eurozone crisis: strategies for risk mitigation

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Understanding the crisis

Potential scenarios

Implications for US corporations

What companies are doing now

fs viewpointMay 2012

Breaking Up is Hard to Do: The Eurozone Crisis—Possible Implications and Contingency Planning for US Companies

Understanding the crisis

3Understanding the crisis

1 Charles Forelle, “EU Sees Wider Greek Deficit, Roiling Markets; Bonds Fall as Investors View Bailout and Default as Givens,” The Wall Street Journal, April 23, 2010.

2 The eurozone consists of the following 17 European Union member countries who have adopted the euro (European Monetary Union): the 11 original members—Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain—and Greece (from January 2001), Slovenia (from January 2007), