11 April 2013

Whos next in line in the eurozone crisis? Portugal and Slovenia are the prime candidates
Key points Both Portugal and Slovenia could need external assistance of some sort.

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Portugal Domestic demand, government spending and investment are contracting sharply, leaving the country heavily reliant on uncertain export growth to drive the economy. By cutting wages and costs at home (internal devaluation), Portugal has in recent years improved its level of competitiveness in the eurozone relative to Germany. However, this trend actually started to reverse sharply in 2012, meaning that the divergence between countries such as Portugal and Germany has begun growing again exactly the sort of imbalance the eurozone is seeking to close. In its austerity efforts, Portugal is now coming up against serious political and constitutional limits. For the second time, the countrys constitutional court has ruled against public sector wage cuts a key plank in the countrys EU-mandated austerity plan while the previous political consensus in the parliament for austerity has evaporated. In combination, it will be increasingly difficult for Portugal to sell austerity at home and consequently to negotiate its bailout terms with creditor countries abroad. Portugal may well need some further financial assistance before long. It is unlikely to take the form of a full second bailout, but could involve use of the ECBs OMT, assuming Portugal can return to the markets fully beforehand (even briefly). Slovenia Slovenia is not Cyprus in fact it is much more like Spain. Its banks are significantly undercapitalised with toxic loans now standing at 18% of GDP. Banks only have provisions to cover less than half the potential losses resulting from these loans. At the same time, a heavily indebted private sector is now desperately trying to get debt off its books, which alongside continued austerity and lack of investment, have caused growth to plummet. Though a full bailout is unlikely, the country could soon need an EU rescue package worth between 1 billion and 4 billion (between 3% and 11% of GDP) to help restructure the countrys bust and mismanaged banks. Such a plan is likely to include losses for shareholder (bail-ins) but, unlike in Cyprus, it may not hit large (uninsured) depositors and there will be no attempt whatsoever at taxing smaller (insured) depositors. The troubles in Cyprus have set off a new examination of the health of the eurozone, with a particular focus on which country might be next in line for a bailout and the extent to which shareholders and depositors will take losses when banks fail (bail-ins). Much of the attention has settled on two countries. Portugal, which has been propelled back into the headlines, with the countrys constitutional court recently ruling against some of the governments EUmandated budget cuts. Secondly, Slovenia, which is facing a massive banking crisis, in turn providing another potential testing ground for the eurozones vaguely defined bail-in plans. Below we provide a quick rundown of the key points to watch in each country.

Portugal The forgotten man of the eurozone? Over the past year, Portugal has avoided the spotlight of the eurozone crisis and been left to continue its programme of cuts and reforms with relatively little market scrutiny. However, last week the countrys Constitutional Court sparked jitters across Europe, by ruling against some of the governments budget cuts. This has put Portugals ability to fulfil the conditions attached to its bailout in doubt. Complicating matters, Portugal is currently locked in talks with its creditors, including Germany and the IMF, to extend the maturity of its bailout loans (which would give Portugal some much needed breathing space). If Lisbon is seen as failing to deliver its promised cuts, creditors are unlikely to grant it this extension. Fundamentally, as so often in this crisis, the eurozone is now coming up against the full force of national democracy. What are the main risks to watch in Portugal? 1) Overreliance on fragile export-led growth Graph 1: Contributions to GDP in Portugal (% GDP)
45 40 35 30 25 20 15 10 5 0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Exports (lhs)
Source: Eurostat

115 110 105 100 95 90 Domestic demand (rhs)

As Graph 1 above shows, domestic demand has declined sharply and is set to continue doing so over the next few years partly due to the private sector trying to get debt off its books, and a lack of credit in the economy. Although household deposits have held up well during the crisis, non-financial corporation deposits have fallen 20% in the past year, with firms depleting cash reserves. With the government also cutting spending, the only avenue for growth will come from exports. Fortunately, Portuguese exports have performed well over the past few years, but it cannot be taken for granted that they will continue to do so. In particular, the deeper and longer recession in the wider eurozone will reduce demand for Portuguese goods and services, having a negative knock-on effect. Furthermore, exports represent a much smaller share of GDP than domestic demand or government spending, meaning that even strong growth in exports cannot indefinitely fill in for collapsing domestic demand. Unlike many other eurozone countries, Portugal has already experienced a lost decade since it joined the euro even Italy was more economically dynamic. With government debt set to peak at 124% of GDP in 2014 and political uncertainty growing it cannot afford to be locked into low growth for a sustained period.

