Are You Ready for the Death of the Euro?

To understand why the stock price of many Asian companies is sliding in and out of the shockingly low levels of the 2008-09 global financial crisis, one must look far away across the oceans to the 17 economies – among them Germany, France, Italy, Portugal and Greece (but not the UK) – that comprise the Eurozone.

 
Ordinarily, Asia’s CFOs would be more focused on issues closer to home, such as the economic growth prospects for their home market and regional giants China, India, Japan and Korea. But we now live in a globalized world and even purely local businesses are getting affected by events in continents miles and miles away.
 
These days, when your bank suddenly becomes more tight-fisted about extending more loans or when the stock market values your company’s shares (and the assets in your retirement portfolio) like they’re rubbish, blame Europe.
 
“Once again, we find ourselves asking whether the Eurozone is heading back into recession and indeed whether the current Eurozone construct will survive,” says Mark Otty, Area Managing Partner, Europe, Middle East, India and Africa for accounting and consultancy firm Ernst & Young.
 
Will the Eurozone self-destruct, bringing down the euro with it and pushing the global economy into a new recession? That’s one scenario that is currently weighing down the markets. Hong Kong’s Hang Seng Index fell 4.4% to 16,822 points on October 3, a level not seen since the depths of the global financial recession in 2009. On the same day, Japan plunged 1.8%, Australia was down 2.8% and Taiwan slipped by 2.9%.
 
In a new report, credit rating agency Standard & Poor’s places the likelihood of a recession in the Eurozone at 40%. “The prospect that Europe might dip into recession again is looking more likely,” wrote Jean-Michel Six, S&P’s chief economist for Europe. “We still do not expect a genuine double dip to occur in the Eurozone as a whole or in the U.K., but we recognise that the probability of another recession in Western Europe has continued to grow.”
 
Like it or not, companies in Asia will now need to plug into their forward planning exercises the the Eurozone’s economic prospects and the likely impact on bank lending, capital raising, export demand and other factors into their forward planning, in addition to the problems in the US and those in China, Japan and other economies in Asia – as well conditions in their own market.
 
Anemic growth
The just released Ernst & Young Eurozone Forecast, prepared in collaboration with Oxford Economics, puts the probability of a Eurozone recession a bit lower than does S&P, at 35%. If the economy contracts, says Otty, there will be “negative consequences for many non-euro markets.” Eurozone imports from Asia and elsewhere will be curtailed, along with Eurozone investments into the region as companies go into cash-preservation mode.
 
Like S&P and other forecasters, the Ernst & Young report expects economic growth to be anemic – 1.6% this year, says Ernst & Young, and 1.1% in 2012. That’s in line with the International Monetary Fund (1.6% in 2011 and 1.3% next year) and S&P (1.1% in 2012), but higher than Goldman Sachs, which now expects 0.1% growth in the Eurozone next year, from 1.3% previously. Goldman projects a mild recession in Germany and France.
 
“Perplexity and risk aversion will be the most powerful reactions in many boardrooms to the economic outlook,” Ernst & Young says. “Investment allocations are likely to be very cautious, with many companies looking to internal reorganization and cost-cutting along the value chain to sustain and improve profitability.”
 
“Our forecast expects no more than a mild 1.5%-2% growth in Eurozone investment next year, which will not provide a real springboard for cutting the 10% unemployment rate and reviving consumer confidence,” the report goes on. “Business investment is not expected to return to pre-crisis levels until 2014.”
 
What does this mean for Eurozone investments in Asia? “Emerging markets will surely be given more attention,” Ernst & Young believes. The indications are that Eurozone companies are sitting on large reserves of cash, part of which can be deployed in still-growing places such as China, India and Southeast Asia. 
 
Greek default ‘unavoidable’
That’s the ‘optimistic’ scenario. A full-blown financial crisis emanating from Europe and possibly infecting the rest of the world cannot be discounted.
 
A crisis can be precipitated by European mishandling a sovereign debt default, which technically has already occurred on some Greek obligations three months ago. “A deeper default than the one in July . . . now looks unavoidable,” reckons Marie Diron, head of European macroeconomic services at Oxford Economics and senior economic adviser to the Ernst & Young Eurozone Forecast project.
 
If handled correctly, a Greek default should not necessarily cause a financial meltdown. From Ernst & Young’s perspective, the following courses of action will ensure that a Greek default is managed in an orderly fashion and thus avoid causing serious disruption:
 
  • Recapitalize the banks in the core Eurozone countries that would face difficulties from losses on their Greek bond assets.
 
