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Eurozone crisis: survival of the fittest

Times are tough, as we have clearly seen over the past few years. ‘Black swan’ events are not infrequent anymore. Five years ago, who could have imagined sovereigns nearly going bankrupt and the Eurozone on the verge of collapsing? In this Business Briefing, we assess the different possible Eurozone break-up scenarios and their effect on the financial world. In particular, we highlight the considerations that corporates would need to take to survive in times of stress.

The financial crisis not only threatened the biggest companies and institutions in the world, but also nearly led to the default of some sovereigns. For example, Greece was eventually saved (at least for now) due to bailout regimes put in place by the ECB/EFSF. However, the question still remains, has the situation been resolved and if so, is the solution permanent?

Ahead of highlighting the impact of Eurozone break-up on corporates, let us first start with the basics around the potential euro break-up and its impact on financial markets.

Potential Eurozone break-up

There have been many discussions around the Eurozone crisis and based on the view of economists/strategists at Lloyds Bank, a euro break-up is likely to occur in the following scenarios:

  1. A disorderly break-up where the markets ultimately force the whole euro project to be dismantled:

    • Each country re-creates its own domestic currency and we return to the situation prior to the euro in 1999, with 17 currencies.

  2. An orderly break-up where there is an exit mechanism (opt-out) put in place for countries to leave the euro:

    • The option will likely be provided to rejoin if key entry criteria are met in the future.

    • The single currency will remain but with a reduced membership, increased economic integration and a significant support mechanism to transfer resources from the strongest members at times of financial and budgetary stress.

  3. Major countries such as Germany and a core group leave the euro to create another currency, for example a euro II or DM zone:

    • There will be a sharp re-valuation of the new currency, which would have serious economic effects on exports and the banking sector. This could hit internal and external competitiveness, leading to an increase in unemployment. The ECB would potentially need to be replaced.

    • However it seems unlikely that Germany would leave the Eurozone in this way, especially given the political and financial gains achieved as a result of the European integration and drastic consequences due to the exit, for their neighbours.

Table 1: The relative likelihood of default (relative to Germany)

Aug-06 Aug-11 Jan-12 Apr-12
Greece 1.02 59.30 1,079.29 1,974.7
Portugal 1.01 16.71 77.94 82.97
Ireland 0.99 10.62 42.51 44.93
Italy 1.02 4.75 29.15 28.76
Spain 1.00 4.66 19.97 31.11
Belgium 1.00 3.17 14.24 11.46
France 1.00 1.55 5.47 8.20
Austria 1.00 1.55 8.02 6.90
Finland 1.00 1.22 2.12 3.85
Netherlands 1.00 1.19 1.41 3.89

Source: Bloomberg, Lloyds Bank Wholesale Banking & Markets (Apr 2012).

Countries most likely to leave the Eurozone

With the uncertainty around the Eurozone in mind, the next question that arises concerns the countries that could be expected to leave the Eurozone, in the event of an orderly break-up.

Table 1 highlights the likelihood of default rates for the countries in the Eurozone calculated as the spread between the two-year bond yields of the country against Germany (considered a safe haven within the Eurozone).

Table 1 illustrates the dramatic increase, over the last five years, in the near-term default risk. For instance, even though Greece and Germany carried essentially similar risks back in 2006 (pre-crisis), Greece is now estimated to be nearly 2,000 times more likely to default on its debt.

Based on the table and considering the likelihood of default for the countries within the Eurozone against Germany, Lloyds concludes that Greece, Portugal and Ireland (in that order) are most likely to potentially leave the Eurozone. However as mentioned earlier, if that were to happen and they satisfied the key entry criteria in the future, they could potentially re-join the Eurozone.

Impact on currencies on leaving the euro

Now that we have established the most likely countries to leave the euro, the question is what happens next? On leaving the Eurozone, the currencies of the stressed sovereigns are not expected to suddenly gain momentum and provide a safe haven. The question still remains: how bad can things get?

