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It’s all Greek to me: A business guide to coping with the -crisis

Author: James Sproule Chief Economist, Institute of Directors January 2015 breakup report_Layout 1 08/01/2015 12:06 Page 2

Setting the scene

• 2014 came to a close with the Greek parliament failing to elect a President, triggering a general election on 25 January. This raises the possibility of a new government seeking to substantially renegotiate the terms of the Economic Adjustment Package, originally negotiated with Troika 1 in May 2010, and revised in March 2012.

• The euro-zone crisis of 2011/12 saw the imposition of strict austerity programmes designed to move public finances to a sustainable position. However implementation has proven to be difficult.

• The battle is changing. It is now between those who fear financial contagion (and so do not wish to raise the possibility of one or more countries being forced from the euro) and those who are afraid of the political contagion that comes from bowing to the demands of populist politicians seeking to reject fiscal austerity.

Key points

• The euro was introduced in stages over seven years, and yet the departure of a member of the single club may well come over the space of a single weekend.

• Given the potential impact and challenges resulting from a country leaving the Euro-zone, we believe organizations should once again begin to plan and prepare their response to such a possibility.

• There will be considerable commentary over the coming weeks as to the possibility of a Greek Exit of the euro (Grexit), but considerably less on what businesses might do to prepare for such an event. This paper seeks to address that gap.

1 Indeed departure from the Euro was seen by the ECB and others to necessitate departing the European Union, although during the last crisis German officials were reported to have given informal assurances to the that they would not enforce their departure from the EU. 2 Eurozone breakup report_Layout 1 08/01/2015 12:06 Page 3

Potential implications include

• What’s it really worth and how interconnected are we? An exit of any member of the Euro would result in a strong market reaction and bank balance sheets would once again come under pressure as a wide range of assets were revalued through repeated iterations.

• Separating good from bad. Assets would need to be segregated into differing and accounts.

• Capital flight. Fear of inflation and further devaluations in at risk countries would drive savings from Southern Europe to accounts in more fiscally responsible countries, denuding local banks of their capital base, curtailing lending and driving affected economies further into recession.

• Can you pay? Concerns over counter-party risk between businesses will emerge as domestic banks of the countries affected face funding difficulties.

• Recalibrate risk. Risk assessments have proven again to be too narrow and thus inadequate. Firms, for a start, will be demanding increased collateral for certain financial products or trade agreements.

• Panic trading. There would be a spike in financial trading activity, at the same time tactical solutions to clearing and settlement in a new currency would have to be implemented.

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On background

How plausible is it that a country would leave the single European currency? For much of its first decade of existence, the answer was clear: not at all plausible. The architects of the euro had meant it to be irreversible, to the point where there is a mechanism by which countries can leave the European Union itself, yet not the euro 2. Then the events of 2011/12 occurred and the spectre of a Greek exit (Grexit) of the euro became a very real possibility, with the result that a good deal of thinking was done as to what Grexit would mean in practice as opposed to theory.

The irreversibility of the euro was initially thought of as being crucial to financial market credibility. And credibility was achieved, to the immense benefit of euro-zone members. The biggest benefit accrued to those governments where, because of a history of inflation or comparatively small financial markets, borrowing costs had traditionally been high. However the idea that the lower debt-servicing costs would be used responsibly by government to consolidate finances proved misplaced. Instead, lower borrowing costs were used to prolong unsustainable fiscal policies to the point where the system itself has become fundamentally imperilled.

Since the crisis of 2011/12 the exposure of European banks to has diminished dramatically, having been helped by a 75% devaluation of bank holdings of Greek debt in Feb 2012. But depending on how far any potential contagion spreads, bank exposure to other EU governments remains considerable. If there is one lesson that has been learnt from the Lehman Brothers crisis, it is that financial markets are far more interconnected than had been thought and no plan, however detailed, is likely to be able to figure out fully the impact of an economic shock. The view of an increasing number of economists is that the longer such a situation goes on without addressing the underlying factors that are causing the strain, the more likely the result is going to be sudden and shocking. Against this are a more recent set of political concerns, where populist far left (and in other countries, far right) parties seem intent on gaining power through promising to renegotiate fiscal consolidation plans. For many, particularly those who are likely to be picking up the bill for any easing of austerity, views on allowing any renegotiation range between highly undesirable and completely unacceptable.

The euro was ratified under the Maastricht treaty of 1992, introduced on 1 January 1999 with notes and coming three years later. So after an introductory period of more than seven years, a country’s exit of the euro-zone may take place over a weekend. If a country were to leave the euro, a short transition time frame may be necessary as there may be significant capital flight as soon as any plans are

2 Indeed departure from the euro was seen by the ECB and others to necessitate departing the European Union, although during the last crisis German 4 officials were reported to have given informal assurances to the Greeks that they would not enforce their departure from the EU. Eurozone breakup report_Layout 1 08/01/2015 12:06 Page 5

announced, with investors anticipating a significant devaluation. Any departure scenario is, therefore, likely to involve complete denial of any plans to withdraw until the moment of actual departure.

