The catastrophe that beset Cyprus’s ‘too-big-to-bail’ banking sector confirmed that the seemingly never-ending crisis in the eurozone is far from over. Indeed, investors are already busy searching for the member of the single currency that is likely to be next in the firing lining.
The hunt has exposed the Republic of Slovenia as the most plausible candidate for a future bail-out, and the financial markets have responded accordingly. The yield on ten-year sovereign bonds jumped from below five per cent mid-March towards seven per cent by the end of the month, while the yield on two-year notes registered an even larger increase. The resulting inversion of the yield curve confirmed that investors believe the risk of default to be high, as too did the surge in the cost to insure five-year sovereign bonds, which rose by more than twenty per cent following the Cypriot debacle.
But, is investors’ heightened concern justified?
The Republic of Slovenia became the first of the former communist states in Central and Eastern Europe to adopt the euro in 2007. The relatively small country – with a population of little more than two million and an economy that accounts for less than 0.5 per cent of euro-zone GDP – staged an impressive acceleration in economic growth during the years that immediately preceded its accession to the monetary union.
Indeed, annual growth in real GDP accelerated from four per cent in 2005 to seven per cent in 2007; the rapid growth reflected robust domestic demand driven by increasingly leveraged private-sector balance sheets, and vigorous export growth arising from strong external demand.
However, the economic expansion came to an abrupt end once the global crisis struck, as the evaporation of external finance precipitated a sharp decline in investment expenditures, while weak demand abroad caused export volumes to shrink by close to 25 per cent. All told, the Central European nation endured a cumulative decline in real GDP of about ten per cent from the peak in the third quarter of 2008 to the trough in the second quarter of 2009.
The Slovenian economy limped through most of 2009, but a recovery was underway by the following year, only for it to be interrupted by an escalation of the eurozone crisis during the second half of 2011. The resulting double-dip has persisted for six quarters and deepened throughout 2012, as weak external demand weighed on exports, while higher unemployment and lower real wages led to a contraction in household consumption.
Persistent economic weakness has placed considerable stress on the banking sector, with a notable deterioration in asset quality. Indeed, non-performing loans increased to €7 billion last year or 15 per cent of total assets. Eighty per cent of the impaired credit or €5.6 billion stems from the non-financial corporate sector – almost one-quarter of all outstanding loans to non-financial firms.
The declining asset quality is even more troubling among the country’s three largest banks. Non-performing loans exceeded 20 per cent of total assets by the end of 2012, with roughly one-third of all outstanding loans to the non-financial corporate sector turning sour.
The banking sector’s credit woes are unlikely to improve anytime soon, and the non-performing loan ratio is virtually certain to increase further during the current calendar year. Indeed, the economic outlook is far from encouraging, and a return to growth is unlikely before 2014.
Slovenia’s pre-crisis credit expansion was concentrated primarily in the non-financial sector, with the outstanding debt relative to GDP jumping from below 60 per cent to more than 90 per cent by the time economic recession struck. The rehabilitation of corporate sector balance sheets has barely begun, and the debt ratio continues to move higher, as the cumulative decline in GDP outpaces the overall reduction in outstanding debt. The deleveraging process seems certain to intensify in 2013, and as a result, investment spending is sure to decline.
Weak investment spending is likely to be compounded by soft household expenditures, as high unemployment continues to weigh on demand. Further, the external environment is unlikely to provide much support to exports in the year ahead, while efforts to reduce the public sector deficit below three per cent of GDP will act as an additional impediment to growth. All told, it is not unreasonable to assume that the economic recession will continue throughout the current calendar year.
The continued contraction will place further strain on the beleaguered banking system. However, it is important to appreciate that the Slovenian banking sector is nowhere near as outsized as Cyprus, or Ireland for that matter, with assets amounting to 130 per cent of GDP, and recapitalisation needs are estimated to be in the region of €1 billion to €2 billion or three to six per cent of GDP. These sums appear manageable in the context of a government debt ratio below 50 per cent of GDP, but credible action to stabilise the banking system is required sooner rather than later.
Investors view the Republic of Slovenia as the eurozone member next in line to require external financial assistance, given a poor economic picture that continues to weigh on its distressed banking system. However, the situation appears manageable – if addressed quickly – but ultimately, the financial markets will determine the country’s fate.
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