Treasury Today Country Profiles in association with Citi

Preparing for the worst

Building statues during sunset

The recent election of the left-wing anti-austerity party Syriza has everyone speculating once again on the future of the Eurozone’s embattled periphery. What’s more, the latest episode of Greek turmoil comes at a time when businesses are already feeling uneasy about the deflationary forces that are appearing to take hold in Europe. Here we ask a treasurer, an economist, a banker, and a corporate ratings analyst how they see the situation developing, and what corporates can do to minimise the impact should events take a turn for the worst.

“What’s the worst that could happen?” That’s a question all conscientious corporate treasurers need to ask themselves every once in a while. Exceptional risks with potentially catastrophic consequences, however improbable, must always be considered; then, once thought through, contingency plans should be drafted and filed away, with the hope of course, that they will never be needed.

Corporate treasurers have received plenty of reminders of the need for such planning since the beginning of the year. The Eurozone crisis is back after several years of respite. And there have been numerous occasions over the past several months in which treasurers may have felt the need to get reacquainted with those earlier prepared Grexit contingency plans (circa 2012); the same plans, of course, which have been gathering dust ever since Mario Draghi bought some time with his famous “do whatever it takes” speech.

“When people see increased volatility there is a natural tendency to hedge more. But if you follow that line of thinking and start hedging further forward, the corporate may find themselves in a situation where the market moves against them.”

Yuri Polyakov, Head of Financial Risk Advisory, Lloyds Bank

To be clear, even in the immediate aftermath of the Syriza election victory, when speculation around Greece’s future in the Eurozone project was at its height, most political analysts and economists thought that Greece will not, on the balance of probabilities, be leaving the euro in the immediate future. “At this stage, we see the risk of Greece leaving the euro as small,” says Adam Chester, Head of Macroeconomics, Commercial Banking, at Lloyds Bank. “It is difficult to make any strong statements at this stage about what the election in Greece means, because negotiations between Greece and the so-called Troika are likely to be ongoing over the next few months. But I think the markets have taken some comfort from the rhetoric that has come out since the election that suggests while [Syriza] are very much looking to reverse some of the austerity measures, they are also very much wedded to staying in the single currency.”

Yet, the recent election of this new, left-wing, anti-austerity government in Athens who are now appearing to engage in brinksmanship in their negotiations with the “Troika”, means it is a possibility that must at least be considered. Even after February’s apparent ‘breakthrough’ in negotiations (the striking of a deal that will extend the current bailout deal for another four months) the fact remains that this crisis, as it was three years ago, is far from resolved. It is likely that the European authorities, particularly the European Central Bank (ECB), will continue to be tireless in their efforts to keep Greece in the single currency. The problem, notes Philippe Gelis, CEO of foreign exchange provider Kantox, is that there are limits to what central banks can influence. For evidence of that, look no further than what happened recently to the Swiss franc. “I’m sure that the Swiss national bank wanted to maintain the CHF peg with the euro,” says Gelis. “But what they realised was that it was no longer possible for them to go on buying euros and printing CHF. I think it could be the same with the ECB. They will not accept a ‘Grexit’, but if at some point it becomes unsustainable, then who knows?”

If that scenario were to play out it is not difficult to imagine, especially with the pressure other nations in the periphery would come under, it precipitating a complete loss of investor confidence in the euro. Some commentators are already speculating that such an event would send the single currency plummeting, potentially, to levels against the dollar not seen since in the history of the currency. It is easy to see why, then, Gelis’s clients have expressed grave concerns about the situation to him in recent discussions. “If this happens, we will probably see for the first time the euro being equal to one dollar,” says Gelis. “Clearly, a Grexit would see the euro lose a lot of value.”

A ‘lost decade’?

Greece or no Greece, the Eurozone economy remains in an incredibly perilous position at present. After growth ground to a halt in mid-2014, analysts do not expect to see any meaningful rebound in GDP in the year ahead. A research report published by Bank of America Merrill Lynch (BofA Merrill) at the end of last year, for instance, forecasts 1.3% GDP growth in 2016 – up just 0.1% from 2015 – and CPI inflation to average 0.5%.

The big fear, of course, is that Europe might be heading into a deflationary spiral of the same sort that afflicted Japan during its ‘lost decade’, an economic mess from which it is only now emerging. Given that the ECB is now committed to a programme of quantitative easing this, analysts say, is also unlikely. According to the base-case of ratings agency Fitch, for example, we are facing a number of years of sub-targetd inflation not, thankfully, Japan-style deflation.

