Eurozone crisis

Contingency planning for eurozone exits

Introduction
Deloittes Euro Crisis Group comprises Vivian Pereira, Ian Stewart, Hans-Kristian Bryn, Rick Cudworth and Wayne Weaver. This short note draws on the Groups discussions with colleagues, clients and policymakers over the last eight months. It provides a succinct guide to the practical business issues that would result from a country leaving the single currency as well as a step by step account of how a country might go about seceding. To discuss any of the issues arising from this note please get in touch with the Deloitte contacts below. Potential issue Areas where we can assist Identify material positions at risk of redenomination through review of operational and contractual arrangements Reduce country risk where feasible and cost effective Develop and implement strategies to mitigate potential losses from redenomination Analyse accounting consequences of redenomination (for both external and intra-group positions) including accounting treatment of any designated hedges Tax treatment of material positions deemed prone to redenomination and tax efficacy of mitigation strategies Deloitte contacts Vivian Pereira Juan Ramirez

Redenomination risk: Euro exit would mean introducing a new currency which could devalue substantially causing major shifts in the external value of certain assets, liabilities and cash flows in the seceding country

Wayne Weaver

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FINANCIAL

Counterparty credit risk: Secession could cause major economic and financial stress, increasing the risk that individuals, corporates and financials are unable to pay out on contracts

Analyse material financial exposures with counterparties (e.g. banks, sovereigns and debtors (trade and other)) and review appropriateness of limits currently in place Consider changing terms of trade for certain counterparties (or similar initiatives) Consider collateral arrangements, buying credit protection and other credit risk mitigation strategies Implement tax strategies for securing effective tax relief for credit losses

Ian Tyler Dino Nicolaides Karlien Porre

Wayne Weaver Ian Tyler Dino Nicolaides Karlien Porre Wayne Weaver Ian Tyler Dino Nicolaides Karlien Porre

Market risk: A breakup of the existing euro group and the introduction of one or more new and unproven currencies and policy regimes could increase volatility in foreign exchange and other financial markets Liquidity risk management and funding: The financial sector in a seceding country could come under significant pressure from capital flight, increases in the burden of foreign currency debts and from general economic weakness. There would be high risk of contagion. Corporates need to be prepared for liquidity shortages and a credit crunch

Obtain close awareness of all existing market risk exposures to enable defensive actions to be taken Stress testing existing positions Revise hedging policy for changing market conditions and current risk appetite Tax analysis of failed hedges and tax effectiveness of mitigation strategies If supporting operations in an at risk country, consider contingency arrangements to ensure payments to staff, utilities etc. are not disrupted as local banks may have very limited liquidity Identify facilities due for re-financing in the short term and bring forward re-financing plans Stress test group position to ensure access to sufficient liquidity or identify potential weaknesses Identify key providers of committed finance headroom and assess risk and impact of any bank failures Tax implications including withholding tax mitigation and transfer pricing of intra-group financing

Wayne Weaver

2012 Deloitte LLP. Private and confidential.

Eurozone crisis
Contingency planning for eurozone exits
Potential issue STRATEGIC Areas where we can assist Evaluate the organisational ability to execute on strategy following country exit Consider what changes the exit will make to the organisations competitive positioning Analyse what changes will be required to the operating model in order to continue to service markets and customers Stress earnings and cash-flow forecasts to understand financial impact of exposures Assess group tax implications and potential mitigation steps Liaise with procurement to assess strength of supply chain and changes to expected stock levels both input and output Consider if you can assist critical links in supply chain with prompt payment or supplier finance programmes Consider if extra precautionary stocks of raw materials would help to conserve future production or could end up redundant if sales collapse Work with sales teams to analyse vulnerability of individual major customers Analyse financing needs against changing stock and storage strategy Test contingency arrangements in simulations and exercises to prove processes and practise people Test alternative working arrangements and familiarise people through operational testing (physical test of arrangements in the event of civil unrest and staff unavailability) Map group dependencies on at risk markets and identify workarounds Specialists to help coordinate and programme manage a response in the support of management Assess ability to upgrade key systems for new currencies and highlight any limitations Upgrade and change system configurations Test that all key transactions and activities can be processed by upgraded systems Test system capacity levels to ensure increases in transactional volumes can be handled Identify impacted contractual agreements and liaise with third party suppliers Ensure that accounting systems cope with redenomination of accounts Deloitte contacts Hans-Kristian Bryn

