Business impacts of the Euro debt crisis

Adrian Peacegood, a director within the assurance department at PwC, considers some options for the unravelling euro debt crisis over the rest of the year and their potential impact

The current UK banking scandals hitting the headlines serve only as a smoke screen to the European debt crisis which is continuing to unravel and impact the global economy. 

As the politicians unpick the mess and countries stave off their over dependence on debt there are a wide range of potential outcomes. While PwC are not in a position to know what will happen from here, businesses should monitor developments carefully. 

Ensuring contingency plans are in place is a prudent course of action.

In recent weeks the Bank of England has committed to inject a further £50bn into the UK economy taking the total size of quantitative easing to £375bn. Southern European states continue to raise money in the financial markets but are being forced to pay higher interest rates, with Spain’s borrowing costs hitting new record highs. The Greeks have gone back to the polls and have managed to cobble together a grand coalition intent on pushing through austerity measures insisted upon by the EU and IMF.

The global economy is still in a precarious situation with Sovereign debt historically high in US, Japan and across much of Europe.  It is unclear what impact record low interest rates, quantitative easing and ECB bank recapitalisation will have on global inflation and the global economic outlook. How global deleveraging affects economic growth and inflation will depend on fiscal, regulatory and monetary policy responses.

Here are four broad scenarios which may play out but there are many others.

Four scenarios for the road ahead

One possible scenario would see successive phases of fiscal and monetary action with the ECB given the go ahead to inject significant liquidity into vulnerable economies and banks. This would enable gradual economic recovery later this year and into 2013 with recession avoided, short term interest rates are likely to be kept low, but inflation would rise above the 2% target and the Euro depreciate.

These events are perhaps the most optimistic but the underlying structural competitiveness and fiscal adjustment problems would persist causing occasional new flare-ups of the crisis. These new flare-ups would need to be contained by successive phases of monetary and fiscal action which ultimately hold the Eurozone together.  

A second eventuality could see a programme of debt restructuring agreed or forced on highly indebted economies and their creditors. To prevent contagion, Eurozone leaders would need to agree to a package of partial bank recapitalisation and make resources available to vulnerable economies.

These support measures would succeed in holding the Eurozone together but the lack of credit to already credit starved banks and the shock to global confidence would plunge the Eurozone into a prolonged recession. The longer term consequence would be slow growth for two years and a prolonged reliance by the defaulting economies on fiscal support from the rest of the Eurozone.

Despite the new Greek coalition, a possible third scenario later this year or early in 2013 would see Greece leave the euro. How this happens exactly is unclear but the short-term impact on Greece would be a sharp deterioration in its economy led by rapid depreciation of its new currency and a spike in inflation.  

Through monetary expansion, fiscal transfers, bank recapitalisation and further Eurozone fiscal and political integration the worst of the contagion to other countries could be avoided and the currency union would remain intact. The loss of Greece however would have an impact on confidence and growth would remain negative in 2012 but expectation would be for it to pick up toward the end of 2013.

The exit of Greece from the euro could lead to a fourth eventuality, contagion amongst other periphery countries. With deepening recession and consumer confidence evaporating the pressure on core Eurozone countries and the IMF may lead to other countries leaving the Euro one by one.

A new, smaller and more tightly regulated currency bloc could be formed led by France and Germany. A new bloc would benefit from inflows of capital and a boom in domestic demand with economies excluded suffering from economic contraction and an uncertain future.

Under any eventuality the impact of the Euro will and is being felt well beyond the Eurozone. While the developing world has largely been the driver of global growth over the last few years, there is no guarantee this will continue especially if the demand for exports from the developed world falls further given the weak economic outlook. The UK and US are seeing exchange rates appreciate against the Euro and this may well continue with exports falling and problems in the banking sectors continuing.

Challenges for the investment industry

Under any of these scenarios there are key issues for business to consider and review. If scenarios 2, 3 or 4 were to unravel, there are potentially greater consequences and disruption to operations within the financial service community.

With the increased risk of any default, management should assess their ability to monitor the quality of their counterparties and as necessary develop new frameworks that provide a fresh and continuous look at health and fitness of these counterparties.

The evolution of the euro crisis is likely to have further significant impacts on both the volatility and price levels in currency and commodity markets, with implications for hedging strategies. Management should consider how portfolios and assets are stress tested under such volatile conditions and consider if these risk exposure benchmarks are still fit for purpose.

If some countries drop the Euro and revert to legacy currencies while others remain, systems will need to be able manage new currencies and have the capabilities to report and record split/dual currency settlement. 

There could be further impacts on bank lending and liquidity, particularly in any country which decides to leave the euro. Cash and other financial and physical assets may become trapped, exposures to banks which may be in difficulty need to be monitored and managed. Custodians need to be prepared to quickly segregate, isolate, agents, counterparties, holdings and transactions.

Preparing and training your resources to be ready to respond quickly and to act with confidence will be essential to providing a clear and accurate response. Management should also make contingency plans for unanticipated processing loads and be ready to eliminate potential processing bottlenecks.

Communication will be another important facet of any contingency plan; management should prepare to communicate both internally and externally. In times of change and uncertainty staff, management, investors and clients will particularly expect to be provided with certainty and confidence and hence a communication strategy and planned responses should be prepared.

If history is anything to go by, a country exit or sovereign bond default could be announced and come into effect over a weekend. In this situation, moving quickly will be paramount. The companies with the best contingency plans in place, with agreed actions and appropriate delegated authority allowing quick decisions; are the ones that will come out of this crisis the in the best shape.

All parts of an organisation could be affected in any one of our scenarios: Business Planning, Treasury, Legal, Procurement, IT, Finance, HR and Tax. We recommend companies prepare a coordinated response.

We are already advising executive committees, Boards and finance teams who are asking questions about how prepared they are and what their contingency plans might look like.