Analysts at Lloyds Bank concur. While the Eurozone is currently experiencing negative inflation, a sustained, broad-based fall in the general price level is not something they believe to be on the horizon. “We think it is largely due to the fall in energy prices that we’ve seen,” says Chester. “You cannot dismiss the risk [of deflation] if conditions in the Eurozone were to deteriorate markedly from here. But given the amount of stimulus that is now being poured into the Eurozone, both in terms of QE, the fall in energy prices, and the weakness of the currency, our forecast is that over the medium term prices will begin to rise again.”

However, if Europe does indeed slip into deflation – and clearly we must be conscious of the risk – what will the implications be for the region’s corporates? Obviously deflationary spells are negative for all businesses, regardless of size or sector. The real cost of debt rises, asset values decline and consumers defer spending on the grounds that a good or service might be acquired for cheaper tomorrow.

Even so, Mike Dunning, Head of European Corporates at Fitch Ratings believes that deflation poses a much greater risk for some types of business than it does others. “At one end of the scale, you’ve got large multinationals, the likes of Nestle and Siemens, who are diversified with core operations in strong economies,” says Dunning.

“It won’t be good for them, but it won’t be a dire situation either. At the other end of the scale, the small and mid-sized enterprise, we think will be hit very hard. Then in the middle, you’ve got corporates who are sitting in periphery countries which still need to rebalance following the sovereign debt crisis. We think they will be affected disproportionately, especially those in cyclical industries, because those economies are still struggling to emerge from recession and structurally rebalance so the impact of any deferral in consumption would be felt more acutely here than in Northern Europe.”

Corporates will not be completely bereft of options, should deflation begin to manifest itself in Europe in the next couple of years. Capital expenditure plans could be cut back to steady-state levels, for example, spending just enough to keep the business ticking over. Certain companies, those in research and development (R&D) heavy sectors such as technology will be faced with a very unenviable predicament, however: cutting capex might cost them their competitive advantage.

“We’ve seen that with Japanese tech companies. They lost momentum and missed a number of technological shifts that were occurring globally because they were not spending enough on R&D,” says Dunning. As such, companies in this sector would be closely monitored by the ratings agencies if deflation were to take hold.

These are budgeting decisions that reside outside of the treasurers remit, strictly speaking. However, treasurers should at the very least be cognisant of the options given that the strategy which is decided upon might, potentially, impact the whole spectrum of treasury activities from financing to risk mitigation and cash management.

In the dark

If there is one thing that is certain in Europe at present, it is uncertainty. With numerous central banks across the world now engaging in beggar thy neighbour currency policies – the ECB being but the latest to join the conflict when QE was announced – there remains a distinct lack of clarity around where the market might take us in the coming months or even years. We can see already how this is going to play out in the currency markets. According to recent research by BofA Merrill, realised FX volatility has now reached its highest non-crisis level in two decades (see Chart 1). The only other occasions in the past 20 years when the magnitude of currency swings have been higher were during the Russia and Asian crises of the late 1990s, and in the aftermath of the Lehman Brothers collapse.

Chart 1: GDP-weighted range-based FX volatility
Chart 1: GDP-weighted range-based FX volatility

Source: Bank of America Merrill Lynch Global Research

In such an unpredictable environment, any kind of extended hedging strategy in which a treasurer uses forwards to lock in the rates could be beneficial or could be detrimental and play against their competitive advantages, says Yuri Polyakov, Head of Financial Risk Advisory at Lloyds Bank.

“When people see increased volatility there is a natural tendency to hedge more,” says Polyakov. “But if you follow that line of thinking and start hedging further forward, the corporate may find themselves in a situation where the market moves against them. That’s a lesson a lot of companies learnt just recently, following the fall in oil prices. Airlines should be happy right now that energy prices have halved. On the other hand, if they have hedged in the past 12-18 months and are locked in at higher prices, the capacity to put in additional hedges now is very limited.”

These experiences could, Polyakov believes, lend more consideration to the case for an options-based hedging strategy. The question of whether corporates should use options, and in what circumstances, has long been a matter of debate in the world of corporate risk management, of course. Typically, there are two camps. On one side, there are those treasurers who argue that there is not enough transparency in option instruments and that, coupled with the accounting complexities, does not make them an ideal instrument for corporate hedging purposes. Other treasurers, meanwhile, take a more positive view. For them options are a useful instrument and have enough internal strength to be able to demonstrate to the board that there are certain situations in which they are the most suitable strategies to deploy.

