After Cyprus, Bond Markets See Slovenia Closer to Bailout

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

Cyprus may be a "special case" in the eyes of European officials, but their handling of its bailout is taking a toll on another small euro zone member with an over-burdened banking sector - Slovenia.

Yields on its two-year bonds surged to nearly 7 percent on Thursday, overtaking those on longer-dated paper and inverting the yield curve - a sign investors are pricing in a high risk of default.

Slovenia issued its first bond in 19 months in October and former Prime Minister Janez Jansa has said the country must sell another bond by June 6, when 907 million euros of 18-month treasury bills mature, to meet its financial obligations.

Contagion from Cyprus, which clinched a bailout deal on Monday at the expense of large bank depositors, has made that task more challenging and the prospect of a rescue more likely.

"One way or another things are coming to a head. June is a long way away for these guys now, so they need to do something," said Tim Ash, head of emerging markets research ex-Africa at Standard Bank.

"It's becoming increasingly likely they are going to have to begin to talk to the IMF and the Troika (about a bailout)," Ash said, referring to lenders including the International Monetary Fund, the European Union and European Central Bank.

The new government has so far declined to say anything about its borrowing plans, but it is expected to tap markets in coming months to repay some 2 billion euros of debt falling due in the middle of this year.

Analysts are sceptical the country will be able to raise that cash given its illiquid debt market and a deterioration in market conditions since the Cypriot bailout.

The yield on Slovenia's January 2021 bond, an indication of how much the country would have to pay to borrow, rose as far as 6.8 percent this week - the highest level since September - in choppy trading.

The market is also pricing in a greater risk that the country will not be able to meet its financial obligations, as indicated by a sharp rise in its credit default swap prices.

The cost of insuring Slovenian bonds against default has jumped by 123 basis points since last Thursday to 405 bps, according to Markit data.

That means it costs $405,000 annually to buy $10 million of protection against a Slovenian default using a five-year CDS contract, more than to buy similar protection against a default by Italy, at 314 bps, or Spain, at 309 bps.

Economists in a Reuters poll this week saw Spain and Slovenia as the likeliest candidates for any future euro zone bailout.

"They will tap the market (in June) but I doubt they will get the money. Now we have long-term interest rates above 6 percent and I would expect above 7 percent the country would ask for help," Commerzbank economist Christoph Weil said.

7 Percent Curse

Only a week ago, things did not look so bad.

Although Slovenia has recently dealt with a political crisis and change in government, its debt burden and banking sector are smaller than those of some struggling peers, which led analysts to believe its problems were far more manageable.

The government expects Slovenia's debt pile to have been 53.8 percent relative to the size of the economy in 2012, far lower than Spain's 84 percent and compared with around 80 percent for Cyprus before its bailout.

Meanwhile, problems at Slovenia's banks have more to do with the quality of their assets following a property bust than the size of the banking system itself. Balance sheet assets of Slovenian banks are equivalent to 135 percent of gross domestic product compared with some 800 percent for Cyprus's outsized financial sector.

But its mostly state-owned banks are nursing around 7 billion euros of bad loans, equal to about 20 percent of GDP.

The new government is expected to carry out its predecessor's plans to establish a "bad bank" that would take over bad loans of state banks and enable their privatisation. But with the economy in recession, efforts to recapitalise the banking system are likely to mean Slovenia must tap markets.

Recent history suggests the odds are stacked against it.

After yields in Greece, Portugal and Ireland rose above the 7 percent level, the cost of issuing new debt quickly spiked and each country was forced to seek international aid.

Those countries' two-year yields also overtook their longer-dated counterparts before they sought financial help, signalling that funding risks were imminent.

For Jaromir Sindel, an economist at Citibank, it is not so much the cost of funding but the stability of the new government and its ability to recapitalise the banking system that will determine Slovenia's fate.

New finance minister Uros Cufer has said the incoming government will push ahead with its predecessors' plan to set up a "bad bank" in a somewhat altered shape..

"If there is a continuous increase in the bond yields and the government is not able to introduce a quick, credible plan, it can be a case for a bailout," Sindel said.