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New Problem for Europe: Slovenia Downgrade a Bad Omen?

View over Lublijana, Slovenia.
Michael Runkel | Robert Harding World Imagery | Getty Images
View over Lublijana, Slovenia.

Moody's rating agency's double notch downgrade of Slovenia to junk status puts the country, already in a precarious condition, firmly in the spotlight again. Concerns are rising that the heavily-indebted country may be next inline for a bailout from international creditors, but some analysts believe Moody's bleak prognosis is not necessarily a bad omen.

Credit Agricole's Economist Olivier Le Cabellec had already warned in a podcast that Slovenia "would probably need external financial support from the EU and the IMF this year". He said the amount required could be as high as 20 percent of Slovenia's GDP.

The agency reduced the country's credit rating to Ba1 from Baa2 with a negative outlook on Monday evening. Ina statement it attributed the cut to the state of the country's banking sector, the deterioration of the government's balance sheet and the uncertain funding prospects which "heighten the probability that external assistance will be needed".

(Read More: What Happened In Cyprus Will Happen Everywhere: Marc Faber)

However, Peter Attard Montalto, Director Emerging Markets Economist at Nomura International, said in a note that there was still room for manoeuver for the country.

"Despite this downgrade we think given issuance (assuming the market is still as forgiving as it has been in recent days) in the near future and a successful program announced on 9th May it will be possible to still avoid a bailout but this move proves that the road to navigate is very risky. However it does reinforce our recent trade strategy point that whilst we think Slovenia will be a buy, there will be better levels available to do so,"he said.

"We highlighted before that the risks of a ratings spiral was an important factor to watch but this is mitigated of course by the prospect of issuance still in the near future (perhaps at a higher spread now -making it look better value) which can cover funding requirements out into Q3 and for the bank plan," he added.

Slovenia's banks are struggling with bad loans and fears of a collapse of the sector mirror those in Cyprus in March. Just hours before the announcement, a bond sale of five and ten-year bonds was scrapped leaving investors wondering where yields will head given Slovenia's bonds are now rated junk. Slovenia said the sale would go ahead at a later date.

(Read More: After Cyprus, is Slovenia Next Euro Zone Domino?)

As the country remains in recession, Le Cabellec said a number of factors meant that a bailout probability was "very high" given that its non-performing loans exceed 30 percent,liquidity is scarce with excessive high rates to finance its debt on the international capital markets and political instability poses a further hurdle to resolving the crisis without international intervention.

"It's difficult to implement speed reforms because of the current political instability. However if this support is acquired financial needs are estimated at between 4 to 8 billion euros and this remains within the average for past support plans for central Europe," Le Cabellec said.

He added that Slovenia was "not a second Cyprus" with a real economy stronger than that of Greece or Cyprus. He believed it could find an exit from the crisis through exports but this would rely heavily on political stability returning.

Much of peripheral Europe remains uncomfortably unsettled. Italy's political situation remains shaky given the lukewarm response to the appointment of Prime Minister Enrico Letta and his speech outlining growth over austerity.

Meanwhile, Spain has been flirting with the bailout question for some time but has so far evaded any serious talk on the subject despite its economy continuing to stagnate. Earlier in the week it reported another quarter of economic decline with a contraction of 0.5 percent in the first quarter compared to the previous quarter and unemployment reaching eye-watering levels at 27.2 percent in the first quarter.

For the time being, debt markets seems to be relatively unfazed by the negative economic picture and yields for both countries have reached record lows in recent auctions.

By CNBC's Shai Ahmed: Follow her on Twitter @shaicnbc

Contact Europe: Economy

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