Risk Management

Managing Euro Exit Risk

What treasurers need to address before the departure of a eurozone member draws any nearer.
Vincent RyanNovember 30, 2011

CFOs and treasurers, it’s time to break the glass that houses your eurozone crisis contingency plan. Don’t have one? Get out your models. Now that the danger of a full or partial breakup of the eurozone has increased, with one country or more potentially going off the euro, experts say it’s time for finance departments to take concrete action around managing their risk exposure in Europe.

That means developing contingencies to deal with volatile exchange rates, commercial relationships in Europe, financial institution counterparty risk, and any knock-on effects to U.S. financial markets. “The treasurer and CFO really need to sit down and take a close look at what the risks will be and what the proper response is,” said Jeff Wallace, managing partner of Greenwich Treasury Advisors, in a webinar on Wednesday.

How would a country get off the euro? It would likely be done with the consent of Germany and France, says Wallace. The breakaway country would establish a new currency by fiat, and would not only redenominate its sovereign debt but also devalue all in-country monetary assets, liabilities, and contracts — private and public. “If a government is going to break away from the euro, to leave the private sector with euro-denominated debt would cripple it,” Wallace explains.

A country leaving the European Union could cause massive damage. “If the Greeks leave, or the Italians leave, or the Spanish leave, then the whole Euroland will be in economic turmoil,” says Wallace. With a legacy local currency or currencies redenominated versus the euro, undercapitalized European banks would face write-downs of the sovereign debt they hold, since the banks classify these assets as “held to maturity.” The write-downs would be significant even if the breakaway country doesn’t technically default on its sovereign debt, Wallace says.

European banks are already shrinking their balance sheets, kicking off the beginnings of a credit contraction, writes David Levy, chairman of the Jerome Levy Forecasting Center, in the firm’s monthly economic forecast. They are jettisoning “both distressed assets to clean their balance sheets and nondistressed assets to raise capital ratios,” Levy writes. That could disrupt financial markets in the United States, he warns, because it’s likely to “disproportionately involve the reduction of foreign (outside the euro area) lending and the sale of foreign assets, of which euro-area banks and their affiliates hold close to $8 trillion. Any forthcoming aid from euro-area governments to their banks is likely to be biased toward stabilizing lending at home rather than supporting foreign operations, leaving banks under pressure to reduce activity in foreign markets.”

Redenomination risk — resulting from a  country leaving the euro — is one of the key dangers that treasurers of multinationals should be examining, say experts. In a breakaway scenario, euro contracts with in-country residents would be converted to the new currency, including foreign-exchange contracts written by local banks. “Foreign holders trying to force a euro contract in Greece [for example] will be problematic,” Wallace says. “Banks all of a sudden become drachma banks [in the case of Greece leaving] and what about forward contracts? You may have sold euros or bought euros, and are you now going to get euros or drachma, and at what rate?”

Treasurers should make sure they are long the euro with nonlocal banks and short the euro with banks headquartered in the potential breakaway countries, says Wallace. If a company has in-country operations, it would make sense to load up on in-country debt but at the same time reduce liquid assets held in the country.

Judging the counterparty risk of European bank relationships is another priority. “What are banks doing with your funds? Who are they investing them with, and do they have any European sovereign exposures?” asks Krishnan Iyengar, vice president of global solutions at Reval, an enterprise treasury and risk management provider. If the information is available, treasurers should also pay attention to any credit default swap contracts that their banks have written on sovereign debt, says Iyengar.

Leading indicators of bank liquidity or solvency problems treasurers should watch are the 5- and 15-day moving averages of a financial institution’s CDS spreads, the market value of a bank’s equity, and movements in a bank’s publicly traded debt.

And if they haven’t already, finance departments should consider diversifying their financial counterparties in Europe. One option: switching to Canadian banks, “which seem particularly attractive with tight capital controls and strong regulatory oversight,” says Iyengar.

Commercial risks also require management. “Companies can help offset the unsettled future of the euro by negotiating deals that are tied to the U.S. dollar or other currencies. This has gone on in Latin America for years,” says Ryan Gibbons, managing partner of GPS Capital Markets, a provider of FX services.

There is a danger to that, says Gibbons. U.S. companies could lose market share to those who are willing to take the exchange risk. On the other hand, “many times companies will get together and set up a joint plan on how to deal with the changes in currency valuation, perhaps having both parties assume equal risk,” says Gibbons.

Reval’s Iyengar recommends reducing commercial credit lines to customers in eurozone countries that are in crisis. He also recommends altering contracts with suppliers and customers in Europe, inserting clauses in supplier contracts that would enable the company to make payments in the new fiat currency. In customer contracts, management should add clauses forcing customers to pay in euros. (These may not be enforceable.)

However CFOs and treasurers prepare for knock-on effects of the eurozone crisis, decisions must be made now. “Typically [an event] happens around Sunday night,” says Wallace of Greenwich Treasury Advisors. “If your New York treasury and you wake up at 6 a.m. and discover Greece has gone off the euro and Spain is thinking about it, you are not going to be able to come up with a good contingency plan in five minutes.”

Wallace says there should be a strong communications link established between senior European finance staffers and treasury personnel at company headquarters in the U.S. Staffers need to go so far as to test the cell phone numbers of their European counterparts to make sure they have European city codes correct.

For treasurers, the eurozone crisis could be a career-defining event. “Once [Greece or another country] goes, it will look so inevitable in hindsight,” Wallace says. “And then the question is, if it was so inevitable, why didn’t you do some planning?”