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Forget Latvia. Slovenia is the next euro domino

June 7, 2013: 7:58 AM ET

The eurozone may be getting bigger, but that doesn't mean it is getting any healthier.

By Cyrus Sanati

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FORTUNE -- Slovenia may be the next domino to fall in the seemingly endless European sovereign debt crisis. The tiny alpine nation's economy has been ripped apart over the last few years thanks to rampant corruption, a banking crisis, and unsound fiscal policies. While a sovereign default isn't exactly imminent, it may be just around the corner, setting off a wave of discontent among investors in other European nations.

This week was supposed to be a happy one for the euro. Instead of getting smaller, as pretty much every pundit thought would happen by now, the 17-member currency club welcomed in a new member, Latvia. In Brussels, European bureaucrats were all smiles, taking the opportunity to bash eurosceptics. "Latvia's desire to adopt the Euro is a sign of confidence in our common currency," Olli Rehn, the EU commissioner for monetary affairs, told reporters in Brussels on Wednesday. "It is further evidence that those who predicted a disintegration of the Euro were indeed behind the curve and simply wrong."

But Latvia's accession into the euro club shouldn't be seen as a vote of confidence in the sickly common currency. The former Soviet republic has been banging to get into the currency club for years now, mostly in an attempt by the Latvian government to further distance itself both politically and economically from its former Russian overlords. In fact, Latvia really had no choice but to join the club given the terms of its entrance into the European Union in 2003, which states that it must join the Euro after hitting certain economic markers. Its currency has been pegged to the Euro since 2005, so for all intents and purposes it has been a de facto member of the club for years.

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The eurozone may be getting bigger, but that doesn't mean it is getting any healthier. Indeed, there remain pockets of economic trouble all around the continent: Spain's banks remain shaky; Italy's new government is reversing austerity measures; the Netherlands can't control its spending; and France remains delusional. With so many of the big eurozone countries in fiscal turmoil, it can be easy to overlook the issues bubbling up in the smaller countries on the periphery. But as we have seen with Greece, Ireland, Portugal, and most recently, Cyprus, big problems in small countries can quickly spin out of control, causing major financial disruptions across the eurozone.

One of those small countries that seems to be in some big trouble at the moment is Slovenia. That may be surprising given its reputation for being the "most Western" and economically stable of the former communist Eastern bloc, but Slovenia has some major issues that could eventually force it to seek a bailout from the European Central Bank.

At first blush, it doesn't appear as if the government has a spending problem, a la that of the likes of Greece or Italy. Its debt-to-GDP ratio stands at 53%, which is well below the EU average of around 90%. But the nation's economy is in free fall and shows no sign of recovering anytime soon. Its GDP has fallen by 10.6% from 2008, which is "one of the most severe falls in any Euro area economy," according to a report by Goldman Sachs. Domestic demand in the country has fallen even harder, down 20% from 2007. Lastly, export growth stalled last year as many of Slovenia's lead trading partners fell into recession. All this has resulted in a drop in tax receipts, which has forced the government to borrow more money at (relatively) high interest rates of around 5% to 8% to stay afloat. With the country's debt increasing and GDP falling, that below average debt-to-GDP ratio Slovenia is currently sporting will start to move up pretty fast.

Slovenia has a lot of issues it needs to resolve before economists can give it a clean bill of health. Unfortunately, some of them are so monumental that it seems impossible for the country to resolve on its own. Among the biggest hurdles Slovenia needs to jump over is a problem that its other Eastern European neighbors dealt with in the 1990s -- transition to a free-market economy.

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While Slovenia broke free of communism at pretty much the same time as the rest of its neighbors, its economy boomed to such a degree that it was able to skip many of the painful steps a country must go through when moving from a socialist to a capitalist state. For example, the state still controls much of the means of production, around 50% of the economy. Cronyism and bad management at the state-run firms have led to an inefficient economy. Corruption is rampant. For example, a recent study conducted by Ernst and Young found that 94% of Slovenes think bribes are a normal business practice. Tax dodging seems to be a big problem in the country, as well. In fact, the country's Prime Minister, Janez Jansa, was forced to step down earlier this year after it was found that he cheated on his taxes (he was sentenced to jail this week).

