THE LAST time the UK was hit by a break-up of a European currency system – when sterling crashed out of the exchange rate mechanism 20 years ago – the impact was hugely positive for the corporate sector.
But this time around a disintegration of the euro would send massively destabilising shockwaves across the channel to the heart of British business.
Many analysts believe the economic impact would be disastrous. “Despite not being a member, the UK is still inexorably tied to the region through trade and financial linkages,” says Ian Bright, a senior economist at Dutch bank ING.
Capital Economics, a consultancy that was among the first to give odds of more than 50:50 to a break-up, says it could cut growth by three percentage points. That equates to some £37bn – almost double the entire £20bn credit easing facility that chancellor George Osborne unveiled in his Autumn Statement to help small and medium businesses.
“A rapid escalation of the eurozone crisis could prompt a slump to rival that seen in 2008,” says chief economist of Capital Economics Vicky Redwood. “The most straightforward channel through which the UK is, and will continue to be, affected by the crisis is trade.”
This is no surprise given that almost half of all UK exports go to the 17 members of the euro. Capital Economics says this impact alone could wipe 1.2 percentage points off growth.
Of course the eurozone is not one market: the strong, lightly indebted and growing economies of Germany, France and the Netherlands account for half of eurozone exports. However, this leaves Italy, Spain and the small southern peripheral economies making up the other half – or a quarter of UK exports.
Mervyn King, governor of the Bank of England, told MPs last month that the euro crisis had already wiped out the equivalent of 1% of GDP growth, or £15bn. But this is nothing compared with what could happen in the case of a full break-up, rather than the agonising indecision that has depressed confidence and growth since August.
ING believes it would wipe out 8% of growth, or £120bn of output, with exports of tourism, farming, clothing and car industries worst hit. This number is based on a 25% fall in exports to the eurozone, thanks to the double-whammy of a collapse in demand as its economy suffers both recession and sharp currency devaluation.
Supply chain worries
But exporters are not the only ones that will get clobbered: importers with a supply chain extending into the eurozone will also be at risk. The last two decades of globalisation following the fall of the Berlin Wall and the admission of China into the world trading system has meant supply chains have become very long and complex.
But perhaps the hardest part of the problem to diagnose is the implication for exchange rates of a major upset in the eurozone. The impact would be different were one country, such as Greece, to exit than if all 17 countries were to revert to their national currencies.
There is also a midway outcome – a ‘hard’ euro centred on Germany and a return of weaker currencies such as the drachma, peseta, escudo and punt.
ING says a free-floating drachma might devalue by 85% against sterling compared with the euro. Combined with a wider collapse in confidence, sterling would appreciate by 35% against the euro, making exports unaffordable for beleaguered eurozone consumers.
Ironically, a collapse of the euro would leave sterling only 15% higher as the more severe economic impact would prompt investors to seek safety in the US dollar.
The effect on the financial system of a euro break-up and on banks in particular, which are key for lending to exporters, has enormous implications.
Andrew Bailey, the director of banking at the Financial Services Authority, has said publicly that banks must plan for “unlikely but severe scenarios. This means that the disorderly departure of some countries from the eurozone must be within the realm of contingency planning,” he told a banking conference in London.
Even the Bank of England said last month that it is making contingency plans for a break-up. Deputy governor Paul Tucker said banks should “push up” their capital levels now, adding: “Almost anything can happen in the next few months, and banks need to put themselves in a position to withstand this.”
ING’s Bright agrees that bank failures would make a “bad situation worse” for exporters. He warns that a collapse in interbank lending, as happened in the wake of Lehman Brothers’ bankruptcy, cannot be ruled out.
“Cross-border lending lines between banks would be severely reduced, and there would be a liquidity crisis in the first instance,” he says. “Loans would be much harder to come by, even for well-run and liquid companies.”
Taken together, it is hardly surprising that a poll of British companies by website growthbusiness.co.uk found that almost half of firms (49%) think break-up would be “extremely” or “significantly” detrimental.
“I would think this is occupying most people’s planning time,” Toby Woolrych, group finance director at pharmaceuticals company Consort Medical, said in response to a question posed on the subject on Financial Director’s LinkedIn group. Ultimately, the issue for businesses is how to deal with what the Economist Intelligence Unit (EIU) calls “eurogeddon”.
Break-up or make-up
Jason Karaian, the EIU’s senior editor for financial services, puts a 40% probability on a break-up. “Businesses need to make contingency plans,” he says. “They need to review risk-management processes in much the same way they would consider the impact of other major events – be it a natural disaster, political upheaval or the loss of a major customer.”
Obviously, the exact make-up of contingency plans will depend on the nature of the company’s business and its direct exposure to the eurozone.
But in general terms, Karaian says the main issues to consider would be finance and cash management, business continuity, revenue assumptions and targets, and client and supply chains.
Given the multilayered nature of the threat – a slump in demand for exports, a surge in sterling’s exchange rate, withdrawal of lending and fragmenting supply chains – it is best to focus on how to offset each of those in turn.