Chart 1: New currencies in Greece and Portugal face significant depreciation
Chart 1: New currencies in Greece and Portugal face significant depreciation

Source: Lloyds Bank Wholesale Banking & Markets (Mar 2012).

Chart 1 highlights the potential intensity of depreciation for the newly created non-euro currencies such as Greek drachma, Portuguese escudo and Irish punt.

Based on the chart, the new Greek currency could be subject to a devaluation of up to 50% in the short-term, with counterparts in Portugal and Ireland depreciating by slightly less at around 40% and 15%, respectively.

The estimates are based on macroeconomic fundamentals pre and post euro entry for modelled (synthetic) euro/drachma, euro/escudo and euro/ punt exchange rates. This includes relative prices to account for relative competitiveness and debt/GDP ratios, on two standard errors (a range made likely by the potentially severe financial market response to any potential euro break-up).

Chart 2: Relative currency valuations for remaining euro members, based on unit labour costs
Chart 2: Relative currency valuations for remaining euro members, based on unit labour costs

Source: Lloyds Bank Wholesale Banking & Markets (Mar 2012).

Chart 2 shows the degree of over and under valuation for the remaining constituent members of the euro, based on relative unit labour costs since their entry to the single currency.

On the face of it therefore, one potential implication of weaker countries leaving the euro area is an appreciation of the resulting euro, of around 10%. This is however based on the macroeconomic fundamentals. In the event of the break-up, foreign exchange rate markets could price differently into the new exchange rates, to encompass the risk of further slippage.

Chart 3: Impact on GBP/EUR in an orderly Euro breakup scenario
Chart 3: Impact on GBP/EUR in an orderly Euro breakup scenario

Source: Lloyds Bank Wholesale Banking & Markets (Mar 2012).

Let us now look at the impact of euro break-up on another major G7 country, such as the UK. Chart 3 compares Lloyds Bank’s latest base case forecast with the break-up scenario of the euro, where one or more members orderly exit the single currency over the next quarter. The chart highlights the implications of the break-up on GBP against EUR taking the potential market sensitivity into account.

Based on the chart, in an orderly break-up scenario GBP/EUR could rise to 1.63 at the time of euro break-up (assumes end of Q3 2012) before easing to 1 54 early next year. This compares to the Lloyds Bank’s base case forecast (assumes no break-up of the euro) of GBP/EUR at 1.22 at the end of Q3 2012 and 1.20 at Q1 2013.

If the break-up of the euro was more fractious and disorderly, the actual trading levels could be even more pronounced than current estimates.

Impact of euro break-up on corporates

Any corporate with Eurozone exposure could potentially be impacted by a break-up of the Eurozone, potentially resulting in an erosion of their profit and balance sheet.

This would of course warrant a review of a more robust risk management strategy particularly focusing on issues highlighted below:

1. Impact on sales and purchases

  • Risk from the corporate customers and suppliers due to disruption in sales and purchases (potential drop in volumes), potentially leading to foreign exchange changes on cross-border trades.

    • Any potential long-term euro appreciation, as the peripheral countries drop out, could be beneficial from a euro denominated revenue perspective (when translated for instance into GBP for a UK company). However this could also lead to an increase in the euro denominated suppliers’ costs.

    • Any potential euro depreciation in the short-medium term, due to uncertainty around euro sustainability, could potentially lead to a decrease in revenues when translated into GBP but benefit due to the decrease in euro denominated cost of sales.

Checklist 1

  • Review and potentially amend the duration on the supplier contracts, allowing the possibility of including the new non-euro currencies.

  • Consider supplier diversification.

  • Have sufficient liquidity to cover for any shortfalls.

  • Update/amend accounting systems to cope with redenomination of accounts with new currencies.

2. Redenomination of euro derivatives

  • Hedged position might become un-hedged due to conversion to a new currency, hence increasing volatility on the corporate’s key metrics.

    • On the other hand if there is no volatility on the corporate’s business performance when the markets have been unpredictable, the hedged position might become over-hedged.

  • Potential loss of value for in-the-money derivatives.

  • Potential mismatch in assets and liabilities increasing volatility on the corporate’s balance sheet.

