By Geri Westphal
It’s not looking good in the eurozone. Despite some recent positive news, treasurers should continue sprucing up their contingency plans.
Although Spain lately is elbowing its way to the front of the pack in the race for Europe’s Most Troubled Country award, Greece continues to pose the largest single threat to the global financial system. This is not only from the fear of a Greek exit from the eurozone, but perhaps more importantly, from the fear of unintended consequences as a result of the contagion effect in the global markets.
Recently discussed at The NeuGroup Treasurers’ Group of Thirty-2 (T30-2) spring meeting was the next major “headline” date of June 17, a new round of Greek elections take place. Results from the earlier elections on May 6, 2012, were far more negative than expected—the results highly skewed toward “anti-austerity,” with nearly 70 percent of voters choosing this as their preferred platform. The two main incumbent parties were dealt significant losses with both PASOK (Socialist) and New Democracy (Conservative) getting only 32 percent of the vote, compared to 77 percent in 2009.
Most Greek voters have identified themselves as pro-Europe, but want anti-austerity, which is a bit like saying, “I love this game, I just hate the rules.” At the moment, Greece does not have a government capable of managing through the necessary debt restructuring to save the country from disaster. The fear is that any new government will also be ill-equipped for the daunting challenges ahead.
But it’s not all negative news and there has been progress made by Greece to take positive steps toward fiscal responsibility. The most recent debt restructuring reduced the private sector holdings from 66 percent of total debt to 32 percent of total, and increased public sector holdings from 34 percent to 68 percent.
Despite these positive changes, Greek solvency concerns remain. A breakdown of the March 30, 2012, €800bn European Union rescue fund “firewall” shows that of the €800bn announced, nearly €300bn had already been spent, leaving an effective firewall of €500bn, against an overall potential need of €900bn.
Greece is not only likely to exit the euro, but because of the uncertainty of the new government, it is likely to exit into a politically volatile situation. The real risk is that Greece exits too soon, well before the technical issues are sorted out for an orderly exit. The markets can absorb the resulting Greek restructuring, but would not be able to absorb a sudden, knee-jerk exit without first dealing with technical issues such as revaluing the drachma, restructuring ATMs and undoing all of the changes that were made for euro functionality. The need for a thorough, well-thought-out contingency planning for a Greek exit is not only prudent but necessary. (Are you ready? See related story IT February 2012.)
FEAR OF CONTAGION
The biggest threat of a Greek exit from the euro is the potential Eurozone contagion, and beyond that the unanticipated negative impacts to the global financial markets. What will Greece’s exit do to Italy, Spain and other troubled European countries? Will the market grab hold of the bad news and drive the euro into the ground?
“I do believe Greece will leave the euro, the question is when,” said one bank strategist, echoing what many observers think. “When you look at European tail risk, the focus is on the exit country, while there should be more attention on the vulnerability of the system as a significant source of contagion risk.”
On May 28, 2012, the Wall Street Journal reported that Spain’s borrowing costs had reached an all-time high, prompting a new call from Prime Minister Mariano Rajoy for the European Union to take action and calm the market.
The focus has been on the exit country, when there “should be more attention on the vulnerability of the system as a significant source of contagion risk.”
One would expect that other eurozone countries are preparing their contingency plans in the event a domino effect starts to occur. The Wall Street Journal has reported that Switzerland is considering capital controls to “fight a sharp rise in the Swiss franc in the event of a euro-zone collapse.” Much attention is being given to the potential negative consequences of a Greek exit.
THE MECHANICS OF A GREEK EXIT
The bank strategist suggested that there is a great deal of uncertainty in the timing and impact of each of the steps outlined below. The first major impact comes from the capital controls that will go into place immediately upon exit. How long and how widespread the capital controls will be is uncertain. Banks will freeze business and lock their doors so money can’t go in or out. The creation of a new currency with an immediate massive devaluation is the next major market event. We have historical examples to point to as indicators, but the real impact of a Greek devaluation is expected to be between 50-70 percent.
These historical events will undoubtedly send shock waves around the globe. The real question is the depth and duration each step will take. At this point it is likely too late to hedge tail risk, but hopefully treasurers have considered the various fallout scenarios and their contingency plans are teed up and ready to go.
The Pain in Spain
While Greece has been grabbing the headlines as the most troubled European country, Spain lately has been emerging as perhaps the real threat to the eurozone.
The problem is many of Spain’s banks are woefully undercapitalized, which is threatening the entire Spanish economy. At the end of May, one of Spain’s largest banks, Bankia, SA, reported it was in far worse condition than previously thought. Spain has announced it will pour about €19 billion into the troubled real estate lender. This follows €20 billion in aid already dispersed to financial institutions. Now authorities there are doing all they can to prevent bank runs on the country’s other banks. Many observers say a Spanish exit from the eurozone would have disastrous effects on the eurozone because its economy is much larger than Greece’s, its unemployment is more than twice the EU average.
As of this writing European officials are weighing a bailout program for Spain that would aid its fragile banking sector.