The First Victim of Cyprus Contagion

Slovenia faces contagion from Cyprus as banking crisis deepens

Slovenia’s borrowing costs have rocketed over recent days as it grapples with a festering financial crisis, becoming the first victim of contagion from Cyprus.

By Ambrose Evans-Pritchard

 “Banks are under severe distress,” said International Monetary Fund in its annual health check on the country. Non-performing loans of the Slovenia’s three largest banks reached 20.5pc last year, with a third of all corporate loans turning bad.

Yields on two-year debt in the Alpine state have tripled over the past week, jumping from 1.2pc to 4.26pc before falling back slightly on Thursday. Ten-year yields have reached a post-EMU high of 6.25pc.

“The country has lost competitiveness since joining the euro and it’s lead to slow economic collapse. Markets have been very complacent, but it has been clear for a long time that the banks need recapitalisation, and it is not easy to raise money in this climate,” said Lars Christensen from Danske Bank.

The IMF expects the economy to contract by 2pc this year, following a fall of 2.3pc in 2012. “A negative loop between financial distress, fiscal consolidation and weak corporate balance sheets is prolonging the recession. A credible plan to address these issues is essential to restore confidence and access markets,” it said.

The new prime minister Alenka Bratusek told the Slovene parliament on Wednesday that the fears are overblown. “Our banking system is stable and safe. Comparisons with Cyprus aren’t valid. Deposits are safe and the government is guaranteeing them.”

Slovenia’s bank assets equal 130pc of GDP compared with 700pc for Cyprus, though the Cypriot figure is misleading since a large part of its banking system is made of “brass plate” subsidiaries of foreign lenders such as Barclays or Russia’s VTB.

Tim Ash from Standard Bank said the events of the past two weeks had pushed the country over the edge. “Slovenia is now inevitably heading towards a bail-out. The eurozone shot itself completely in the foot in Cyprus,” he said.

The Slav-speaking state - a Baroque jewel with historic ties to Austria - has a population of just 2m and is too small to pose a financial threat.

However, analysts say a crisis in Slovenia would further complicate EMU politics, forcing the northern creditor states to define their rescue strategy yet again. Austerity fatigue in Germany and Holland has already caused policy to harden.

Luxembourg has also come into focus as markets take a closer look at EMU money centres. Its banking assets are 2,500pc of GDP, by far the highest in the eurozone.

Eurogroup chief Jeroen Dijsselbloem fanned the flames in an interview this week, advising Luxembourg to cut leverage in its financial system and slim down its banks. “Deal with it before you get into trouble,” he said.

The comments caused fury in the Grand Duchy. “We do not attract Russian money to Luxembourg with high interest rates. The Luxembourg financial centre is based on several pillars, we are characterised by the breadth of our product range,” said premier Jean-Claude Juncker.

Luxembourg officials have been deeply alarmed by the handling of the Cyprus crisis, intervening in the talks to try to soften the demands. Foreign Jean Asselborn accused Berlin of pursuing “hegemony” in Europe. “Germany does not have the right to decide the economic model for other EU states,” he said.

The knock-on effects in Portugal, Spain and Italy have so far been mild, though bond spreads have spiked to three-month highs.

“It’s remarkable how little contagion there has been, since capital controls and major depositor haircuts violate fundamental principles. The assumption has always been that this would be game over,” said Julian Callow, chief global economist at Barclays.

Moodys warned that the erratic handling of Cyprus had “significantly heightened fears surrounding the safety of bank deposits in other European systems”, and left Portugal vulnerable to renewed stress.

While the agency praised Lisbon for carrying out deep reforms, it said public debt had reached 123pc of GDP in 2012 and is still rising. The economy is likely to contract by 2pc this year.

“The ongoing recession has been the main reason that revenue shortfalls have persisted, and has contributed to the further deterioration in the government’s debt metrics,” it said.

Italy faces its own crisis after last-ditch efforts to form a government collapsed on Thursday night, raising the likelihood of a caretaker leader and fresh elections.

Mr Callow said it is hard to see Italy can now comply with the strict terms of an EMU bail-out, which in turn leaves it is unclear whether the European Central Bank’s back-stop for Italian debt is still valid.

Italy’s national data agency Istat said the economy may contract by more than the official forecast of 1.3pc this year, with no recovery until 2014.

“The eurozone is running out time. If there is no growth for another year, and unemployment ratchets higher, citizens are going to turn against the euro,” said Mr Callow.

Italy’s business lobby Confindustria said the country faces a “full credit emergency”. The authorities are to raise €40bn or 2pc of GDP to pay off arrears to suppliers, a way to form inject immediate fiscal stimulus, while skirting EU deficit rules.

Loan data released by the ECB on Thursday show that credit to eurozone private firms contracted by 2.5pc in February, with signs of a deepening credit crunch for small business across the South.

Europe’s top officials may have jumped the gun earlier this year by proclaiming the EMU debt crisis to be over and the economy to be well on the way to recovery. The mission is not yet accomplished.