LJUBLJANA (Reuters) - Slovenia, trying to avoid becoming the euro zone's next bailout victim, may have "significantly" misread the cost of fixing its troubled banks, the OECD said on Tuesday.
Following last month's messy rescue of Cyprus, the country of 2 million perched on Italy's northeast border is facing intensifying market pressure while seeking funds to heal its state-owned financial sector.
The Organisation of Economic Cooperation and Development, a 34-member club of wealthy states, said Slovenia should save state-owned banks that were viable and sell them into private hands and allow those that were not to fail.
According to an assessment made last year, the local banks, mostly state-owned, are burdened with 7 billion euros, or a fifth of Slovenia's annual output, in bad loans.
The country risks falling behind in its race to catch up with Western living standards, the Paris-based organisation said.
It predicted a second straight year of economic contraction, by 2.1 percent. It also noted public debt had more than doubled to 47 percent of gross domestic product since 2008 and said that could rise to 100 percent by 2025 with no new reforms.
Facing uncertain costs to bail out its lenders, continued pressure on its exports from the euro zone crisis, and a rise in lending costs after Cyprus's bailout, Slovenia had one of the worst economic outlooks in the OECD, the organisation said.
"Against this difficult background and with a possible further deterioration in the international environment, Slovenia faces risks of a prolonged downturn and constrained access to financial markets," the OECD said.
It recommended Ljubljana increase the powers of the competition office, gradually raise the pension age, wean wealthier citizens off family benefits, cut unemployment and other benefits and improve efficiency in education and healthcare.
Slovenia is the only ex-communist European Union state that declined to sell most of its banking sector into private hands, a strategy that led to political influence, mismanagement and disastrous lending that has now put the lenders at risk.
"Slovenia is facing a severe banking crisis, driven by excessive risk-taking, weak corporate governance of state-owned banks and insufficiently effective supervision tools," the OECD said.
The OECD said last year's estimate of the level of bad loans in the banking system was outdated and created by methodology that was weak and non-transparent, so the real damage could be worse.
"Capital needs are uncertain and could in fact be significantly higher," it said.
It welcomed a plan to create a "bad bank" to take non-performing loans away from state banks but said "lack of transparency and potential political interference pose risks". It added that weak corporate governance and credit misallocation could potentially be attributed to corrupt behaviour.
It urged Ljubljana to launch new stress tests of the banking sector based on more robust methodology and publish the results, before recapitalising distressed but viable banks, preferably through share issues.
But it said market valuation showed equity in state banks had been "virtually wiped out", and banks that were non-viable should be wound down, with holders of subordinated debt and lower-ranked capital instruments absorbing losses.
The OECD then said Slovenia should then privatise the banks, and it criticised a plan being discussed by the current left-of-centre government for the state to retain a blocking minority, saying it could lead to political interference and new problems.
It said failure to pursue reforms pledged when Ljubljana tapped the dollar debt market last year could "significantly raise borrowing costs", as could a higher than expected bill for recapitalising banks. All of this put pressure on growth.
"Potential growth has fallen significantly since the outset of the crisis," the OECD said. "As a result, Slovenia is unlikely to resume the catching up towards more developed OECD countries soon."
Reporting by Michael Winfrey; Editing by John Stonestreet