Do I think the Euro will still be around in 5 years?

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The short answer is yes.  And this is due to self-interest, particularly for Germany.  The Euro has certainly been a weaker currency for Germany than a stand-alone Deutschemark would have been.  At the same time it has been a stronger currency for many other Eurozone countries than stand-alone currencies would have been.  This might have been expected to force the latter countries to become more productive and remove some compulsion for Germany to become so.  In fact, Germany has improved productivity substantially over the life of the Euro and produced very strong export performance helped by a weaker Euro.  At the same time, other countries, notably Italy have not restructured, or notably improved productivity, and fallen behind.  However, their borrowing costs, until recently, have been low.  Germany has in effect been benefiting from a weak currency policy (like China has) relative to its economic strength, under cover of the common currency. 

 

If weak Eurozone countries left the Euro, their currencies would likely plunge dramatically making it even more difficult to repay debts that would still be denominated in Euros.  This would apply not only to sovereign debt, but also to corporate debt.  Large bankruptcies and default s would follow resulting in massive losses for German banks that are hugely exposed to these countries.  As import costs for these weak countries would soar, German companies would also lose significant export markets.  Also German goods internationally would be more expensive with a stronger Deutschemark

 

Conversely, if Germany left the Euro, a new Deutschemark, would soar compared to the new weaker Euro and other currencies hitting German exports globally.  German banks would incur large losses as their Euro exposures lost value against the Mark.

 

In short, there is certainly going to be large cost for Germany arising out of all this one way or the other.  They have benefitted from the Euro for over 10 years and now will have been shown to have squandered part of the surplus generated by providing liquidity to unreformed weak economies.  Ensuring survival of the Euro is probably the least bad course, which is why I think the Euro will still be around in something like its present form in 5 years.

Do you think the Euro will still be around in 5 years?

by Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Perhaps “in its current form” should be added to that.  For any corporate treasurer, this is an important question and should encourage them to re-examine their currency exposures and hedging practices.  (Exposures may include hidden exposures like imported components in goods bought from domestic suppliers for example.)  The effects of a Euro break up, or of a change in its form may well be felt much more and further afield than most people might realize.  An independent analysis and view might be appropriate for many businesses.  Whatever your view, this should be on the radar as high risk.

 

Too little too late has characterized all or most actions during the current crisis.  Denial, prevarication and changing positions have also been in plentiful evidence.  Of course, it is politicians of various different stripes and different nationalities and cultures that are trying to find a common solution to the problem.  Not necessarily the recipe for a timely, practical and effective solution.  The main player, Angela Merkel, has been trying to keep domestic political balls in the air during all this and that appears to have precluded swift and decisive action. 

 

Of course it could be argued that without going to the brink, countries like Italy will not institute any truly effective reforms.  On the other hand, the longer it takes to come to a satisfactory solution, the higher the cost is likely to be and the higher the risk that the house of cards will come crashing down.

 

There seems to be an intent to maintain the Eurozone in its current form.  However, when going close to the brink, events can get out of control and unintended consequences come about.  (Look back in history to how the First World War started.)

 

 

Next: Do I think the Euro will still be around in 5 years?

Confronting and Managing Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

The recent confrontation between Greece and EU officials provide a good lesson for risk managers.  EU officials continue to minimize potential risks, fail to take realize their magnitude and communicate the problems, and take the necessary steps to remedy the situation.  These are all symptoms of a failure of risk management.  

 

Greek Prime Minister Papandreou made a stand, against the proposed Greek debt restructuring, and even though he was forced to backpedal, Wyplosz argues that he did the Eurozone a favor by providing it an opportunity to change course.  The Greek government has largely been following the dictates of EU officials to not restructure their debt, but this might have been the least costly remedy if done in a timely manner.  

 

The Greek revolt, even if short lived, is good news on the European crisis front – it might provoke the long-awaited policy turnaround that is necessary to end the Eurozone crisis.  It may finally awaken Eurozone leaders to the futility of the path they’ve chosen.  One way or another, a disorderly Greek default is in the cards with its attendant contagion for all of the rest of the PIIGS (Portugal, Ireland, Italy, and Spain) and maybe even France.  The cost of a default could be much larger than delaying the inevitable Greek restructuring.

 

Dazed and Confused?  Eurozone officials took the wrong path in early 2010, because they did not fundamentally understand the nature and depth of the problem.  Perhaps, they did not want to deal with it and brazenly assumed things would revert back to normal.  However, the seriousness of the surging debt and slow growth revealed all the flaws hidden in the euro’s first ten years.  There is a cost for their negligence. 

 

At that point a real solution is inevitable – one that requires Eurozone leaders and the ECB to play on the same side with credible rules for all.  An ECB backstop for Eurozone bonds will be required, but this does not mean underwriting banks and sovereigns. The ECB guarantee should be set to protect the ECB and to force a debt restructuring for countries that face unbearably high interest rates. 

 

Banks will have to be bailed out, possibly with EFSF resources, but in a way that minimizes moral hazard and maximizes taxpayer protection.  That means wiping out shareholders and, if need be, unsecured bondholders.  The cost of the bailout could reach into the hundreds of billions and does not include recapitalizing financial institutions.  A long-term cost is the sustained period of sub-trend growth resulting from the overhang.

 

Can we learn anything for risk management?

For more on this follow the link:  http://www.voxeu.org/index.php?q=node/7222

Eurozone Risk Identification & Mitigation

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

Eurozone policymakers and politicians continue to ignore the growing risks to the euro and the failure to take appropriate action to address these risks.  They continue to view recent developments as a temporary liquidity crisis instead of a solvency issue.  They commit all the classic failures of risk management outlined by Rene Stulz in a recent article in the Journal of Corporate Finance (2008).  A proposed outline on VOXEU identifies some of the methods how the Euro crisis can be addressed. 

The Eurozone crisis has taken a turn for the worst.  A group of German economists from the “German Council of Economic Experts” have proposed a temporary program to stabilize financial markets by creating two temporary entities: the European Redemption Pact and the European Redemption Fund. 

This involves the creation of a joint debt vehicle with a finite maturity date.  The objective is to ease temporary market dislocations and mandate the implementation of credible fiscal reforms for all Eurozone members.  This program would combine two elements: accounting and solidarity.  Accounting requires member countries to consolidate public debt and eventually reduce debt levels toward more sustainable levels.  Solidarity requires assistance from stronger members to weaker partners, but encourages fiscal discipline. 

The European Redemption Pact is based on a revised Growth & Stability Pact that combines joint and several liabilities and a strong commitment to push countries toward a 60% debt-to-GDP ratio.  The point is to separate the accumulated debt of member countries into a part that is compatible with a 60% debt threshold and a part that exceeds this limit.     Participants can refinance themselves through a joint European Redemption Fund (ERF) until the debt refinanced reaches the 60% debt threshold.  Participants in the program would be jointly liable, but each country is required to service its own debt financed through the ERF. 

The advantage of the program is its limited duration and the strong strings attached for participation (tax provisions, collateral & redemption guidance).  Another advantage of the program is a market rate for weaker members and for stronger member’s avoidance of a potential messy default.

The classic failures of risk management include using the appropriate metrics, measuring known risks, accounting for all risks, failure to communicate and failure to monitor and manage.  Can we learn something from events in Europe?

For more on the article A European Redemption Pact, please follow the link: http://www.voxeu.org/index.php?q=node/7253