So people are wondering if Slovenia will be the next eurozone crisis focal point. I can find Slovenia on a blank map, so we’re off to a good start. But how about some background?
Stop me when this sounds familiar.
Surging investment in the middle of the last decade produced a home price bubble and a household consumption binge, as foreign sources of financing helped fuel increasing purchases of imports and a newly prosperous construction sector. The annual current account deficit reached 8 per cent of GDP at its peak.
With the crisis came the reversal. Investment collapsed and so did imports. External funding disappeared as foreign banks started pulling their loans to Slovenian banks, which had relied more on interbank lending than on capital markets. The seemingly inexorable rise in household borrowing and spending immediately halted.
Unemployment spiked, just as in the rest of the eurozone, while the government budget deficit widened when tax receipts fell.
You can see the story in these charts from an excellent note by David Watts of CreditSights, on whom I’ve relied for much of the data and context in this post (thanks David):
As Watts explains, the decline in imports and borrowing would have brought Slovenia’s current account deficit into balance sooner, were it not for “factor payments” — mainly interest on those interbank loans — which had risen from one per cent of GDP in 2000 to three per cent by 2008.
Watts adds:
With a current account deficit still to be funded and a large outflow of funds as foreign banks pulled back their interbank lending, the Slovenian government and banks were forced to cover that current account deficit and deficit in the ‘other investments’ component of the balance of payments on the financial account with sales of bonds to foreign investors.
And those bonds became the problem?
Sort of, but let’s not get ahead of ourselves.
Slovenia’s government debt is about half of GDP, still quite low for Europe, and its budget deficit is projected to be a manageable 5.1 per cent this year.
But the country’s economic malaise, the decline in its fiscal position and problems in its banking sector led to difficulty finding foreign buyers for its sovereign bonds — naturally coinciding with the general collapse in cross-border flows throughout the eurozone overall.
So the government stopped issuing bonds, and since 2011 it has paid its debt obligations — including servicing the bonds it sold to foreign investors — and funded its budget deficit through short-term bills.
And many of those bills have been sold to the country’s domestic banks, the three largest of which are owned, directly and indirectly, by the government.
So that’s the connection between the sovereign and the banks.
That’s just the beginning.
The way it works is that Slovenia’s domestic banks then pledge these bills as collateral to the Banka Slovenije, Slovenia’s central bank. In exchange, Banka Slovenije gives claims on euro liquidity to the domestic banks, which then transfer those claims to the government.
The government then uses those claims to pay off its foreign bondholders through the ECB’s Target2 payments system.
We won’t get into the complexities of Target2 here. For this post it is enough simply to consider the Banka Slovenije as an arm of the ECB.
The ECB is therefore directly exposed to Slovenian banks and to the assets they use as collateral, many of which are these government bills (just how many is unclear).
Okay, now this is starting to sound familiar.
Yes, hopefully the sovereign-bank debt loop is coming sharply into focus, and you can see that Slovenia’s recent experience isn’t exactly sui generis within the eurozone.
Looking at the Slovenian banks, non-performing loans are now reaching levels somewhere between those of Spain and Greece, and closer to the latter than to the former:
Slovenia is mired in a brutal double-dip recession: real GDP was down 2.3 per cent last year, and will decline by slightly less this year.
The country’s non-financial corporate sector remains hugely overleveraged, having boasted the highest net debt-to-income ratio in the entire euro area at the end of 2011, according to RBC Capital Markets and Eurostat.
The downturn has precipitated a credit crunch, and the unwillingness or inability of banks to continue rolling over loans to these companies exacerbates both the recession and the problem of non-performing debt.
All of which means that the banks’ problems are almost certain to get worse before they get better. The IMF has called for the banking system to be recapitalised, and everyone expects that it will be. But there continues to be much uncertainty about what the recapitalisation would look like.
Before we even get into the possible details of this hypothetical recapitalisation, how much money are we talking about here?
Hard to say, but let’s begin with estimates of Slovenian bank securities. These banks have roughly €4bn of equity and €2bn of combined senior and subordinated debt outstanding, a total of €6bn.
Recapitalising the banks would require first making up for any losses above that €6bn total — in other words, above the amount at which all security holders are completely wiped out — and then additional capital to bring leverage ratios back to something reasonable. (The current ratio of assets funded by equity is 7.7 per cent.)
Now, CreditSights has considered a worst-case scenario…
Slovenian banks have domestic non-financial, non-government loans and bonds of €30 bn (84% of GDP) and domestic equity holdings worth €1 bn. As a worst-case scenario if we were to assume that:
1. If non-performing loans were to more than double from their current 13% to 30%
2. Recoveries were to fall to just 25% across the entire banking system’s non-financial loan book
3. And Slovenian banks holdings of domestic shares were to be written down to zero,
… and concluded that the losses across the banking system in such a scenario would be about €7.7bn, or 22 per cent of Slovenian GDP.