On the most basic level, companies for whom the eurozone is a major market should adjust their internal budget assumptions to take account of much weaker growth, Karaian says.
The corollary implication is the need for these companies to look for new markets, such as the fast-growing BRIC economies – something UK exports have failed to do when times were good.
A recent report from the Confederation of British Industry and Ernst & Young found that just 4% of UK exports go to the BRIC nations.
Andrew Tyrie MP, the chairman of the Treasury select committee that grilled King on qualitative easing plans, said firms need to “re-orientate exports away from a weak European market to stronger demand in emerging markets”.
Jonny Michael, managing director of JMCL Consulting, which advises clients on procurement, says companies should plan now for a collapse in eurozone export markets. “There are a lot of people who say they have a plan B, but no one knows what plan B is,” he says. “One thing is to try to expand exports to areas outside the eurozone.”
He says the alternative is to reduce exposure to exports, but that would leave companies reliant on weakening UK demand, adding: “Most companies that are exporting are set up to do that.”
The EIU says companies should look at the basics, such as cutting costs and maximising operational efficiencies: “Use crisis-preparation to drive organisational change, replacing obsolete or underperforming product lines.”
On top of that comes the currency issue: ensuring your bank (assuming it is solvent) can accept payments in a new currency from a customer (assuming the customer is solvent).
The EIU recommends that finance directors examine their invoicing and billing systems to ensure they can be reconfigured to deal with new currencies.
If sterling can be expected to appreciate against the euro and new national currencies, then it might be wise to look at hedging out that risk. “From an FD standpoint, there is the immediate, such as spreading cash around, and foreign exchange,” says Woolrych.
The problem is that as the likelihood and magnitude of that risk rises, the cost of hedging it out becomes prohibitive.
JMCL Consulting’s Michael says some exporters have started to put in place agreements to accept payments in the new domestic currency in the event of a euro collapse. “That’s one thing you can do, but whether the other side would agree is another issue,” he notes.
TUI Group, the travel giant that owns Thomson, recently sparked a row in Greece after asking hotel owners to sign new contracts that included an option to pay in new drachmas.
An alternative is to hedge against a surge in sterling. One problem, says Douglas McWilliams, chief executive of CEBR, a consultancy that advises multinational companies, is that it is difficult to hedge “as it is unclear when you should hedge”.
The big unknown is the risk of a repeat of the banking failures that occurred during 2008, culminating in the Lehman collapse.
Nomura, the Japanese bank, says given that the risk of some sort of break-up is “now material”, companies should think about redenomination risk – the conversion of obligations and assets into new currencies. “If the euro ceases to exist, contracts cannot – for practical purposes – continue to be settled in euros,” says Jens Nordvig, managing director of Nomura Holdings.
Either obligations are redenominated into new national currencies, or converted into a new European currency unit – as long as participants can agree its value and a settlement and clearing process.
ICAP, the UK company that is the world’s largest broker-dealer for foreign exchange and government bonds, says it has tested its trading system to handle the collapse of the euro and re-emergence of national currencies.
For non-financial companies, the issue is whether their bank will be in a position to offer funding. “Ensure bank relationships are the right ones,” says Karaian. “If possible, assess whether the banks on which the company relies are healthy enough to withstand a euro collapse.”
The good news is there is some evidence these messages have got through. Almost three-quarters of corporate treasurers are confident they have already put in place policies to protect against the financial consequences of a split.
A survey of 75 senior treasury professionals by IT2 Treasury Solutions at a conference in London also found that four out of five (78.5%) believe their firm could cope with a split, with less than three months’ notice.
“They understand the risk and believe their financial exposures are sufficiently managed and understood to enable them to weather the financial consequences of a break-up,” says Kevin Grant, CEO of IT2.
An international supply chain is perhaps the biggest area that is most out of the full control of UK finance directors. The EIU urges companies to use the opportunity to identify weak links going as far back as suppliers’ suppliers.
Karaian says an obvious contingency is to establish or expand alternative supplier arrangements in non-euro countries.
Woolrych says that evaluating the stability of suppliers in the face of disruption is a real challenge. “Ensuring multiple sources of supply is more important than ever,” he says.
Taking care of business
Michael says companies should learn lessons from last year’s earthquake in Japan: “Companies looked to ensure their first- and second-tier suppliers were OK, but then found it was the sixth- or seventh-tier suppliers out in the sticks that were left without electricity and water.”
One response has come from SAP, the software company that launched cloud-based network Supplier InfoNet to enable users to assess the sustainability of supplier companies. The business is fully capable of managing “any sort of crisis”, said an SAP spokeswoman.
“If you are a small company, how do you find out about your sixth- or seventh-tier suppliers? You simply don’t have time,” says Michael. “One way of doing so, without spending a fortune travelling around Europe, is through something like InfoNet.”
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De La Rue, the banknote printer that recently won a contract to print notes for South Sudan, the world’s newest country, sees similar opportunities in the eurozone.
As De La Rue chief executive Tim Cobbold told analysts on a conference call, the company could start printing new notes for any country that breaks away from the euro – in as little as six months. ?