Strategic risk management: Euro exit creates a new economic and financial structure and outlook for the seceding country. Corporates will need to reassess their operations, plans and prospects.

Wayne Weaver Hans-Kristian Bryn William McLeodScott

Supply chain and operational buffer: Deep financial and economic weakness would put corporates and supply chains exposed to secession under pressure

OPERATIONAL

Business continuity planning, testing and responses: Processes and people in all organisations would face additional demands from the upheaval and uncertainty associated with exiting the euro System readiness: Corporates and financials will need to adjust their systems to cope with the arrival, possibly at short notice, of a new currency

Rick Cudworth William McLeodScott

Stephen Ley Steve Bailey

Vivian Pereira: Wayne Weaver: Juan Ramirez:

+44 (0) 20 7007 0558 viviapereira@deloitte.co.uk +44 (0) 20 7303 4105 waweaver@deloitte.co.uk +44 (0) 20 7007 6288 juanramirez@deloitte.co.uk

Ian Stewart: Stephen Ley: Dino Nicolaides:

+44 (0) 20 7007 9386 istewart@deloitte.co.uk +44 (0) 20 7303 7386 sley@deloitte.co.uk +44 (0) 20 7007 8545 dinicolaides@deloitte.co.uk

Hans-Kristian Bryn: William McLeod-Scott: Karlien Porre:

+44 (0) 20 7007 2054 hbryn@deloitte.co.uk +44 (0) 20 7007 9952 wmcleodscott@deloitte.co.uk +44 (0) 20 7303 5153 kporre@deloitte.co.uk

Rick Cudworth: Ian Tyler: Steve Bailey:

+44 (0) 20 7303 4760 rcudworth@deloitte.co.uk +44 (0) 20 7007 7551 ityler@deloitte.co.uk +44 (0) 20 7303 7069 sjbailey@deloitte.co.uk

