Dealing with the fallout

Authors: Michael Storck and Folker Trepte

As the once unthinkable becomes commonplace, effective scenario planning is now crucial to survival and success. While there has been a lot of focus on scenario planning in large financial corporations, how to anticipate and mitigate the threats facing mid-size enterprise has attracted less attention. Using an illustrative mid-size business as our focus, this first article in our Eurozone series explores the impact of the crisis on the company and offers practical solutions to cope with them. Thereby, we focus on two extreme scenarios, as many feel lost with the multitude of various development paths and the necessary precautionary measures will in many cases be very similar.

Reflecting the challenges and dilemmas facing many such businesses, the article pays particular attention to treasury, finance, sales, procurement, legal issues and IT, though scenario plans could cover many more areas than this. So what lies ahead for our company, and what can it do to come safely through the storm?

Although we have invented EuroEngineers to illustrate the points in this article, it would be typical of many other mid-size enterprises in Germany and other parts of the Eurozone. EuroEngineers has an annual turnover of around €2 billion and 3,500 employees. The main markets for its sales are the EU, US and, to a lesser degree, Asia. The company is listed on the Frankfurt Stock Exchange and mainly finances its operations through bank loans. The company’s IT, treasury and HR functions, as well as its R&D and production, are centrally located in Germany. However, some minor production facilities are located in Ireland and Hungary and supply of components and assembly takes place in the sales markets. So, what are the extreme scenarios which EuroEngineers might be confronted with in the short and long run, and what is the likely impact on the company?

The fate of the euro will have a significant influence on demand within EuroEngineers’ markets. There are essentially two extreme and disruptive outcomes that the company will need to plan for. On the one side is the preservation of the common currency within the Eurozone through structural reforms, austerity measures and shared fiscal policy in a more deeply integrated EU. On the other is the collapse of the euro in its current form and breakup of the Eurozone. The breakup might range from a single state leaving the monetary union to the full deconstruction of the shared European currency.

Preservation of the Eurozone

The structural reforms and austerity measures of the first scenario would primarily consist of reduced public spending and higher income taxes. These cutbacks, together with significant cuts in pay in troubled Eurozone member states, would cause a drop in demand in these countries. Suppliers in weaker Eurozone markets are especially likely to suffer from these difficult conditions and might fall into bankruptcy. Falling demand would also curtail exports in more stable Eurozone markets and lead to lower growth prospects within the Eurozone. Growth would become more and more reliant on emerging markets. Thus companies in Europe would face increasing pressure to lower costs to cope with global competition in emerging markets. This increase may even accelerate in the long run: While the current period of uncertainty is causing investors to seek safe havens and the euro to depreciate, its value is expected to increase again in the long run as trust in the European currency returns. With a stronger euro the global competitiveness of EuroEngineers decreases further.

Figure 1: Weighing the risks and opportunities:
Preservation of the Eurozone

To offset these risks, the preservation of a common currency for most of Europe would keep transaction and administrative costs at a relatively low level and enhance planning security. In the long run, the structural reforms that are likely to follow in the wake of austerity measures might cause markets in weaker Eurozone member states to grow, equalise European tax systems and push further deregulation. Over time, low interest rates and regained trust in capital markets would also boost investments and growth in the Eurozone. Figure 1 compares the risks with the opportunities.

Breakup of the Eurozone

Figure 2: Weighing the risks and opportunities:
Breakup of the Eurozone

The opposite scenario describes a breakup of the Eurozone in its current form. The breakup might lead to an immediate drying up of orders and investments, and plunge the Eurozone into an even deeper recession than in the first scenario. Again, the value of the euro is likely to drop in the short term. However, once a smaller Eurozone with stronger member states is established, its value would probably rise even higher relative to the first scenario. Thus, EuroEngineers’ products would become less competitive and exports might decrease further over time. Conditions in the credit markets would also deteriorate in a similar way to the first scenario, though a rapid collapse of the euro would squeeze liquidity even further.

Weaker member states exiting the Eurozone would probably return to their former currencies. In such cases, those currencies can be expected to decrease in value, leading to a corresponding decrease of the value of the assets in these countries. This, in turn, leads to depreciation and corresponding losses on EuroEngineers’ books. Should the new currency decrease in value, the exiting state is widely expected to impose capital controls to stem sudden outflows from a deeply devalued new currency. Such controls would greatly restrict EuroEngineers’ ability to bring money out of that country.

Alongside these risks, there are also long-term opportunities emanating from a Eurozone breakup. Should the former Eurozone markets have to go through a massive devaluation, while some markets find their currency’s value increased, our company, with its German headquarters, may benefit from these foreign exchange (FX) opportunities, for example, by finding chances to cheaply acquire companies in those weaker states. As a company’s credit rating also reflects country-specific factors and Germany currently enjoys higher political and economic stability relative to the troubled Eurozone markets, EuroEngineers might find easier access to capital for investments. Governments in former Eurozone markets might also offer lower taxes and investment incentives in order to attract investment. Figure 2 compares the risks with the opportunities.

