beyondbrics

By Andraž Grahek of KD Funds

On Saturday, a full eight weeks after parliamentary elections in Slovenia, Janez Janša, the leader of the centre-right SDS, finally secured parliamentary backing for his appointment as prime minister and a mandate to form a five-party coalition government.

Janša has got the job after some tortuous political manouvering and bungling by his chief challenger, Zoran Jankovic, mayor of Ljubljana and ex-CEO of Mercator, the largest hypermarket chain in the Balkans. But given the economic mess the new government faces, it may be Jankovic, who eventually gets the last laugh.

Janša’s victory is a surprise since Jankovic was the clear winner in the December elections, with his his newly-formed, centre-left Positive Slovenia party to pole position, taking 28.5 per cent of votes, followed by Janša’s SDS with 26.2 per cent.

This poll result mutated into a Pyrrhic victory for Jankovic because the centrist Civic List of Gregor Virant (CLGV) opted to stay out of a Jankovic-led coalition. Positive Slovenia supporters accuse Virant of betrayal. More critical observers say the left-leaning Jankovic bungled, allowing his electoral victory to go to his head, failing to win over even his one ideological ally, the centre-left Social Democratic Party let alone Virant.

He built his immensely successful campaign on his image of a successful mayor and business leader, but promised ill-defined “positive change,” and challenged anyone to find “a truer leftist.”

So where does that leave the new prime minister, as far as the economy is concerned?

Just one day before the parliament vote, Fitch, as the last of the big three rating agencies cut Slovenia’s credit rating by two notches to A, with a negative outlook, and gave it a 50/50 chance of further downgrade this year.

Moody’s and Standard & Poor’s made similar moves in December, with downgrades to A1 and A+ respectively.

In truth, the current ratings are still quite respectable; they reflect the fact that the public debt to gross domestic product currently stands at round 45 per cent, a healthy position by comparison to many countries in the region.

But it is the swiftness of debt accumulation, coupled with the deteriorating macro-economic performance growth in non-performing loans and losses in the banking sector that are causing sleepless nights in Ljubljana.

The trends are shocking. In 2007 Slovenia had a balanced budget. In 2011, the state over-spend will hit 5.5 per cent of GDP, according to our estimates, and this includes a primary deficit of 3.7 per cent.

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In order to plug this hole, Slovenia’s debt to GDP ratio has more than doubled in just three years.

Meanwhile the country face a recession in 2012, while non-performing loans in the banking sector are approaching 20 per cent of the total, and losses are eroding the capital base.

As a result, the banking sector needs an estimated capital injection of up to 10 per cent of GDP to achieve a sufficient coverage ratio and fulfil the minimum 9 per cent Core-tier 1 ratio put forward by the European Banking Authority,

And who is responsible for this much-needed capital injection?

Unlike many countries in the region, which privatised the banking sector in the past two decades, the Slovene state is still the majority owner of the sector, including the two biggest banks, NLB and NKBM.

Unless the new government can get its act together and garner the funds quickly, these two institutions in particular face a precarious 12 months without a state-supported capital injection (assuming no other strategic solution can be devised, an unlikely scenario given the troubles across Europe.)

On top of all this, an unsustainable pension burden hangs over the entire state after the Pahor government’s planned reforms foundered in last year’s referendum.

Even more disturbing, Slovenes are unable to finance the burgeoning debt – foreign captial, rather than domestic savings, has backed some four-fifths of the increased burden in the last three years, and we calculate that foreign entities now hold some 63 per cent of Slovenia’s sovereign debt.

What is the market telling Slovenia?

Yields on Slovenia’s 10-year bonds have risen to 6.4 per cent – compared to 1.8 per cent for Bunds – a spread of 460 basis points against the German benchmark, far beyond what should be expected for a country with an A+ rating by S&P.

Indeed, the spreads are wider than Italy (rated BBB+) and closer to Romania (BB+), Ireland (BBB+) and Croatia (BBB-).

In other words, the markets are already pricing in a downgrade by three to four notches.

Are the markets too pessimistic?

Can a Janša-led coalition manage to stabilise the economy in such difficult circumstances?

Will his five-party coalition hold together, given the tough decisions to be made, and necessity for long, demanding negotiations with unions representing workers whose standard of living has, in many cases, declined of late?

Time is of the essence. The only positive factor is that the tasks are very self evident: draw up and present a credible programme of reforms for the pension system, the labour market and taxation; implement (yet more) cuts in the public sector to control the deficit; figure out a solution for the banking sector, bail out if you have to, but make sure you reduce state holdings as soon as possible; privatise rationally and open up the economy for fresh capital.

Even if Janša succeeds to holds the line among the coalition ranks, these tasks – while long overdue – represent and enormous challenge.

Janša faces long, arduous union negotiations, potential vetos from the state council (the upper chamber of parliament, comprising representatives of ermployees, employers, farmers etc), and potential populist calls for referendums.

Janša has no time to enjoy his political victory. And he faces a tough fight avoiding an economic defeat.

Andraž Grahek, is head of asset management, KD Funds, Ljubljana