Getting the leverage ratio back to its current level in such a scenario would then require €5bn in additional capital.
But again, that’s an extreme scenario, though one that also assumes bailing in all junior and senior debt. (A smaller bail-in would require more capital raised, all else equal.)
Analysts at RBC Capital Markets, for instance, reckon that any recapitalisati0n would not climb above €3bn. In March, the IMF pegged the cost at closer to €1bn for recapitalising Slovenia’s three largest banks, and that is also the estimate of the Slovenian finance minister. Nomura analysts, meanwhile, say a pessimistic outcome would require €9bn, though this is an outlier.
That doesn’t sound so bad, but where is the capital going to come from?
The capital for the banks will come from the Slovenian government. The question is whether the Slovenian government can manage the recapitalisation on its own or whether it will turn to eurozone policymakers for help. The latter is more probable at this point, but nothing is given.
Let’s assume for now that Slovenia does ask for help. What would this look like?
There are several possibilities, but the most likely scenario involves the Slovenian government borrowing bonds from the European Stability Mechanism (ESM) and then using those bonds to recapitalise the banks.
The bonds might be borrowed directly by the government or channeled through the country’s Bank Asset Management Company, or “bad bank”, but either way the government will be on the hook to the ESM for the bonds.
Slovenian banks can then use the ESM bonds as collateral pledged to the Slovenian central bank. Kind of similar to what happened in Spain.
The hope is that the additional borrowing by the sovereign won’t further freeze it out of open debt markets but rather do the opposite — make it easier for the Slovenian government to borrow because debt markets will gain confidence that it won’t have to further support its banks in the future.
It is also hoped that foreign lending would return to Slovenian banks, whose balance sheets would be stuffed relatively less with Slovenian government bills, having been displaced by those ESM bonds.
The banking system’s strength would thus depend on the stability of the eurozone as a whole rather than on fluctuations in the Slovenian government’s ability to fund itself.
The ECB would be cool with this?
As we discussed earlier, the ECB’s main concern would be its own exposure to the Slovenian banking system, and by extension to the Slovenian sovereign.
This exposure has grown in the absence of willing foreign lenders to the country’s banking system, and the worry is that the exposure will continue to grow either if the position of the banks keeps deteriorating or if the sovereign encounters further trouble selling its debt on the open market at sustainable yields. Or both.
This is important, so it’s worth emphasising one more time. A recapitalisation via ESM bonds would effectively shift the ECB’s exposure from Slovenia to the rest of the eurozone, which collectively backs the ESM bonds.
The reason is that the ESM bonds would be serving the same function as the Slovenian bills had previously served (as collateral with the Slovenian central bank, and by extension with the ECB).
So yes, the ECB would be cool with this.
What about the rest of the eurozone?
As for (northern country) eurozone demands… Until last week, Slovenian debt yields had been climbing since March following the Cypriot bailout and a lacklustre speech by the Slovenian prime minister about what to do.
It’s true that a recapitalisation would push up the Slovenian budget deficit, and the government also holds big stakes in the country’s three largest banks — which means that wiping out their equity would also increase the deficit.
But it’s also true that Slovenia has already undertaken rigorous and domestically unpopular austerity measures. Even after recapitalising its banks, the country’s debt-to-GDP ratio would still be among the lowest in Europe, and Slovenia is also now running a healthy current account surplus.
Of course, there might be a requirement that Slovenia privatise some of its assets, and particularly within its financial sector.
But in terms of “fiscal responsibility”, Slovenia isn’t much more in need of a lecture than other European governments. And in case you hadn’t noticed, austerity is suddenly out of vogue.
I’ve heard that Slovenia might be the new Cyprus; so far it seems different.
It is dramatically different, and this chart from Exane BNP Paribas shows the main reason why:
The Slovenian banking system wasn’t a tax haven being used to recycle dodgy Russian money. It is also far less reliant on deposits for funding, and the scale of its importance to the domestic economy doesn’t rival that of the Cypriot banks.
And again, relative to other peripheral countries its finances also look decent:
Yes, the country does have plenty of other economic problems. Without pretending to be an expert, the structural adjustments recommended by the IMF seem like a good idea. You can read more about the Slovenian state’s heavy presence in the economy, and especially in its banking sector, here.
But unlike interbank lending, deposits haven’t evaporated, and nobody thinks that even uninsured depositors would take a hit in Slovenia. The problem is both different in nature and also smaller. Slovenia’s experience more closely resembles that of Spain, which is also why analysts mostly believe that a bailout would also resemble Spain’s.
You mentioned that yields had been climbing until last week?