The immediate aftermath of a departure from the euro is going to see a rapid easing of austerity policies in the departing country with predictable falling of exchange rates. There are numerous examples of countries departing from an ‘irreversible’ currency peg. Breaking such a pegging arrangement is simply a matter of declaring the link dead and letting the markets determine a new exchange rate. Leaving the euro would be much less straight-forward.

There are any number of potential scenarios that might come about in the euro area, from a complete break-up to a country being ejected or “deciding” to leave, which amounts to the same thing. We are going to examine the scenario discussed most frequently: a financially recalcitrant country being asked to leave, or departing as it refuses to meet the requirements enabling it to stay.

PlAUSIBlE SCEnArIoS Scenario 1: Scenario 1.5: Scenario 2: A solution is found Just sufficient, but never A country departs the enough euro Economic growth resumes: a Economic growth proves elusive. Economic divergence proves prerequisite for an optimal unbridgeable and country departs scenario from euro. • ECB accommodates and • Risk reassessed with greater rigor • Devaluation inevitable in provides the necessary liquidity / in credit assessments and wider departing country, triggering confidence to satisfy investors’ risk premiums prevail; questions as to which assets are concerns into the medium term governments will face difficulties affected financing open ended deficits; • Debt restructuring the solution higher bank reserve requirements • ECB acts decisively to ensure could well be that government constrain lending contagion does not spread; (semi- sovereign) debt is significant program of restructured/defaults, but • Deflation looms as consumers quantitative easing is country remains in euro in Europe remain nervous and announced even terrified • Deflation avoided; consumer • Banks fail in departing country demand remains subdued • Debt burden caps growth; as they face potentially through period of public and creditor nations dictate terms to insurmountable funding crisis; private debt consolidation, but debtors Exchange controls to limit recovers subsequently capital flight may be attempted • Savings flee out of Southern • Long term structural reforms Europe, curtailing banks’ ability • Trade stumbles as payments are enacted triggering corporate to lend and accounts become difficult investment, promotes for all at risk countries entrepreneurialism, and allows • Business relocates stock market growth to emerge listing/HQ, longer term brain drain • Minor country departure from euro will have marginal impact • Prolonged recession with on multi-national business constant threat of sliding into next scenario 5 Eurozone breakup report_Layout 1 08/01/2015 12:06 Page 6

Immediate impacts

• Businesses will need to re-calculate exposures to new risks, as well as credit exposures to local institutions and to other banks with significant exposure to the new Greek drachma. This will need to be supported by new risk calculation frameworks and may also require other trading and credit limits and issues such as living wills to be examined following this credit event.

• Accounting and settlement systems for the potential new currency will have to be reintroduced. For a time it may be necessary for businesses to run a parallel euro accounting system which will allow for the rapid reintroduction of any new currencies. More broadly the interbank real time gross settlement system, Target2, has for the past five years been used in all euro-zone countries for high value interbank payments. It is no longer multi-currency.

• Finance departments will see both immediate and long-term impacts, through the need to segregate assets between the euro and new Greek drachma – a complex task that will likely result in months and possibly years of legal wrangling.

Some immediate impacts for financial services:

• Bank balance sheets would once again come under intense pressure. The lesson from the 2008 credit crisis was that financial markets severely punished those in most trouble, but that all banks suffered to a greater or lesser extent. Exposure to any potential euro crisis varies by geography and by individual bank. The good news is that overall bank exposure to Greece has diminished significantly in the last three years.

• Data Management reconfiguration will be required to ensure that reference data supports the new Greek drachma. Similar impacts will be felt across technology as the capability to support data, processes and calculations in the new currency will mandate widespread reconfiguration across all systems. In many cases, this will result in duplication of processes (both manual and automated) for example, through the need to issue confirmations in a new currency. 6 Eurozone breakup report_Layout 1 08/01/2015 12:06 Page 7

• Asset Liability Management will come under immediate pressure to allocate increasing capital to cover the higher collateral requirements associated with more risky new Greek drachma denominated products, which will result in a spike in Collateral Management processing. This will be challenged by capital reserves falling as new Greek drachma holdings devalue.

• Bank trading desks will see a spike in activity, notably through demand to trade in and out of the new Greek drachma felt by FX desks and through the need to re-finance bonds and exercised Credit Default Swap (CDS) contracts. Longer-term, banks will need to develop new Greek drachma denominated products and re-structure desks if they want to support the new Greek drachma.

• Financial services research teams must be prepared to meet immediate and ongoing demand for new Greek drachma focused analytics and reports, which will be a challenge in the early days of the new currency but an important source of information in an uncertain environment.

Long-term impacts

• Following the adoption of short-term tactical fixes, strategic solutions to cater for the new Greek drachma will be required across the full trade lifecycle, notably including Cash Management & Payments, Clearing & Settlement and Confirmations.

• There is a strong possibility that the devaluation following introduction of the new Greek drachma would trigger significant inflation.