External debt also remains very high at 300% of GDP, even with the substantial cut in the current account deficit. Out of the struggling eurozone countries, only Ireland has a worse external debt position, although Portugals net international investment position is worse even than that of Ireland (at 105% of GDP in 2011).1 These factors mean that a change in sentiment abroad regarding Portugals economic future could seriously hamper debt sustainability, while they also highlight that assets will continue to be transferred abroad. This would be less of an issue if the debt built up had helped promote productive investment, but Portugal has been stuck with low growth for some time and much of the investment seems to have artificially boosted wages and standards of living.2 In addition, in order to have any chance of sustained export growth Portugal must massively improve its competitiveness stuck with an overvalued currency in the euro this must come from internal devaluation. 2) Improvements in competitiveness have stalled

Graph 2: Unit labour costs (1999Q1 = 100)

140 135 130 125 120 115 110 105 100 95 90

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Portugal

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Portugal (required adjustment)

Source: Eurostat and Open Europe calculations

Despite some positive steps up to the first quarter of 2012 there has been far too little improvement in the cost competitiveness of Portugal. Unit labour costs a key measurement for the relative competitiveness of a country inside the eurozone indicate that Portugals level of competitiveness is now starting to fall once again. In other words, the divergence between Germany and Portugal is again increasing. The dotted line shows the path which Portugals unit labour costs should have taken, in order to make its position in the

The net international investment position of a country is the difference between its total financial assets abroad and its total financial liabilities to foreign investors (both public and private). In Portugals case the liabilities significantly outweigh the assets. This not only means that money will continually be flowing away from the country due to interest and profits on these investments but also that any swing in the sentiment of these investors could increase pressure on Portugal, particularly through borrowing costs. 2 For an example of a more detailed discussion of this problem, see The PIGS external debt problem, posted on Vox by Ricardo Cabral, May 2010: http://www.voxeu.org/article/gips-external-debt-problem

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eurozone sustainable in the long term (based on Open Europes estimate of the workable gap between stronger and weaker countries in the eurozone).3 Furthermore, legal points of the constitutional court ruling aside, spending on wages and social protection accounted for 60% of all government expenditure in Portugal. That is a huge amount and represents a prime area for savings. Ring-fencing this area could make it very difficult for the government to meet its targets. 3) Portugals austerity programme is coming up against huge political and constitutional limits Economically, Portugal clearly needs to continue to cut costs. As the experience with internal devaluation in the Baltics showed, for austerity programmes to be successful, cuts need to happen across the economy, including public sector wage cuts. However, in Portugal as elsewhere in the eurozone there is an ever-growing mismatch between what creditors and markets demand, and what the national democratic system can realistically deliver. This is the second time the Portuguese Constitutional Court has ruled against public sector wage cuts (the previous time was July 2012).4 Whats more, the previous political consensus in the countrys parliament in favour of the bailout programme has evaporated this was one of the countrys strong points in comparison to eurozone peers such as Italy and Greece. The opposition Socialist party is now openly questioning the austerity drive, meaning that it will be far more difficult to push austerity measures through parliament in future. Portuguese politics is likely to become increasingly divisive. This has already been seen over the past week with the Socialist party actively calling for the government to resign and for new elections,5 while the current government has already faced four no-confidence votes since it took office in mid-2011. On top of this, popular support for the measures is also coming into question. Unemployment is already at 17.6%, despite the Troika target for this year being 16.4%. Youth unemployment is up to 38.6% and long-term unemployment reached 8% in the third quarter of 2012 - a 2% increase on a year earlier. These figures are only likely to increase with more reforms and cuts to come. The question is how long this can continue without triggering social unrest and seriously hampering the productive potential of the economy. Last autumn, the government was forced to reverse tax hikes due to significant protests this could become a more regular event.6 Will Portugal need a second bailout? So with the problematic mix of falling competiveness and growing political problems, is Lisbon on path for a second bailout? Fully returning to the markets in September this year as scheduled will be very tricky for Portugal. Some further assistance is therefore likely to be needed. However, it may not come in the form of a full second bailout.

For more details on the calculations and thinking behind the sustainable level of divergence in the eurozone, see Open Europe, Can struggling eurozone countries achieve the necessary internal devaluation and at what political cost?, September 2012: http://www.openeurope.org.uk/Content/Documents/Pdfs/Internaldevaluation.pdf 4 Cited by BBC, Portugal court rules public sector pay cut unconstitutional, July 2012: http://www.bbc.co.uk/news/world-europe-18732184 5 Cited by the WSJ, Portugal warns high-court ruling may derail bailout, 6 April 2013: http://online.wsj.com/article/BT-CO-20130406-701164.html 6 Cited by WSJ, Budget U-turn scuttles Portugal plans, 24 September 2012: http://online.wsj.com/article/SB10000872396390444813104578016043305870194.html

Instead, it will probably be a combination of: Lengthening the maturity of the bailout loans as well as an easing of the deficit targets. This is already underway, with a seven year extension agreed in principle and the deficit target already being relaxed twice. A final agreement on the extension was expected at tomorrows meeting (12 April) of eurozone finance ministers. However, this is now reliant on Portugal finding cuts to replace those overruled by the Constitutional Court. Agreement next month seems more likely. Some assistance from the ECBs OMT, bond buying programme. Indeed, the OMT is only meant to be used once a country has fully returned to the market but what exactly this means is yet to be clearly defined.7 It could be imagined that Portugal successfully manages to sell a couple of long-term bonds later this year, which may be enough to qualify. Even the prospect of such an option could be enough in the end to help Portugal fund itself in the short term, although we doubt this will be enough to ensure long-term debt sustainability.