Last Wednesday, Slovenia managed to sell €1.1bn in 18-month bills, more than twice as much raised as expected, and then used €885mn to pay off some of its debt coming due in June.
Yields on Slovenian bills and bonds fell a bit into this week. But the bids came mainly from the country’s three biggest, state-owned banks.
This isn’t what you would call a long-term solution. But it does, perhaps, mean that the government has a little more time than previously thought to work on one.
This is what the country’s debt maturity profile looks like following the retirement of that big chunk of June debt (chart from Nomura):
Regardless, last week’s auction didn’t alter the sovereign-bank interdependence, and so I doubt it amounted to anything more than a postponement.
But if the Slovenian government does try to recapitalise its banks on its own — and for now, that’s the official line it is taking — then postponement was the first step. The next steps would probably be to hope that it gains increasing access to open debt markets; recapitalise the banks and fund its “bad bank” (which will buy and resolve the troubled loans of the banks); and then perhaps to privatise at least a few of its state-owned assets.
Oh right, you mentioned privatisation earlier. If the state is so heavily involved in the economy, why doesn’t it sell off assets to raise money for the bank recapitalisation?
The Slovenian government does indeed plan to announce some kind of privatisation agenda to its parliament by May 9, but it is unclear which assets will be included.
As for why it hasn’t done so yet, I’m not sure. Here is one article with lots of background. More recently, the IMF cited a “misconceived defense of ‘national interests’” as a reason — a phrase impressively free of substance, even for the IMF.
It may come down to the simple reluctance on the part of the government to relinquish power. The corruption that typically accompanies these arrangements is always difficult to combat.
Another straightforward possibility is that these assets are likely to be worth more in the future, when the economy is growing again. To sell now would require a heavy discount.
Here is interesting detail from Nomura analysts:
… the capital asset management agency of Slovenia (ZUKN) reported that as at the end of 2011, the Republic of Slovenia (RS) held direct ownership stakes in 76 companies, with a book value of almost EUR9bn.
To be clear, we do not have any estimate of the current market value of these holdings, and it is not clear what accounting treatment they receive from the entities that finance them (i.e. whether they are carried at book or market).
However with the stock market down almost 80% from the pre-crisis peaks, even if part of these holdings and cross-holdings are financed by the banks, they may add to the systemic risks posed by over-leveraged corporates to the state-owned banks. …
We believe [selling state assets] is probably by far the best long-term option for Slovenia because in a single stroke it reduces state involvement in the economy, while raising cash and without increasing indebtedness.
For example looking at just the state holdings in the components of the SBITOP, it may be possible to raise around EUR1.2bn at current market prices.
According to ZUKN the market securities may represent just a fraction of what the state owns, so the total amount of money that may be raised this way might be a lot higher.
But with the stock market down heavily, this option may meet heavy resistance because of the feeling that the state may be divesting its assets at fire-sale prices.
On top of that in a climate of attention focused on the country and its banking woes it is difficult to see how a privatisation strategy can progress successfully in the short to medium run.
However, it may yet be possible to come up with a creative solution, where the state retains some of the upside of asset price appreciation, while giving up control to the private sector, and indeed the authorities themselves may come round to the idea that they are not divesting assets but jettisoning liabilities.
As the analysts go on to note, the big unknown around asset sales isn’t how much money the country would raise, but whether the political will exists to go through with it, and quickly.
Let’s say that markets don’t buy into whatever solution the Slovenian government comes up with, and yields stay elevated. What would actually trigger the bailout?
It could be a request from Slovenia, but thus far the government has made a show of intending to deal with the problem itself without eurozone help.
Just as likely, the ECB could force the issue, as David Watts argues. Remember that from a certain perspective, the ECB is effectively financing the government’s budget by accepting Slovenian bills as collateral.
But the longer that Slovenia’s government and its banks have trouble accessing external funding, the more that the ECB’s exposure will grow — and the more uncomfortable the ECB will become with that growing exposure.
The bottom line?
It would be a mistake to act blasé given the chance of a policy error or unanticipated complications. But at the moment it seems that the Slovenian problem is soluble and brings less risk of such an error than Cyprus carried.
Bail-ins on bank debt are possible and even probable. But after the chaos of the Cypriot bailout, it is also unlikely either that depositors will be threatened or that such extreme measures as capital controls will even be broached.
With any luck, 1) the requirements imposed by the eurozone wouldn’t be too punitive in the event of a bailout, and 2) the injection of ESM bonds would give the sovereign and the banks a smooth path back to debt markets.
On both counts, it surely helps that Slovenia didn’t enter this recent phase with an extent massive debt problem and that it is also running a current account surplus.
So you’re saying I shouldn’t be worried?
Hey now, that’s not at all what I said.
That a problem is solvable is no assurance that it will be solved — especially in Europe, where casual disregard is a leading contrary indicator.
