, according to recent IMF estimates. Slovenia's second-largest state-owned bank -- NKBM -- was one of four lenders that failed to meet the loose criteria of the European Banking Authority's recent capital adequacy test. Only three other lenders in Europe failed the EBA's test, among them the Bank of Cyprus and the Cyprus Popular Bank (the Laiki Bank) -- the two banks whose depositors are being "bailed-in", losing as much as 60% of their deposits in the former, and the latter simply being shut down.
The Slovenian government will need an additional €3 billion this year for sovereign financing and debt service. Considering its relatively low debt-to-GDP ratio of 53%, and being one of very few Eurozone members that meet the Maastricht criteria of a 60% debt-to-GDP ratio, Slovenia should in theory have little trouble accessing international capital markets to finance its needs. This should be further reinforced by the fact that Slovenia's troubled banking sector amounts to "only" 140% of its GDP, compared to a Eurozone average of around 350%. Despite this, since 2011, Slovenia has several times been locked out of the capital markets and postponed accessing them only weeks ago as surges in funding costs again put them at risk of being locked out. In spite of the downgrade, investors seem unconcerned, and Slovenia is currently pursuing a dollar-denominated bond issue.
The markets' fundamental reservation about Slovenia's future performance -- despite a low level of indebtedness and its relatively small banking sector -- points to the importance the market attributes to irresponsible political governance. The new government, confirmed only two months ago, is Slovenia's third in just two years. Part of the current coalition are the Social Democrats that, from 2008 to 2011 resisted any fiscal reform or austerity, stood in the way of the privatization processes, and consider the austerity and spending cuts to be the wrong approach. Whether the new Prime Minister Bratusek shares their position remains to be seen. Although calls for abandoning austerity are echoed across Europe, Slovenia's supposed austerity fatigue is little more than populist rhetoric, disguising the results of bad political governance as consequences of an austerity program that was never enacted.
The fate of Cyprus is now well known, and the likelihood that Slovenia will follow its path appears to be great. While some hope of a miracle occurring in the coming months remains, so does the question of whether the new Slovenian government is willing to invest enough political capital to push through the necessary reforms before the capital markets decide to lock Slovenia out once again. In reality, Slovenia's problem is primarily political, rather than economic, but it is having profound economic consequences. The process of regaining confidence in the Slovenian government's capacity to reform can either be swift, or punishingly long. Given the unfortunate performance of a plethora of governments in Europe in the recent past, the Slovenian people should expect a long and painful road ahead.
Luka Orešković is Head of Research at Provectus Capital and IQSS Associate at Harvard University. Daniel Wagner is CEO of Country Risk Solutions, a cross-border risk advisory firm based in Connecticut, and author of the book "Managing Country Risk".
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