Slovenia: Ripe for Disappointment

Slovenia’s banks are failing, and many expect the country to receive Europe’s next bailout. Headline risk may seem high, but global economic risks are low. As a miniscule and isolated portion of eurozone GDP and bank assets, Slovenia’s problems are likely contained, though volatility wouldn’t surprise.

Some speculate awell-executed bailout could build credibility for Slovenian and European policymakers alike, resetting Slovenia on a path to renewed economic growth. Color us skeptical, but we’re not buying it.

The country’s state-owned banks (a legacy of communism) control 80% of the country’s banking system. Domestic banks hold over 70% of the country’s total bank assets, which are mostly comprised of loans to other state-owned companies. Non-performing loan (NPL) rates are over 20%, with corporate NPLs surpassing 30%. Why the bloated balance sheet? Unlike private shareholders, the state lacks profit motive—rather, it’s politically motivated. That led to lax loan policies, and for a while, inefficient lending was enabled by manageable governmental debt and deficits.

But then Slovenia’s economy and housing market turned, and many loans went bad. As a result, the Slovenian government faces a rapidly expanding bill to recapitalize its failing banks, now estimated at €3 billion, or 8% of GDP (the OECD forecasts an even larger number). Months ago, the government could have borrowed its way out of the problem—its debt and deficit were a modest 53% and 3.8% of GDP, and borrowing costs were falling fast.

Post-Cyprus, however, borrowing costs are rising, raising questions about how the government will be able to fund its failing banks as losses expand and private investors withhold capital. Slovenia’s had some disappointing debt auctions in recent weeks, and the nation likely has a difficult time accessing debt markets when funds for interest payments dry up later this year.

One source of capital is existing bondholders, but that alone may not be enough. However, any proposals to raid depositors should be rejected. Deposit taxes are an awful way to rebuild confidence in a banking system already known for inefficient capital allocation, even if Slovenia’s largest depositors are the very corporations responsible for banks’ loan losses. Markets need strong private property rights.

If step one is recapitalization, step two is privatization. The government proposes winding down the weak banks and privatizing the strong, but much is uncertain. For instance, who will buy the government’s bank assets? Europe’s banks are shedding struggling operations, while strong US and Asian banks may not be first in line to commit funds to a dysfunctional financial system run by a newly elected government.

Funds from the European Stability Mechanism (ESM) may partially ease Slovenia’s plight, but investors in Slovenia’s banks should be prepared for writedowns, debt for equity swaps, deposit haircuts or some combination of the three.

Sources: https://www.iie.com/, https://www.ihs.com/