By Michael Winfrey and Marja Novak
LJUBLJANA (Reuters) - Slovenia's struggle to avoid joining the euro zone bailout line intensified on Tuesday after the OECD said the country may have underestimated the cost of cleaning up its banks and a debt auction went awry.
Following last month's messy rescue of Cyprus, the country of 2 million perched on Italy's northeast border is seeking funds to heal its state-owned financial sector and has come under increasing pressure from markets.
Slovenia is not in immediate need of rescue, said Yves Leterme, deputy secretary general for the Organisation for Economic Cooperation and Development.
But in a damning economic survey, the Paris-based organisation said the country faces "risks of a prolonged downturn and constrained access to financial markets."
The first country to break away from the former Yugoslavia in the 1990s, Slovenia is the only ex-communist European Union state that had declined to privatise most of its banking sector.
"The problem with the banking system is problem number one in Slovenia," Prime Minister Alenka Bratusek told reporters in Brussels on Tuesday, adding the government would transfer a first tranche of bad loans to a "bad bank" in June.
"We will solve our problems alone," she added, saying Slovenia's strengths included a current account surplus and relatively low public debt.
The OECD, a 34-member club of developed economies, said Slovenia should sell state-owned banks that were viable and allow those that weren't to fail.
"The government of this country has been able to meet its financial needs without difficulties so far," Leterme said in Ljubljana while presenting a survey that assessed Slovenia's economic outlook as one of the worst in the OECD.
"It (borrowing) was at a relatively high cost (but) as far as we are concerned, there is no reason to anticipate an immediate need for a bailout," he said.
Still, in signs of growing investor caution, Ljubljana raised far less funding than planned and at higher costs at a treasury bill auction held after the OECD report and investors pushed the cost of insuring Slovenia's debt higher.
According to an assessment made last year, local banks, mostly state-owned, hold 7 billion euros (5.8 billion pounds), a fifth of Slovenia's annual economic output, in bad loans.
The Paris-based organisation predicted a second straight year of economic contraction, by 2.1 percent, citing the uncertain costs of bailing out lenders, poor demand from euro zone neighbours for exports, and higher borrowing costs after Cyprus's bailout.
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.
"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.
Investors pulled back slightly. The Finance Ministry sold only about half of the 100 million euros it sought to raise at an auction, and paid yields on one-year bills of 2.99 percent, an increase by almost half from a February sale.
Five-year credit default swaps on Slovenian government debt rose 8 basis points to 336 bps, according to data monitor Markit, meaning it cost $336,000 a year to buy $10 million of protection against a Slovenian default.
ENOUGH CASH TILL AUTUMN
Analysts said Slovenia could still avoid a bailout, but that could not be taken for granted. Finance Minister Uros Cufer said last month it had enough cash to last until autumn.
Cufer did not respond specifically to the recommendations in the OECD report, but he made what his office said was a general comment on the report: "We need to be aware of the fact that the phase of analysis and tests has already taken too long and that this is the time to act."
The OECD said Slovenia now faces "a severe banking crisis, driven by excessive risk-taking, weak corporate governance of state-owned banks and insufficiently effective supervision tools."
It said last year's estimate of the level of bad loans in the banking system was outdated and used weak methodology, so "capital needs ... could in fact be significantly higher."
It welcomed the "bad bank" plan 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. The OECD urged Ljubljana to put the banking sector through tougher tests and publish the results, then recapitalise 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 weren't viable should be wound down, with holders of subordinated debt and lower-ranked capital instruments absorbing losses.
Banks that could be recapitalised should then be privatised, the OECD said. It criticised a plan being discussed by the left-of-centre government for the state to retain a blocking minority, saying it could lead to political interference.
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 the economy.
(Reporting by Michael Winfrey; Editing by Ruth Pitchford)