Slovenia is not the next Cyprus but it could be the next Spain Following its hugely controversial bailout, everyone is looking for the next Cyprus. Slovenia has emerged as the country-elect to fill this role, broadly due to the countrys banking problems. Looking deeper, though, it is clear that there are substantial differences between the situation in Slovenia and that in Cyprus. In fact, there are more similarities with Spain (albeit on a much, much smaller level). Therefore, the shape and form of a potential Slovenian bailout is likely to differ substantially compared to the Cyprus case. What are the key problems facing Slovenia? 1) The banking system is severely undercapitalised Graph 3: Eurozone bank assets as percent of GDP
SK EE SI GR IT BE FI DE AT PT ES Euro NL FR IE CY MT LU

84 113 143 222 270 287 294 306 308 333 335 347 409 426 676 707 802 2,189 0 500 1,000 1,500 2,000 2,500

Source: ECB and Open Europe calculations

Cited by the FT, ECB damps hope of cheap loans, 7 March 2013: http://www.ft.com/cms/s/0/a4d9c804-875311e2-bde6-00144feabdc0.html#axzz2Q8eu3c5Y

The first point to note is that, although larger than GDP, the banking sector in Slovenia is nowhere near the size of that in Cyprus. However, there are numerous problems stored up in the banking sector which are large enough to impact the state as a whole and push it towards requiring external assistance. As in Spain, Slovenia has experienced a significant boom and bust (particularly in real estate) partly driven by lower than expected interest rates ahead of and following its euro entry in 2007 (designed to accommodate stronger eurozone economies) and a significant inflow of foreign capital. This has left the banks exposed to a large amount of bad loans and needing a significant recapitalisation as growth and investment have plummeted.

Graph 4: Slovenian banks need more capital

7,000 6,500 6,000 % of NPLs millions 5,500 5,000 4,500 4,000 3,500 3,000 2010 Q4 2011 Q1 2011 Q2 2011 Q3 2011 Q4 2012 Q1 2012 Q2 2012 Q3 2012 Q4 Bank capital (lhs) NPLs (lhs) Level of provisions (rhs)
8

50 45 40 35 30 25 20

Source: IMF Financial Soundness indicators and Open Europe calculations

Graph 4 displays a stark picture, highlighting that the growth in non-performing loans (NPLs) has significantly outstripped any increase in bank capital over the past two years, with the gap between the two widening massively since the start of 2011.9 On the positive side, provisions against NPLs have grown at a similar rate. However, this is only a small fillip given that they still only account for 45% of the NPLs and given that the number of NPLs is expected to increase further (due to poor growth and high private indebtedness).10 For these reasons, we estimate that banks in Slovenia may in total need 3.5bn in capital (10% of GDP) or the level of loss provisions needs to double. Provisioning would be cheaper since it can be done with lower quality assets, but it is also far less convincing in the long run. It is likely that international investors and other eurozone partners will want to see the banks restructured and recapitalised fully (we discuss the technical details of this below).

IMF, Financial Soundness Indicators database, Slovenia (accessed on 8 April 2013): http://fsi.imf.org/Default.aspx 9 The definition of a non-performing loan used here is that used by the ECB and the Eurosystem. Broadly, when interest and/or principal on a loan are more than 90 days past due it becomes non-performing. 10 The level of provisioning is lower than in Spain, where currently it reaches 55%. However, this is after it has received a bailout and the bad bank has been instituted.

2) Corporate sector is heavily indebted, which will weigh on already poor growth outlook

Graph 5: Slovenian Non-Financial Corporations

40000 35000 30000 25000 20000 15000 10000 5000 0 0 100 50 Debt as % of equity 200 150 250

millions

Shares and other equity (lhs)

Source: ECB and Open Europe calculations

Debt (lhs)

Debt/Equity (rhs)