• Surge in demand for foreign or euro denominated banks accounts as citizens and businesses in affected countries, or potentially affected countries, try to protect accumulated wealth. The result is that banks taking deposits will face problems in coping with the volumes of cash, while banks in the departing country will have difficulty in funding as savings will have fled to safe haven euro denominated accounts. This pattern was well established in 2012 and the effects of that capital flight have only been partly reversed

• Until and unless new Greek drachma could be printed the new (probably electronic) currency would have to circulate alongside euro notes and coins. This is likely to result in a variant of “Gresham’s law”, with bad (new) money 7 Eurozone breakup report_Layout 1 08/01/2015 13:38 Page 8

driving out good (non inflationary) euro currency. The result could well be a significant shift to electronic payments. Cash payments account for approximately 70% of financial transactions across Europe. This figure rises to 90% in Italy. It is likely that those countries which might leave the euro-zone all have a greater number of cash transactions than the euro-zone average.

• Moving banks will be difficult as client on-boarding teams in financial services firms will face an increased workload through the need to establish new accounts, which will include following “Know Your Client” procedures 8 Eurozone breakup report_Layout 1 08/01/2015 12:07 Page 9

establishing new clients. This includes banks’ assessment of client demand to trade and a risk and opportunity assessment that will require evaluation from Strategy teams.

• Bond debt. The introduction of a new Greek drachma is almost certain to count as a material change to a bond contract, allowing for the bond to be called. Therefore the need to refinance bond debt could be considerable. World Bank and IMF data indicates the amount of outstanding Greek domestic and international bond and debt securities in June 2014 was $564 billion.

• Bank debt. While bank debt is unlikely to be called in, there is likely to be a desire by corporates to align the currency of revenues and debt payments. The latest Bank for International Settlements data records external loans and deposits to banks in Greece was $79 billion. At the very least, many companies would seek to hedge their new bank debt FX exposure.

• Forex. Foreign exchange demand (spot, forward, swaps) for smaller European countries equates to between 4% and 12% of GDP, implying for Greece average daily FX volumes would be approximately $24 billion.

• Regulatory functions will also need to comply with detailed reporting requirements of holdings in, and exposure to, the new Greek drachma. This is especially true while fear of contagion following the default persists. Regulators are likely to stipulate that banks must conduct wider-ranging scenario stress tests to ensure they are prepared for the risks of further defaults or exits across the euro-zone.

These implications will clearly vary depending on businesses’ exposure to the new Greek drachma. There will be opportunities to take advantage of market dislocation but on top of both rapidly implementing strategic fixes, and implementing strategic solutions over the longer term, businesses must assess their appetite for the new Greek drachma and the potential for the Greek economy under their new government.

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BUSInESS ACTIon lIST Trading partners Asset positions Commercial Business provisions planning

• reduce exposure to • Ensure cash positions • Arrange alternative • Delay investment in the Greek risk through reflect new perceptions lines of credit (i.e. with countries which might accelerating payments of risk and accelerate Banks in northern euro- be affected from within the affected the movement of cash zone countries) area. out of potentially • Undertake scenario adversely affected • Assess which financial planning models • If possible, supplier and banks insurance instruments dealing with different customer agreements (Credit Default Swaps) degrees of euro- zone and contracts to be • Move inventory from can be trusted to pay disruption to better drafted in English, not potentially affected out as expected understand potential local, law countries financial impact • Seek out banks with a • reduce planned sales or dynamic and flexible • Discuss at senior/board plan for write-offs of approach level contingency plans collections in affected on how to deal with the countries euro crisis

• Investigate / seek • Consider how staff in alternative vendors or affected countries suppliers from might be paid countries with lower perceived risk for • Communicate with sourcing key materials clients, explaining planning efforts • Establish which supplier or counter-parties may • Assist clients with be in financial difficulty contingency planning

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Conclusion

Anglo-Saxon economists and commentators tend to under estimate the degree of political capital that has been invested in the euro project and its importance to governments across the euro-zone. The European single currency was, is and always will be, a political project. Its success is crucial to political careers and much will be done to save it, including rewriting of rules which appear on the surface to give little room for flexibility.

This crisis is particularly problematic as a political faction refuses to play by the accepted rules and seeks to land the leader of the EU – Germany - with a hefty bill. Handled badly, concessions to the new Greek government could well lead to ‘political contagion’ and similar demands for financial concessions from a range of populist parties. A crisis handled well would at best leave many southern European countries facing near generation length debt repayment plans and a need to recast the relationship between state and individual if they are to ever recover.

This paper makes no predictions about the likelihood of a Grexit, but it does look at a number of the key challenges that would face businesses were any country to be forced to leave the euro. These range from coping with the reaction of any naturally nervous public, to corporate refinancing and the longer term implications.

Given the potential impact and challenges resulting from a country leaving the euro-zone, we believe businesses should be considering how they might respond to various scenarios.

We hope you have found the discussion useful.

Author: James Sproule Chief Economist, Institute of Directors E: [email protected]

Disclaimer The information and opinions contained within this report are for information purposes only. They are not intended to constitute legal or other professional advice, and should not be relied on or treated as a substitute for specific advice relevant to particular circumstances. The Institute of Directors shall accept no responsibility for any loss which may arise from reliance on materials contained in this document.

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