January 30 (SeeNews) - Fitch Ratings said it has downgraded Slovenia's long-term Issuer Default Rating (IDR) to 'A' from 'AA-' with a negative outlook while its short-term IDR was downgraded to 'F1' from 'F1+'.
The downgrade follows the Rating Watch Negative (RWN) placed on the sovereign ratings of Slovenia and five other Euro Area Member States (EAMS) on December 16, Fitch said in a statement on Friday.
The ratings agency also said in the statement:
"[...] The RWN was initiated in response to concern over the lack of clarity on the ultimate structure of a fundamentally reformed Economic and Monetary Union; the risk of self-fulfilling liquidity and even solvency crises in the absence of a fully-credible financial 'firewall' against contagion; and the significant negative external shock to the region's economy from the prolonged nature of the eurozone systemic crisis.
The two-notch downgrade of Slovenia's sovereign ratings primarily reflects two factors:
- a re-assessment by Fitch of the potential financing and monetary shocks that members of the eurozone face in light of the increasing divergence in economic, monetary and credit conditions and prospects across the region, which is also a factor in the downgrades of some other eurozone sovereign governments;
- the continued deterioration in the financial position of Slovenia's banking sector.
The intensification of the eurozone crisis in the latter part of last year and the funding stress faced by the Slovenian government and financial sector, albeit since eased by ECB's three-year Longer-term Refinancing Operations, highlight the continuing risks posed by the absence of a fully credible framework for providing financial support to solvent but potentially illiquid sovereigns. Moreover, the divergence in monetary and credit conditions across the eurozone and near-term economic outlook highlight the greater vulnerability to monetary as well as financing shocks faced by eurozone sovereign governments. One notch of the two-notch downgrade of Slovenia reflects this systemic weakness that only a more fundamental reform of Economic and Monetary Union can address.
A further one-notch cut is driven the continued deterioration in the financial position of the banking sector, which has now made a loss for the past two years, and still poses a significant risk that the sovereign will need to contribute heavily to future bank recapitalisation.
The political position remains unclear given the election produced an unexpected result, although it will probably ultimately lead to the return to office of an experienced former prime minister with a sound majority.
The deterioration of the financial position of the banking sector, as well as the defeat of the then government's flagship pension reforms, was the cause of Fitch's first downgrade of the Slovenian rating in September 2011. Asset quality is a concern following a sharp rise in non-performing loans (NPLs, which stood at 15.6% of customer loans at Q311).
The reported Tier 1 ratio for the banking sector was 10% at end-H111. However, this would fall to a low 3.8% if reserves rose to 80% of already recognised NPLs. Under Fitch's revised base case scenario, the banking sector will require EUR3.1bn of new capital (of which about EUR2.5bn, or 7% of GDP, would relate to domestic banks). This scenario assumes a sector Tier 1 ratio of 10%, NPLs rising to a peak of 18%, a further 50% write down of equity holdings and NPL reserve coverage of 80%. If NPLs were ultimately to rise to 25% (an unlikely, but not implausible scenario in the agency's view), capital requirements could rise to EUR5bn, including approximately EUR4bn (11% of GDP) for domestic banks.
The banking sector is also exposed to heightened funding pressures in view of the current negative sentiment towards euro area banks and its own high loans-to-deposits ratio, which was 150% at end-Q311, which highlights the dependence on foreign financing. ECB funding does provide a potential buffer, but is not a long-term solution to the banks' problems.
Fitch estimates the 2011 general government budget deficit at 5.7% of GDP, taking into account preliminary state budget outturns. This would represent significant slippage compared with the original budget target of 4.8%, and a slight widening from 5.4% in 2010, rather than consolidation. This would give an average deficit of 5.6% of GDP over 2009 to 2011, which is well above the much smaller deficits achieved every year in the previous decade and a half. Fitch estimates the public debt ratio rose to 45% of GDP at end-2011, from 22% at end-2008, and expects it to reach 52% by the end of this year.
Slovenia's once firmly held reputation for fiscal rectitude lies in the balance and the next government will need to implement fiscal consolidation measures to re-establish the country's fiscal credibility. The caretaker government has introduced a freeze on transfers to households and public sector wages. If this holds as intended to June it would be positive for the fiscal position as does the government's latest efforts to strengthen the fiscal legislative framework. Robust economic policy, however, depends on a strong elected government to impose it. The expected five party coalition may be that government. The government has some access to markets - it was recently selling 18-month T-Bills, presumably to domestic banks. Its ability to tap international markets in the current environment is untested.
Pension reform remains highly important. Attempts to alleviate the existing and projected rising burden (from 11% of GDP in 2009 to 17% of GDP in 2060) brought down the last government and will be an ever present threat to the next. New reform proposals are still required from the incoming government and could be placed before parliament after June 2012, but Fitch is not optimistic of a successful reform given the likely inclusion in the government of the Pensioners Party.
The economy appears to have grown by about 1% in 2011 and is now stagnating. Real GDP is unlikely to grow this year and recovery in 2013 depends on a broader euro zone advance. The outlook for international trade is particularly uncertain. Fitch has assumed a current account balance close to zero but as a small, open economy, Slovenia is relatively vulnerable to a sharp slowdown in eurozone growth.
The Negative Outlook mainly reflects the condition of the banking sector as well as the risk that the eurozone crisis could intensify further. Greater than anticipated increases in NPLs and recapitalisation requirements in the banking sector could lead to further negative rating action. A failure of the government to provide timely support, if required, would also be negative, as would heightened funding pressures. Material fiscal slippage could also lead to negative rating action. Positive rating action could result if a new government takes appropriate action to restore fiscal discipline and reduce debt and if there is a moderation in the eurozone crisis."