2012 Deloitte LLP. Private and confidential.

Eurozone crisis
Euro break up how might it happen?
History provides numerous examples of countries undergoing large scale currency devaluations, as occurred when Argentina broke its dollar peg in 2001. Such devaluations are far simpler than seceding from a monetary union and introducing a new currency. The breakup of the Czech-Slovak monetary union and the Soviet Union in the early 1990s provide perhaps the two most recent European precedents. Breaking a monetary union tends to be traumatic. A UBS study of the dissolution of eight monetary unions identified a number of common themes. The expectation of a breakup leads to currency flight as citizens move money to safe havens. As a result the breakup of a currency union requires the imposition of capital controls. Historically break ups are often accompanied by the expropriation of financial assets from domestic and overseas depositors to help bolster the governments finances. Finally, monetary union breakups are socially and politically wrenching events which, according to the report, risk significant civil unrest (A brief history of break-ups, UBS, 11 th October 2011). Every episode is different and it is possible to imagine many ways, some of them more benign than history suggests, in which a country might leave Europes monetary union. There are different varieties of breakup too, from a single country seceding to a complete disintegration of the union. The creators of the euro did not envisage that countries would leave the union and, as a result, did not build an escape route. An exit for which there had been careful preparation, and perhaps information sharing with the private sector, would be more orderly and less disruptive than a sudden and unplanned exit. Given that the euro area has been grappling with the problems of high public sector debt and financial instability for more than three years it would be surprising if some contingency plans for exit were not now in place. The following sequence identifies one possible exit route. It is speculative but nonetheless sheds light on the considerations involved in seceding from the euro: 1. The decision to leave the euro might well be announced without warning late on a Friday evening once US markets were closed. The aim would be to act with stealth and to seek to limit capital flight. The seceding country would almost certainly have drafted a New Currency Law beforehand. It would be published, debated and agreed at an emergency meeting of the national Parliament over the weekend. Parliament would need to agree all the necessary details: the name of the new currency, its exchange rate with the euro, capital controls and the redenomination of all contracts and debts from the euro to the new currency. Banks and corporates would have to switch all bank accounts, wages, debts and assets into the new currency. If the exit had been planned well in advance, new currency might have been printed and be available for immediate distribution. Otherwise in order to provide a functioning physical currency the central bank would need to set in train a massive operation to stamp or mark all existing euro notes with the name of the new currency. This temporary currency would circulate until the new notes could be printed and distributed. Doing so would be a huge task. As the Financial Times has noted, In 2003 the US-led coalition managed to do it in Iraq in less than three months. But that required the efforts of De La Rue, a British speciality printer, a squadron of 27 Boeing 747s and 500 armed Fijian guards to ease the process. The current crisis has already led to significant withdrawals of capital from Greek and Spanish banks. This process would accelerate in the run up to any anticipated exit as households and corporates sought to avoid a devaluation of their capital. To prevent a further of flight capital, foreign exchange controls would probably be introduced over the weekend of any announcement. Indeed, it is possible that capital controls would be put in place before the announcement of secession. A bank holiday, of possibly several days, would be announced to prevent bank runs and provide time for the switch-over to take place. Withdrawal of euros from cash points would stop and electronic transfers of euros outside the country would be prevented. Residents would not be permitted to take Euro notes and coins out of the country. The borders might be sealed by the police and the armed forces to prevent people taking money out of the country.

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2012 Deloitte LLP. Private and confidential.

Eurozone crisis
Euro break up how might it happen?

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Engineering a smooth and orderly transition to a new currency would require a very high degree of planning and coordination beforehand, done in conditions of great secrecy. This is not inconceivable. But there is clearly a risk that the actual process would be more disorderly and would be followed by a period of uncertainty and economic turmoil as the details and implications of secession became apparent. Corporates would face swings in the external values of assets and liabilities depending on the performance of the new currency on the foreign exchanges. Estimates of the scale of the likely devaluation of a new drachma vary significantly, though published estimates range from around 40% to 80%. This would mean a sharp decline in the external purchasing power of consumers and corporates, rising inflation and, especially, import costs. Contracts written in national law, such as for public sector wages or pensions, could quickly be switched over to the new currency. But there would be possibly protracted legal disputes about contracts made in foreign law. Those outside the jurisdiction of the courts of the exiting country and payable outside the exiting country would be most likely to avoid conversion. Doubts about the stability of the new currency and an accumulation of euro notes and coins by households could encourage the development of informal transactions in euros or other foreign currencies.

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10. An exiting country would probably default on its euro debt and, unless it were able to secure aid from the IMF, could face difficulties financing everyday public services. 11. Holders of overseas euro-debt which did not redenominate would face sharp increases in the value of their liabilities. Bankruptcies and stress would rise in the banking, household and corporate sectors. A country seceding from the euro would hope that a combination of devaluation and debt write-offs would boost competitiveness, stabilise the public finances and, in time, restore growth. But to get there the country would face a period of uncertainty and major change. The scale of disruption involved in seceding might well mean a far deeper recession and high inflation. Views on the likelihood of exit or some form of breakup are changeable. But a quick and comprehensive solution to the crisis remains elusive. The possibility that a country might leave the euro may be here for a long time to come.

2012 Deloitte LLP. Private and confidential.

Eurozone crisis

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2012 Deloitte LLP. All rights reserved.

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2012 Deloitte LLP. Private and confidential.