Slovenia's economic crisis has been categorized as a "banking" crisis, a la the likes of Spain and Ireland. But while the roots of the crisis in Spain and Ireland centered on bad property loans to the private sector, the roots of Slovenia's banking crisis centers on corruption and organized theft. It turns out the banks were lending money to people -- no doubt close "friends" of the government -- to buy stakes in state-controlled firms. It also did the reverse, finance management buyouts for people, again close friends of the government, who had stakes in state-controlled firms. The banks also loaned lots of money directly to Slovenian companies to either expand, or in some cases, to simply keep the lights on. Can't make payroll at the inefficient factory? Just borrow it from the bank.

All this borrowing has its consequences. The EU reports that the Slovenian (non-financial) corporate sector has an average debt-to-equity ratio of around 200% -- far and away the highest level of corporate indebtedness in the EU. Around 50% of the bank's loans outstanding were made to Slovenian companies, 30% of which are non-performing, analysts say. Slovenia reported this week that in total, around 20%, or one out of every five, of the nation's bank loans are non-performing. That number is almost certainly a conservative estimate.

The government is attempting to fill the hole in the banks' balance sheet by borrowing money from investors through the sale of government bonds. For this scheme to be successful, the government must be able to borrow enough money to: a) recapitalize its banks; b) cover its budget deficit; and c) to cover its old bonds -- much of which are rapidly coming due over the next few months.

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How are they doing with that? Well, in April the government went to the market to raise 100 million euros but only managed to sell around half that much. No one was interested. Then in May, Moody's downgraded Slovenia's credit rating to non-investment grade (i.e. junk). But miraculously, two days later, the country said it sold 3.5 billion euros of debt to eager investors. Who was the main buyer? Slovenian banks. So Slovenia's state-controlled banks essentially loaned money to the government which will be used to fill the hole in their own balance sheet. Really? Yes, really.

This is obviously unsustainable on a multitude of levels. But the solutions put forth by the EU aren't any better. For example the EU is pushing Slovenia to quickly sell off 15 state-controlled companies. Who would want to buy an inefficient and insolvent state-controlled company in a country where domestic demand is collapsing? Any transaction would be at fire sale prices, which will only serve to make a bad situation even worse. How? If, say, a U.S. company bought the nation's state-controlled grocer, Mercator, you can bet they will trim a lot of the government fat out. That means layoffs -- massive layoffs. That would send Slovenia's economy crashing.

There is no easy way to solve Slovenia's crisis. The EU is right to insist on Slovenia privatizing its state-owned industries, but it needs to be done slowly and thoughtfully, or else the country risks becoming even more corrupt and lawless. Think Russia, circa 1995 -- oligarchs, mafias, Western exploitation, etc.

At the same time, the government must also get control of its own spending. A good chunk of the money Slovenia borrowed in May was used this week to refinance 900 million euros of old state debt, which it issued back in 2011. With a short debt roll schedule, Slovenia will need more and more cash to stay afloat. While the country appears to have enough cash to make it through 2013, making good in 2014 could be a stretch, especially if the economy remains in the toilet.

It's probably a good bet that Slovenia won't be able to get through this crisis on its own -- the state or its banks will eventually need a bailout. While it may look as if things are safe on the surface, the situation could go from bad to worse in a blink of an eye. To be sure, Slovenia certainly won't bankrupt the EU rescue fund, but a sovereign default, no matter how small, is never a positive indicator. As such, perception here is key, and the faster the EU can control the situation, the better. Slovenia doesn't have to wait to be insolvent to ask for help -- it can do so at anytime. If Slovenia waits to go to the ECB when it is in ruins, investors will again associate dismal failure with the eurozone. But unlike the past, they may choose to take their money and put it elsewhere -- this time, permanently.

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