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    If the crisis in the Eurozone results in a break-up, British businesses will face yet another ‘Black Swan’ event. Lloyds Bank’s Jyotsana Bindal explains how companies can get ahead of the game and reduce the risk.


    We live in uncertain times. In the past few years, we have seen that ‘Black Swan’ events that lie in the tails of statistical probability appear to be happening more frequently. Five years ago, who could have imagined European sovereigns on the verge of bankruptcy and the Eurozone on the brink of collapse? In this article, we assess the impact of the ongoing Eurozone crisis on the financial world. In particular, we highlight the considerations that corporates should address in order to survive in these times of stress.


    Potential Eurozone break-up

    The European crisis has produced a lot of discussion on the likelihood of a euro break-up, both around disorderly (dismantling the whole euro project) and orderly (exit mechanism for countries to leave the euro).

    When we observe differences in European government bond yields, we see that Greece, Portugal and Ireland (in that order) show the highest probabilities of default, relative to Germany. By inference, these countries could be the most likely candidates for an exit from the Eurozone. The currencies of the countries exiting the euro are expected to depreciate and there is a substantial risk that the economies of these countries will experience higher inflation.

    Chart 1 highlights a view on the intensity of depreciation for the newly created non-euro currencies, such as Greek ‘drachma’, Portuguese ‘escudo’ and Irish ‘punt’. Based on Chart 1, 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. Additionally a potential implication of weaker countries leaving the euro area is an appreciation of the resulting euro of around 10%.


    This scenario, however, is based on 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.


    Assuming an orderly break-up scenario of the euro, Chart 2 highlights the implications of the break-up on GBP against EUR, taking the potential market sensitivity into account.


    GBP/EUR could rise to 1.67 at the time of euro break-up (assumes end of Q3 2012) before easing to 1.58 early next year. This compares to the Lloyds Bank’s base case forecast (assumes no break-up of the euro) of GBP/EUR at 1.28 at the end of Q3 2012 and 1.30 at Q1 2013. 


    Impact of euro break-up on corporates

    Any corporate with Eurozone exposure could potentially be impacted by a break-up of the Eurozone. This could result in an erosion of profits as well as having a detrimental impact on the balance sheet. A review of the current risk management strategy would seem appropriate in the current circumstances. Some key exposures have been highlighted:




    Sales and Purchases

    • Risk from customers and suppliers due to disruption in sales and purchases (potential drop in volumes), potentially leading to changing foreign exchange exposures on cross border trades:
      • Euro appreciation (long-term): increase in euro denominated revenues and costs.
      • Euro depreciation (short-term): decrease in euro denominated revenues and costs.
    Checklist for corporates:
    • Potentially amend the duration on the supplier contracts, allowing the possibility of including the new currencies.
    • Consider supplier diversification.
    • Have sufficient liquidity to cover for any shortfalls.
    • Update/amend accounting systems to cope with redenomination of accounts.



    Euro Derivatives

    • Risk of hedged position becoming un-hedged due to a new currency, hence increasing volatility on the key metrics.
    • On the other hand, no volatility on the metric when the markets have been volatile can lead to an over-hedged position:
    • Potential loss of value for in-the money derivatives.
    • Potential mismatch in assets and liabilities increasing volatility on the balance sheet.
    • Legal implications on negotiations, restructuring and enforceability of any hedging facilities.
    • Hedge accounting issues such as a decrease in hedge effectiveness if, for example, liabilities and hedging transactions are denominated in different currencies.
    • Loss of value of foreign operations through the re-denomination of euro into local currency and the related impact on any existing net investment hedging.

    Checklist for corporates: 


    • Match assets against liabilities.
    • Use option based strategies to hedge any cash flow uncertainty.
    • Regularly monitor derivative valuations.
    • Evaluate the impact of un-hedged exposure on key performance indicators.
    • Review of documentation to establish governing law, jurisdiction and place of payments.



    Eurozone Bank Default

    • Potential loss due to bank default on deposits, money market instruments, debt facilities and in-the-money value on derivatives.
    • Legal implications on negotiations and restructuring of facilities.

    Checklist for corporates:


    • Diversify the exposure to reduce the potential systemic loss.
    • Measure counter-party credit risk/limits.
    • Review documentation including any potential legal implications on bank default/downgrades.



    Financial Flexibility

    • Limited bank credit availability (depending on scenario/location/exposure) and reduction in euro financing sources.
    • Expected refinancings/new funding requirements to corporates over next four years of c$46tn (S&P, May 2012)
    • Mismatch between assets and liabilities due to limited funding sources from the Eurozone, where assets remain in euro but the funding is in the new non-euro currencies, or vice-versa.

    Checklist for corporates: 


    • Assess future funding requirements, potentially considering pre-funding.
    • Use any current undrawn committed facilities.
    • Match liabilities to underlying assets.



    Capital Disruption Issues

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

    Legal implications on negotiations and restructuring of facilities.


    Checklist for corporates: 


    • Have a cash and liquidity management plan in place.
    • Review the capital structure. 
    • Understand the impact of euro break-up on key credit metrics and the inter-dependence on the cash flows. 
    • Consider moving cash to countries with potentially less strict exchange controls.




    It is not easy to accurately predict the impact of euro disintegration. What we can do is consider some of the issues that might arise, 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 corporates should prepare themselves to minimise the impact.


    The potential collapse of the Eurozone could result in many different scenarios but as a first step, corporates would benefit from evaluating their current risk management approach and testing it against the potential impact of a euro break-up by: 


    • Assessing the historical effectiveness of current risk management strategy. 
    • Determining the risk exposure under different stressed break-up scenarios.
    • Identifying key areas of concern.
    • Designing a new risk management strategy as necessary.
5/31/2020 8:49:42 PM