As mentioned above, Slovenian companies are heavily indebted. They took out huge loans during the boom to finance rapid expansion meaning that, when the bubble burst, they were left massively overleveraged. A standard measure of such leverage and indebtedness is debt to equity (broadly the amount of liabilities taken on by a firm relative to the value of its shares).11 Graph 5 shows that, in Slovenia, non-financial corporations have a debt to equity ratio of 200%. As a comparison, according to the ECB, the average debt to equity ratio of corporates across the eurozone peaked at 70% in 2009 (the height of the bubble) falling to 55% by 2011.12 It is inevitable that such high debt levels will weigh on the economic performance of these firms in many cases they will struggle to stay above water let alone expand since they are a large part of the economy this will be a substantial drag on economic growth. This debt will also have further knock-on effects on Slovenian banks, since around 50% of their loans are to these firms.13 Clearly, the poor financial performance of the corporate sector, low economic growth and the level of losses for banks are closely interconnected. The risk of a reinforcing negative spiral between these aspects in Slovenia cannot be ruled out. Fortunately, Slovenia does have some scope to absorb this, with government debt standing at 54% of GDP at the end of 2012. However, as Spain and Ireland demonstrated, this can increase quickly, particularly when it comes to the cost of dealing with a banking crisis. This is already being seen in Slovenia with debt increasing by 55% since 2009. With all the costs of the crisis thrown in, debt to GDP could jump again to 70% this year (see more below). Borrowing costs are already at painfully high levels (ten year at 6.4%), while Slovenia has only issued one bond since March 2011 (which it needed to issue in dollars to ensure sufficient demand at low enough costs). The government faces around 3bn (8.5% of GDP)
11

The figures are taken from the ECB data warehouse. The measurement of debt here differs slightly to that taken by the OECD, which puts the level of corporate debt to equity at around 140%. Even at this level the OECD warned of the substantial risks involved. 12 Corporate indebtedness in the euro area, ECB Monthly Bulletin, February 2012: http://www.ecb.int/pub/pdf/other/art2_mb201202en_pp87-103en.pdf 13 Data taken from the IMF FSI database.

in funding needs this year, not including the cost of the bank bailout.14 These magnitudes are not huge, but a liquidity crisis is already setting in and significant work on the banks and structural reforms is needed to avoid a solvency crisis taking hold. Corruption remains a problem in Slovenia Numerous international organisations have noted on-going problems with corruption, not least within state-owned organisations due to political interference, in particular the banks. For example, NLB and NKBL provided loans worth 20% and 15% of their capital respectively to a financial holding company which was already in bankruptcy, a move which likely had political motivations.15 At the start of the year, numerous leading politicians, including the former Prime Minister Janez Jana and former Head of the opposition Zoran Jankovi, were forced to resign because of a scandal over failing to reveal all their assets and interests.16 Will Slovenia need a bailout? Slovenia will likely need some form of EU assistance. However, this will probably not come in the form of a standard bailout package. Given that the problems are predominantly with the banks we expect any lending to be focused on the financial sector but only after senior creditors have been bailed in. This is less likely to extend to uninsured depositors17 than in Cyprus, for two reasons. Firstly, there is more debt to be bailed in (around 2.4bn, equal to 37% of NPLs, whereas in Cyprus it was negligible) and secondly, the issue of illicit, rich foreign deposits being bailed out will not arise (although corruption could be a concern). As in Spain, a bad bank is likely to play a key role in the policy to deal with problems in Slovenia. At the end of 2012, the Slovenian government set up a bad bank, the Bank Asset Management Corporation (BAMC).18 The BAMC has the ability to absorb up to 4bn worth of non-performing assets from Slovenian banks in exchange for government guaranteed bonds. This is a positive step. However, as the OECD noted this week, given the size of the NPLs (6.5bn) its scope and firepower may need to be widened. Meanwhile, attracting private investment will be difficult without some direct cash injection from the government (this is likely where eurozone assistance will come in). As with all bad banks, the key remains the value at which the assets are transferred to the bad bank if they are overvalued they will store up losses in the future, which will (in the end) fall on government books. If this is not established by a comprehensive outside stress test, it is likely the values will be distorted by political incentives. The format of the policy is likely to be a widespread bank restructuring, with a large amount of assets being shifted to the bad bank. Parts of state owned banks will be sold off while there will likely be some bail-in of creditors at good banks the bad bank is not a substitute for the recapitalisation of the good banks which will still be needed. External assistance may be needed to help finance the bad bank or smooth over government financing in the interim. This could total somewhere between 1bn and 4bn (between 3% and 11% of Slovenian GDP).

14

For details on Slovenian government debt, see the Ministry of Finance website: http://www.mf.gov.si/en/investor_relations/government_securities/ 15 OECD, Economic Surveys Slovenia, April 2013. 16 For more details see the Slovenian Commission for the Prevention of Corruption: https://www.kpk-rs.si/en 17 Uninsured deposits here refer to deposits over 100,000. Insured deposits below that l evel are very unlikely to be touched. 18 Slovenian Ministry of Finance newsletter, 2 December 2012: http://www.mf.gov.si/fileadmin/mf.gov.si/pageuploads/Invst/Newsletter_RS_2-12_2012.pdf