  • Legal implications on negotiations and restructuring of any hedging facilities.

  • Hedge accounting issues such as a decrease in hedge effectiveness.

Checklist 2

  • Hedge naturally by matching assets against liabilities.

  • Use option based strategies to hedge any cash flow uncertainty.

  • Regular monitoring of derivative valuations.

  • Evaluate the impact of un-hedged exposure on key performance indicators.

3. Potential loss due to bank defaults/downgrades

  • Potential loss due to bank default (following the sovereign crisis) on deposits, money market instruments, debt facilities and in-the-money value on derivatives.

  • Shorter pool of liquidity due to bank downgrades by rating agencies.

  • Increase in hedging related costs by the banks in the event of bank downgrades, in addition to revised collateral agreements.

  • Legal implications on negotiations and restructuring of facilities.

Checklist 3

  • Diversify the exposure to reduce the potential systemic loss.

  • Measure counterparty credit risk/limits.

  • Potentially obtain collateral in the event of bank downgrades.

  • Review documentation including any potential legal implications on bank default/downgrades.

4. Limited financial flexibility

  • Limited bank credit availability and reduction in euro financing sources.

  • Mismatch between assets and liabilities due to limited funding sources from the Eurozone.

    • The situation could potentially arise when the assets remain in euro denominated countries but the funding is in the new non-euro countries, or vice-versa.

Checklist 4

  • Assess future funding requirements.

  • Use any current undrawn committed facilities.

  • Potentially match liabilities to underlying assets by moving debt closer to the assets.

5. Potential capital disruption issues

  • Capital trapped within some Eurozone countries may become subject to exchange restrictions.

  • Legal implications on negotiations and restructuring of facilities.

Checklist 5

  • Have a cash and liquidity management plan in place.

  • Review the capital structure on the consolidated basis as well as separated by the potentially strong/weaker Eurozone countries.

  • Understand the impact of euro break-up on key credit metrics such as covenants and rating triggers, and the inter-dependence on the corporate’s cash flows.

  • Diversify the asset portfolio by potentially moving cash to countries with potentially less strict exchange controls.

Conclusion

The impact of euro disintegration is not an easy question to answer. In fact, it raises more issues, such as:

  • New legislative changes for a country leaving the Eurozone to limit the impact on the current euro denominated contracts and provide for the new non-euro currencies.

  • Enforcement of stricter exchange controls for the new countries to limit the exit of local capital.

  • Possibility of further economic and financial uncertainties leading to market volatility and possibility of hyper-inflation/deflation scenarios.

  • Possibility of a scenario where the market could potentially price in extreme volatility events on their instruments.

  • Additional regulatory constraints on instruments.

In summary, it is very difficult to answer exactly what could happen in a euro break-up scenario, but it is possible to outline how the corporates should prepare to minimise the impact.

The potential collapse of the Eurozone could result in many different scenarios but as a foremost step, the corporates would benefit from evaluating their current risk management approach by:

  • Assessing the historical effectiveness.

  • Determining the risk exposure under different break-up scenarios.

  • Identifying key areas of concern.

  • Designing a new risk management strategy.

Lloyds Bank Wholesale Banking & Markets

Lloyds Bank Wholesale Banking & Markets, part of Lloyds Banking Group, provides comprehensive expert financial services for businesses, from those in excess of £15m annual turnover, to those with a turnover in the billions. We have over 26,000 corporate clients, ranging from privately-owned firms to FTSE 100 PLCs and multinational corporations to financial institutions.

We have a network of relationship teams across the UK, as well as internationally, who have the mix of local understanding and global expertise necessary to provide long-term support and advice to our customers.

Lloyds Bank offers a broad range of finance, covering structured and asset finance, import and export trade finance, securitisation facilities and capital market funding. Our product specialists provide bespoke financial services and solutions including tailored cash management, international trade treasury and risk management services.

Contact details:
Jyotsana Bindal
Associate Director
Financial Risk Advisory
+44 20 7158 2065
Lloyds Bank Wholesale Banking & Markets