"Slovenia is not out of the woods yet, a lot of work is still to be done," said Marko Kranjec, who sits on the European Central Bank's Governing Council and heads Slovenia's central bank.

The Balkan country, which joined the euro zone in 2007, is seeking to raise funds through privatisation and clean up its indebted banking sector.

Slovenia's economy shrank much more than expected in the first quarter, data showed on Friday, prolonging a recession that began a year ago and spelling more trouble for the two-month-old government's efforts to manage its debts.

The European Commission told Slovenia this week to bring its budget gap below 3 percent of gross domestic product (GDP) by 2015, on the assumption that the economy would shrink 2 percent this year.

But Friday's figures cast doubt on that. First quarter GDP shrank 4.8 percent year-on-year and 0.7 percent on the previous quarter, the state statistics bureau said. The jobless rate rose to 11.1 percent, from 9.6 percent in the previous quarter.

"Slovenia is in a sense in a position like Greece or Spain or Ireland ... in that the country itself has to pick up the pieces from a huge banking crisis," Michael Landesmann, a director of the Vienna Institute for International Economic Studies, told Reuters on the sidelines of a business conference.

The statistics office reported domestic consumption fell by 7.7 percent year-on-year and investment dropped a staggering 20.7 percent. But exports rose by 1.8 percent, the strongest result in the past four quarters.

Slovenia's banks, most of them state-owned, carry 7 billion euros (5.9 billion pounds) of bad loans - about a fifth of annual GDP.

"Presumably this (recession) will just put further upward pressure on non-performing loans," said Timothy Ash of Standard Bank.

The government is already planning to cut public sector wages by an average of 1.3 percent this year but will have to take more radical steps to squeeze the budget gap unless the economy picks up.

"This data just makes the adjustment that much more difficult - and the message to the authorities is that they cannot waste time on key issues like privatisation," Ash said.

Slovenia is scrambling to sell more than a dozen state firms, including the two largest banks, the national telecom and retail chain Mercator.

The European Commission has given it two more years to cut its deficit, hoping that will help it to avoid asking for help.

Speaking at a business conference in Bled, Kranjec said the state "should reconsider its role in many areas." He reiterated that he expected an independent review of the banking sector requested by the Commission to show the Slovenian central bank's estimates for bad loans were accurate.

He said the euro zone's crisis would last a while longer, but the political will to solve it was there.

(Reporting by Marja Novak; Editing by Ruth Pitchford)

By Marja Novak