The latter group’s case is becoming ever more difficult to counter with everything we are seeing taking place in the Eurozone at the moment. “I think in the current market conditions the case for considering options-based hedging is becoming stronger,” says Polyakov. Moreover, those who already use options are realising that they need to be smarter in the way that they use the instruments. Often, such instruments are most effective when only used to hedge the big moves in the market, rather than day-to-day volatility. “This calls for a risk management strategy which will clearly define the ability of the business to take a little bit of uncertainty, and only hedge the uncertainty beyond that,” he adds.

What’s the plan?

Options contracts are undoubtedly useful instruments in today’s uncertain markets. As we all know, there are some risks that derivatives cannot hedge, however. Greece leaving the Eurozone is one such example.

What is needed instead is good contingency planning, says Dimitris Papathanasiou, Coca-Coca HBC’s Financial Risk Manager. Coca-Cola HBC used to be headquartered in Athens but moved to Switzerland in April 2013 following the initial outbreak of the sovereign debt crisis. But with an operational footprint retained in Greece, the trauma of a Grexit and treasury’s options in terms of limiting the fall out is something Papathanasiou has given much thought to.

“There are many elements in a contingency plan that a corporate could look at,” he says. Perhaps the most important of these is cash. First and foremost treasurers would want all of their assets to be outside of the country (see Chart 2) – which is near impossible, of course – and would want external liabilities to be locally denominated. But there are a whole host of other areas that could be affected, from payment issues, to supply chain stability to credit issues with your customers. There is no ambiguity around what Papathanasiou deems to be the principle concern, however. “When putting together a contingency plan the big thing on your mind is how you can keep on working with a local banking system facing trouble,” he adds. “In general we try not to keep balances in the country. We have always used a centralised cash management pool, so fortunately we have a relationship only with highly rated international banks.”

Chart 2: Greece: renewed deposit flight

Bank deposits of households and companies, % yoy

Chart 2: Greece: renewed deposit flight

Source: Thomson Reuters Datastream; ABN AMRO Grup Economics

Before one can draft their plan, one must first understand the impact of events in question. This is of fundamental importance, suggests Lloyds’ Polyakov. “The one exercise I would encourage everyone to do is to assume it does happen and then try to understand the potential impact,” he notes. Take, for example, a treasurer at a European multinational with a subsidiary in Greece. If, after analysis has been performed, the treasurer concludes that revenues from that region will halve in the eventuality that Greece leaves the euro but the overall impact on company earnings is only marginal, the company may be in a position to take that hit. Meanwhile, if the data shows company earnings will be impacted significantly, a more protective strategy might be required.

“A good example is how people are dealing with what happened in Russia recently,” says Polyakov. “There are plenty of companies who have seen earnings in Russia halve. However, some of these same companies remain very focused on the market and a couple that have actually increased their inventory. They will tell you it’s about positioning and that they are prepared to take the volatility.”

“When putting together a contingency plan the big thing on your mind is how you can keep on working with a local banking system facing trouble.”

Dimitris Papathanasiou, Financial Risk Manager, Coca-Cola HBC

What does Polyakov believe the strategy should be to deal with risk events of significant impact? “If there is no way you can possibly hedge it,” he says, “you need to create enough liquidity and enough expectations management so that the company can withstand the shock and move on to redefine the strategy in the new environment. If it does happen, understand the impact, make sure you have enough liquidity, deal with it and move forward.”

Think the unthinkable

Yanis Varoufakis, Greece’s new and rather eccentric finance minister recently likened Greece’s position to the line in the Eagles Song ‘Hotel California’ in which Joe Walsh sings “you can check out any time you like, but you can never leave.”

The message was unmistakeable. Greece, he wants the world to know, is not going anywhere despite the rising speculation in the midst of negotiations with the Troika. Leaving the euro would just be too painful for all parties, not to mention difficult considering there is no mechanism in place for forcing a country out of the euro (nor, for that matter, to guide a country who wants to leave of its own accord). But like Victor Hugo once wrote in Les Misérables, “Nothing is more imminent than the impossible. What we must always foresee is the unforeseen.” That, particularly at this moment in time, would seem to be the perfect motto for corporate treasury professionals with interests in Europe.

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