Contingency planning

Looking at the risks and opportunities surrounding each of these scenarios, what practical conclusions could EuroEngineers draw from the outcomes?

To prepare for these extreme scenarios, EuroEngineers might open its short- and long-term contingency planning with a focus on sales, procurement, financing, treasury, legal issues and IT. While some of these contingency measures are useful in both scenarios, others are specific for an eventual breakup of the Eurozone.

General measures for any scenario

Sales: As both scenarios would, at least in the short run, deteriorate EuroEngineers’ growth prospects, the company should assess how prolonged recession in Europe would constrain consumer spending. Given the immediate risk of insolvent business partners, EuroEngineers may also wish to think about enhancing its contract and claims management for business partners in crisis markets, for example, by insisting on bigger upfront payments for services and products or by reducing payment periods. If the company has its own retailers, EuroEngineers might—in the long run—also think about consolidating its network of stores in troubled markets into fewer and bigger outlets to cope with plummeting sales there. The company would also benefit from a broader customer base, which would reduce dependency on any individual group. For example, it could invest outside the Eurozone in emerging markets. By diversifying its sales regions, the company would certainly reduce its vulnerability.

Procurement: To address falling demand in the short term, EuroEngineers might also move to more flexible payment and delivery arrangements with suppliers. Whether the company is able to introduce flexible payment to suppliers and at the same time tighten contract and claims management with customers depends on its bargaining position in the supply chain. In addition, our company should figure out whether critical suppliers are located in troubled markets and pay particular attention to their financial stability. To enhance supply chain security, EuroEngineers could work with critical business partners on some win-win propositions for both sides. It could offer credits to its suppliers to make best use of its cash resources, as this can generate a good interest income and secure supply. In the long run, the company could try to diversify procurement markets and suppliers.

Finance: As both scenarios might cause liquidity problems in the short term, EuroEngineers should check its readiness to fund its operations for the next 12 months and to pay back its debts in the absence of its usual access to bank credit or bond markets. The company should also take into account that its loans and bonds might have covenants linked to specific key performance indicators, its rating or the country where it is located.

In both scenarios it is important to check readiness to fund operations, to enhance supply chain security and contract and claims management, and to broaden the customer base.

Specific contingency planning for a breakup of the Eurozone

Treasury: A Eurozone breakup would raise the question of how to safeguard cash. To limit its exposure in the short term, EuroEngineers should verify how much cash it actually needs in a possible crisis country. It might move spare cash out of a troubled country into currencies such as the US dollar or the Chinese renminbi and transfer its cash deposits to the safest possible bank. For example, some big companies such as engineering group Siemens and carmakers BMW, Daimler and Volkswagen have already acquired banking licences and are therefore able to deposit funds with the ECB, the safest of all safe havens in the Eurozone. As a breakup of the Eurozone raises FX uncertainties for trade with former Eurozone members, our company should set up procedures to deal with currency uncertainty. Beyond financial hedges for each currency, which become pricier at times of vulnerability, EuroEngineers might also think about ‘natural hedging’ in the long run, which means localising supply chains within the Eurozone and balancing production as much as possible with where it sells and where it buys. This diversification into the biggest possible basket of different currencies would reduce the company’s exposure to currency risks.

Legal issues: In addition to measures in treasury, EuroEngineers should include contractual issues in its contingency planning. Most contracts usually fail to foresee a collapse or partial disintegration of the euro, so existing contracts might need amendments to reflect the new legal requirements. Moreover, the status of supplier contracts should be reviewed. Our company should, for example, determine whether supplier contracts remain in euros or convert into the successor currency.

IT: EuroEngineers should also check whether its IT systems are ready for a potential change in the invoicing currencies and in cash flows, which would follow the introduction of new currencies. IT systems should also be prepared to support internal reporting with new currencies.

Figure 3: Contingency Checklist

Procurement, production and administration: Finally, contingency planning should include measures to take advantage of opportunities arising from the Eurozone crisis. Lower wage levels in troubled markets relative to those in stronger Eurozone member states allow EuroEngineers to gain maximum competitive advantage in the long run from moving production, procurement, financing back office activities and IT services to former Eurozone member states.

Figure 3 summarizes ways that the company can respond to the issues in each of these main areas.

Specific contingency planning for a breakup of the Eurozone

Given the serious impact of the Eurozone crisis, contingency planning could provide a valuable way to reduce risks and make sure the business is prepared for different eventualities. However, the multitude of potential scenarios should not confuse CFOs and risk managers, as the impact of most scenarios differs less in quality than in intensity and timing. Instead of getting lost in theoretical scenarios, they should be geared up with a comprehensive overview of the major risks caused by the Eurozone crisis, and develop short- and long-term action plans to adequately manage them. Certainly, a proper contingency plan has to be specific and focus on the peculiarities of the industry, size and location of a company’s operations, as well as its individual investment, sales, procurement, finance and treasury strategy. Therefore, a specific in-depth analysis is important and should be the starting point for all further actions. This will make sure that companies can see through what really matters in these uncertain times and come through stronger.