The possibility of euro zone restructuring feels like a blockbuster risk: it's big, grabs headlines and seems to strike in the summer months. Unlike Hollywood flicks, however, the implications of euro zone restructuring are extremely complex and don't appear to have terribly happy endings. As a result, leading organizations are taking steps now to ensure that the fallout does not inflict tragic impacts. As PricewaterhouseCoopers principal Peter Frank and PwC principal Shyam Venkat note in the following Risk Chat, the impact of the crisis on U.S.-based companies vary by industry.
That said, "all companies can expect to see some degree of disruption and changes to their operations," according to Frank, who provides background on the potential structural changes that may (or may not) be on the horizon and weighs in on the nature of risks that various possible scenarios create for U.S. companies. Venkat follows with some examples of the ways forward-looking companies are creating contingency plans as well as specific mitigation steps.
Eric Krell: What is euro zone restructuring and what is the range of possible changes it might include?
Peter Frank: When we refer to a restructuring of the euro zone, we generally mean potential structural changes to the composition of the European Union member countries that have adopted the euro. Most likely, such a change in composition would mean one or more members dropping out of the euro and adopting a new currency. A restructuring may also mean continuity of the current set of euro zone countries, albeit with significant changes to organizational, fiscal and monetary policies and protocols.
While there is a high degree of uncertainty around potential outcomes, PwC has defined four restructuring scenarios that represent a range of potential resolutions to the crisis. Note that these scenarios are neither mutually exclusive nor collectively exhaustive, but represent some potential likely outcomes [italics are Frank's]. The scenarios include:
1. Phases of monetary and fiscal action hold the euro zone together at the cost of inflation.
Higher inflation will ease debt restructuring and improve competitiveness of peripheral European economies. As the European Central Bank (ECB) raises interest rates to bring down inflation in the medium term, credibility will be slowly restored. Most euro zone countries will be running primary surpluses of many years, putting a substantial drag on potential growth.
2. Voluntary defaults for highly indebted sovereigns.
Restructuring governments will be locked out of credit markets and require long-term support from the rest of the euro zone and other bilateral institutions. Over time, these countries will reestablish credibility with investors but in the short term these countries will limit European economic recovery.
3. Greece exits the euro zone and a firewall is built around other economies.
Greece: Significant depreciation of the drachma constituting an implicit default on debt with a soar in inflation. The Greek economy would enter a severe recession as credit conditions and confidence deteriorate and further fiscal austerity is mandated in return for IMF funding. In the medium term, the economy could recover driven by exports spurred by a weaker currency and improved competitiveness.
Other euro zone countries: A recession is expected in the euro zone as investors' losses and eroded confidence lead to a capital flight and deteriorating credit condition. However, a Greek exit would also provide an impetus for other vulnerable countries to bring forward fiscal and structural reforms improving long term growth prospects.
New union: A new bloc will benefit from an inflow of capital in the first year; however, transition costs and a loss of competitiveness as a result of the stronger currency will drag on growth in 2012. The new euro exchange rate will potentially be higher compared to the exchange rate for major trading partners.
Other euro zone countries: Economies that break away from the euro face challenges of depreciating exchange rates, soaring inflation and failing output. Future success will depend on the ability of these countries to rebuild credible fiscal and monetary institutions.
What are some of the largest and most notable risks that the euro zone restructuring presents for U.S.-based multinationals?
Frank: The impact of the crisis for U.S. corporations will vary based on industry, extent of global operations and competitive position within industry, among many other factors. However, all companies can expect to see some degree of disruption and changes to their operations. For most companies, the most significant risks are likely to be related to the global macroeconomic impacts of the crisis.
Under most scenarios, it is likely that there will be significant contraction in aggregate demand in the euro zone. This in turn is likely to result in a contracted supplier base, unfavorable price and foreign exchange movements, contractual defaults, increased credit risk, liquidity issues, etc. Strategic contingency planning is essential for companies looking to minimize the risk of these potential scenarios.
At a high level, how can scenario and contingency planning help address these risks?
Frank: Contingency planning based on potential risk scenarios can provide companies a structured framework within which to identify, assess, mitigate and monitor potential operational and financial risks. Companies should proactively develop contingency plans to address the potential consequences of various euro zone scenarios and take steps to minimize the risks today. Proactively addressing the cause of these potential risks will enable organizations to ensure they are prepared for the outcome of this constantly evolving crisis.
What are some examples of possible mitigation steps?
Shyam Venkat: Organizations have already started to anticipate the consequences of the euro zone crisis and implement steps to mitigate potential risks. While response strategies to date have varied by industry and company, many companies have taken steps to mitigate potential financial risks by reducing euro-based investments, modifying foreign currency risk management strategies and reducing customer and counterparty credit exposures. Operationally, there has also been a focus on stressing sales forecasts and their resulting operating plans and reducing exposure to potentially vulnerable European suppliers as part of a broader supply chain risk program.
What is the board's role in these activities, and what information do boards and risk committees need to keep current on contingency planning efforts?
Venkat: As with any significant risk, the board of director's role is to provide oversight and ensure that management has developed adequate plans to deal with the euro zone crisis. In practice, the level and nature of board engagement on the euro topic has varied in depth and nature. Some boards (or a committee thereof) have been actively involved with management to develop response plans and are engaged near real-time in the monitoring of progress. Other boards have limited their engagement to a review of management's risk assessment and mitigation/response plans, resisting the urge to get actively involved in the actual management of risks.
Are there other important components of the contingency planning effort (e.g., crisis management plans)? If so, what do they entail?
Venkat: Successful contingency plans are usually developed by cross-functional groups of stakeholders within an organization and approved/overseen by the board of directors and audit committees. These plans are typically developed using a structured process to identify potential risks, assess the magnitude and probability of these risks, prioritize based on identified risk impact, and outline clearly defined mitigation steps, focusing on the highest impact risks.
Contingency plans should also consider both financial and operational mechanisms to reduce risk exposures, have clearly defined owners and monitor metrics for revision on a regular basis to ensure continued appropriateness given the constantly changing economic and socio-political environment. In addition to having plans to mitigate risks upfront, many companies have also spent time to develop plans more akin to a crisis response plan (i.e., "if X, Y, or Z happen, then we will do the following").