* Slovenia trying to avoid bailout, investors seek signs of reform
* Transformation from communism to market economy half finished
* Govt faces resistance to austerity, privatisations
* Banks central to changes
By Michael Winfrey and Marja Novak
LJUBLJANA, April 22 Igor Luksic, leader of the Social Democrats in Slovenia's ruling coalition, disagrees with the European leaders who say his country should privatise its three biggest lenders to avoid the misery of another bailout in the euro zone.
The political science lecturer who has lined his office with portraits of Martin Luther King, John Kennedy, Mahatma Gandhi and Che Guevara said his party would fight the move.
"We have always been against selling banks," said Luksic, whose party is the second largest in Prime Minister Alenka Bratusek's government.
The banks in the Alpine former Yugoslav republic of 2 million people are a key reason why it showed up on the agenda of Friday's Dublin meeting of the bloc's 27 finance ministers on preventing a new eurozone debt crisis.
"Slovenia is facing serious challenges," EU Economic and Monetary Affairs Commissioner Olli Rehn told Reuters on Thursday, calling for decisive action to restructure and recapitalise the banking sector among other urgent measures.
Financial market pressure on Slovenia has lain bare how this tiny euro zone state achieved Europe's smoothest transformation from a Communist economy to a market-based model: it only went half way.
While former Soviet satellite states like Poland and the Czech republic privatised big firms, slashed budgets, and pushed through other reforms, Slovenia held on to public assets, avoided cost cuts and repeatedly bailed out state banks after escaping the violent breakup non-aligned Yugoslavia in 1992.
That has now become a liability for Bratusek who, after last month's chaotic rescue of Cyprus, is scrambling to stop a spike in Slovenia's borrowing costs and convince investors it can change its ways and avoid insolvency.
Bratusek, who took power only four weeks ago, has pledged to break taboo by imposing unpopular austerity measures and selling at least one of the publicly owned companies that make up as much as half of the economy, and possibly a bank.
Luksic stopped short of threatening to quit the coalition if it privatised the banks, but the cabinet has not rejected its predecessor's plan for Ljubljana to keep blocking stakes in the main two ones, which experts say will prevent their sale.
The coalition of parties whose members range from neo-liberal centrists to leftists, is not united on other reforms either, and may face staunch opposition from voters.
"Slovenia did not embrace reforms because it did not have to," said Borut Hocevar, an analyst at the daily Finance.
"Everything seemed fine on the surface until a few years ago but now it is clear that banks were used as a tool of political and economic elites and that Slovenia would be much better off if it had sold them a while ago."
From its immaculate highways to the trendy shops and bars in its capital Ljubljana, Slovenia resembles developed EU states like Austria and Germany far more than its ex-Communist peers.
With living standards measured at 84 percent of the EU average, it has leapfrogged euro zone laggards Portugal and Greece and enjoys more than twice the standard of Serbia, from which it split when it left the former Yugoslavia in 1991.
But, following a nasty downturn and spike in the budget deficit, its once enviable debt levels have doubled to 54 percent of gross domestic product.
Last week the Paris-based Organisation for Economic Cooperation and Development (OECD) warned the debt level, fuelled by the cost of saving Slovenia's banks plus healthcare, pension, and other costs, could reach 100 percent by 2015 if Ljubljana does not embrace reform.
Luksic acknowledged his party might not prevail in its attempt to stop the banks being privatised but said at the very least the biggest bank Nova Ljubljanska Banka or NLB, should stay in state hands, since it could become a big regional bank.
"This is the tool that the state, as a national state, should use for promoting its perception of how the state should develop," he said.
Foreign institutions have for years criticised successive governments' for stifling competition and investment and say it has avoided painful reforms that its regional peers embraced.
Spending by the state is about 50 percent of gross domestic product, one of the highest levels of the OECD club of wealthy countries. Governments have also repeatedly rejected foreign bids to buy state-owned firms, most recently killing the sale of leading grocery chain Mercator to a Croatian rival in 2011.
Protecting national interests, diplomats, business leaders, and others say, is also tangled with corruption and cronyism in Slovenia's small ruling elite and will be a hard habit to break.
"Whenever they want to keep something because they are connected in some way with the business or a certain group of people because they have interests in those businesses, they always throw up this concept of national interest, when really it's personal interest," a Western diplomat told Reuters.
"Everyone has convinced themselves that it's truly in the best interest of the country to work in this way, because it worked for 20 years and they were the model for the rest of the former communist countries," said the diplomat who declined to be identified.
The combination of state ownership, a tight-knit political network, and bad management helped trigger the lending spree from state banks that, following a collapse in real estate prices, has gone sour.
Bratusek plans to shift some of the 7 billion euros in bad loans choking mostly the banks NLB, Abanka Vipa, and Nova KBM, in which the state is either the majority or a strategic stakeholder, to a "bad bank" in June.
The government must then pump some 1 billion euros of new capital into them this year - the OECD says maybe much more - with the aim of selling them, even though bankers, analysts and diplomats say there are no prospective buyers for now.
It is not the first time the government has had to bail out its banks. It has injected capital into NBL - which needs an estimated 375 million euros this time around - on five separate occasions.
"It has been proven that foreign owners are better," said Tomaz Boltin, the head of Slovenia's banking sector union. Selling them "is the only way to cut the cycle in which banks are used to finance the political and economic elite," he said.
But it may be hard to convince voters. It was a wave of protests against austerity measures - and graft - that helped topple Bratusek's predecessor.
"I think the government should not sell banks and other state companies which are the property of us all," said Omar Beckanovic, a retired builder at Ljubljana's main open market.
Although Bratusek can find support for the measures from the centre-right opposition, parties within her own coalition could oppose them, which could destabilise her fragile cabinet.
Another risk is the role of plebiscites in Slovenia, where anyone can demand a vote to knock down a newly passed law by gathering 40,000 signatures. Unions have used them to attack laws on belt-tightening and state asset sales.
There are already signs Bratusek is softening on austerity. In talks with unions, her government has trimmed a plan to cut public sector wages to 158 million euros from some 255 million envisaged by the previous, right of centre, government.
Last week, it postponed a debate in parliament on the fiscal "golden rule" which calls for a balanced structural budget by 2015, and Luksic's party has said balancing the budget should take longer to shield poorer Slovenes.
Andrew Page, Britain's ambassador to Slovenia said reforms could require a significant shift. "The challenge here is not just to bring one or two political parties with the Prime Minister but actually to begin to change public perceptions."