By Ted Howard and Joseph Neu
The eurozone is in trouble and treasurers must be prepared for any and all fallout.
The conventional wisdom about tsunamis has always been that if you could see one, it was probably too late to avoid being overtaken by it. This is what MNC treasurers want to avoid when it comes to the possible eurozone collapse. Up until recently many were in the camp of “It’ll never happen.” But as the chaos and contagion have spread around the continent, MNC treasurers are paying more attention.
The apprehension of course is whether the countries at risk will make the required, albeit difficult, changes to shore up their debt, reduce their spending deficits and restore economic growth prospects. European Union members are meeting as of this writing to reach agreement on a “grand bargain” on “fiscal union,” as the Financial Times put it. Grand solutions have been promised without success several times now. This means members giving up a bit of their sovereignty, which may not go over well.
Of course, that the EU is still bargaining at this late date is what has prompted a mood change: maybe they want come up with a solution in time. And the change in tone has been swift. Although it has been percolating in the back of treasurers’ minds for some time—and many have taken steps to mitigate their eurozone exposure—more recent events have sharpened their focus. As one NeuGroup peer group member pointed out, Greece was one thing—a likely easily managed problem if it failed. “But a country of more substance like Italy or Spain would be a significant challenge.” Not to mention an entire continent.
However it all plays out (it is still playing out as eurozone now enters a “critical period of 10 days,” as one EU official put it, with likely further critical periods to follow), MNC treasurers will be dealing with a variety of challenges from funding to reduced business to getting deals done. Here is a sampling of some of the issues being discussed within the NeuGroups and elsewhere.
Changing Bank Environment
Between the sovereign debt crisis, recent S&P downgrades of banks across Europe, and forthcoming bank regulation (compliance to which is being accelerated by market crisis sentiment) treasurers will have to cope with a changed bank funding landscape on the continent (globally, too). Although S&P’s late-November downgrade of banks worldwide was more a function of a ratings model adjustment, it nonetheless could have the effect of forcing banks to post more collateral in their daily trading activities, already suffering from a dearth of collateralizable paper acceptable to counterparties, which makes it less available to lend. Downgrades can also trigger clauses in contracts underlying derivative trades, which will also force banks to put up more collateral.
Recent events will also change bank relationships. For instance, the availability of credit sold at a loss will become much scarcer except for the bank’s most strategic clients, according to feedback from a bank presenting to one of the NeuGroup’s. The inability of European banks to fund in USD at anything close to market rates makes this especially true with dollar credit. Indeed, a dearth of USD liquidity outside the US period, a sign of the important intermediation role played by European banks throughout the world, was becoming a growing problem for the global financial system. This helps explain recent central bank intervention, including the 50bps reduction the Fed’s USD swap line. The prior rate of 106bps set something of a floor on USD borrowing costs that was forcing a massing pullback in USD credit facilitation that included growth markets in Asia. The change will slow, even if just marginally, the degree to which many non-US banks exit capital-intensive businesses requiring USD, favoring more transaction services oriented lines of business and advisory work.
This environment is expected to last for a few years as banks sort out the implications of the euro crisis, regulation and economic uncertainty. The conditions are changing rapidly, however. Funding costs are going up for most every bank, including US banks with native access to USD liquidity, and de-leveraging realities are forcing every bank to again become more selective about who they fund and less predictable as to when they will say no thank you when asked to participate in a credit facility.
Most MNCs will not find themselves completely flatfooted with the company’s cash in the face of a potential euro collapse. Members of the NeuGroup Peer Group universe have been slowly taking steps to reduce exposure to Europe.
Making the Easy adjustments
A few of the easier actions taken throughout the fall included shifting deposits from European banks that seem most vulnerable, scrubbing from portfolios any European financial institutions that are there, and in some cases shifting assets altogether out of Europe. More specific actions (taken and considered) include:
- Acceleration/prepayment of intercompany payments due from entities in Portugal, Italy, Ireland, Greece and Spain (PIIGS) if allowed under statutory terms.
- Deceleration of intercompany payments, due to entities in PIIGS countries, again if possible under statutory terms.
- Prepayment of intercompany loans due from entities in PIIGS countries.
- Use Intercompany loans/dividends to strip out excess cash from entities in PIIGS countries, although this may have adverse tax consequences.
Then the question becomes how much further should you go into the more difficult actions?
Exploring Tougher actions
Many of the more difficult actions anticipate some sort of euro exit with the need to redenominate various P&L streams and balance sheet items from the euro into whatever new national (the new lira) or supranational currency (a Nord euro) may be destined to replace it.
Figuring out the impact on both financial and commercial contracts referencing the euro under various break-up scenarios is indeed challenging. Since there is no legal mechanism to exit the euro, there is also no legal certainty that efforts to mitigate a euro break-up would work as intended. They might even prove counterproductive. It is hard to act when no one can tell you with confidence what action will prove beneficial. Much depends on which jurisdiction gets precedence in a given contract and what that jurisdiction does with its currency situation. Inherent in this, too, is the legal interpretation of the contract. For example will it denominated in the euro or the prevailing currency of the country?
What happens to the euro if the eurozone does collapse? One scenario has Greece, Italy and maybe the peripheral countries, reverting back to their local currencies at unsatisfactory conversion rates. A recent German resolution would allow countries to leave the eurozone without having to exit the EU. In another scenario, the Euro would cease to exist and the northern European countries would form their own union with a new currency, while the southern countries would revert to their local currencies or form their own union.
According to UBS, the economic cost of either of these scenarios would be significant and include sovereign and corporate default, and a collapse of the banking system and international trade. Nor would devaluation help. A weak euro country abandoning the currency “would incur a cost of around EUR9,500 to EUR11,500 per person in the exiting country during the first year.”
Any euro exit and new currency introduction would likely follow lex monetae (sovereign nations determine their currency) as well as certain aspects of earlier precedent, where a mechanism to transition out of a currency regime is not spelled out to make it seem more permanent. This is why people are looking for modern examples to help guide them (e.g., Argentina’s exit from its currency board).
Stress tested
US MNC treasurers, having survived the economic crisis over the last several years, likely do feel prepared for the worst. This was reflected in a recent survey from treasury management system provider IT2, which showed treasurers are confident that they are prepared: 74.2 percent said they are confident that “corporate treasury policy already in place is positioned to protect corporates from the financial consequences of a Eurozone split.” And 78.5 percent believe that their companies can accommodate a eurozone split.
Having survived last year’s crisis does not always mean a company is prepared to survive this year’s, or the one coming next year. This is why stress testing and contingency planning should be redone regularly with refreshed assumptions and to account for the new risks that might rise to the surface with each wave of the crisis. It’s easy to say that no action is needed but it is safer to say that based on the stress testing and scenario planning recently conducted, additional action will not with confidence mitigate significantly the range of outcomes indicated.
The table below identifies some of the issues associated with the risks of a eurozone collapse and suggests action steps to minimize negative effects on treasury operations.