  • Recapitalize the entire Greek banking sector, which will require international money since the Greek government does not have the cash at this time
 
  • Adhere to the Euro-Plus Pact agreed in March 2011, which aims to foster competitiveness, employment, sustainability of public finances, financial stability and tax policy coordination
 
There is little room for error. As it is, the Euro-Plus Pact, while a step in the right direction, is seen as not as strong as it should be. It does not provide for the issuance of common Eurozone bonds, for example (Germany, France and other Eurozone countries currently issue their own bonds denominated in euro), nor does it mandate an increase in the size of the European Financial Stability Facility (EFSF).
 
The EFSF currently has a lending capacity of €440 billion. Eurozone governments approved an increase to €780 billion in July, but ratification by the parliaments of all 17 Eurozone countries is required. Even while that process is on-going, however, there are already calls to raise the size of the EFSF once again. Ernst & Young thinks “an almost 700% increase” from the current level will be required – that’s around €3.1 trillion.
 
Death of the euro?
There’s the rub. The Eurozone’s problems are as much political as economic and fiscal. “If the Eurozone is to remain in its current form,” says Diron, “an unequivocal and firm commitment is necessary from the core countries [such as Germany and France] for greater fiscal union.”
 
“Many countries will resist this implied loss of sovereignty,” she says, “but without the ability to monitor, control and finance spending across the Eurozone, there can be no guarantees that fiscal stability can be maintained [even] after the existing severe problems are resolved.”
 
Despite these problems, Ernst & Young puts the probability of a break-up of the Eurozone at just 5%. “We are not privy to all the political discussions and recognize that the situation is very uncertain, but we do not believe that a breakup will result,” Otty writes in the introduction to the report. Europe’s leaders will make sure the Eurozone stays intact because “the consequences [of a break-up] for business and the wider economy would be huge.”
 
Others are more pessimistic. In the latest quarterly Bloomberg Global Poll conducted in September, four out of ten investors said they expect one Eurozone country to drop the euro within a year. Another 32% said a nation will exit within two to five years. Charles Dumas, director at Lombard Street Research in London, says he expects Greece to stop using the euro within 18 months.    
 
A slimmed down Eurozone does not necessarily mean the euro will die, some analysts argue. In fact, a Eurozone without Greece and other weaker economies in it could emerge a stronger currency. It would be like “cutting off a gangrenous leg to preserve the body,” David Marsh, author of The Euro: The Battle for the New Global Currency, told Bloomberg.
 
However, the short-term impact of a break-up will be chaotic, especially if it happens at a time of great volatility, such as the present. As it is, the financial markets are already on a frightening roller-coaster. The S&P 500 plunged into bear market territory on October 4, dropping 1.4% to 1,084 points, down more than 20% from its intra-day highs in May. The index recovered somewhat to 1,162 points on October 6.
 
For now, the financial markets have achieved a measure of calm with the announcement by the European Central Bank that it will resume purchases of assets backed by mortgages or public-sector loans and will extend year-long loans to banks. Political leaders and policymakers have also kept up a drumbeat of reassurances about imminent action on the Eurozone’s troubles.
 
These include a promise by French President Nicolas Sarkozy and German Chancellor Angela Merkel to deliver a plan by the end of October that will address the immediate problems of Greece and the longer term "structural defects" in the Eurozone. However, there are fears that the raised expectations will be dashed when the initiatives are actually unveiled and implemented.
 
Don’t panic
What should CFOs do? The first thing is not to panic. If a recession hits (and there’s always going to be one simply because recessions are part of the business cycle), it will end sooner or later. A study by Bank of America Merrill Lynch of the past four recessions that afflicted Asia finds that they ended after 15 months on average.
 
Even the negative effects of the 2008-2009 global financial crisis on Asia did not last that long – nine months in Indonesia and 12 months in Singapore, Malaysia and Thailand, for example.
 
Bank of America economists believe that “a recession, if it does materialize, will likely be of the milder rather than the more severe form.” If they are right, the negative effect on economic growth, inflation and interest rates in Asia will likely resemble the relatively shallow impact of the 2001-02 dotcom implosion or the 2003 SARS-induced slowdown, rather than the 1997-98 Asian crisis or the recent global recession.
 
Asia’s enterprises have proved over and over again that they can roll with the punches. The coming storm should be no exception.
 
About the Author
Cesar Bacani is Editor-in-Chief of CFO Innovation.
 

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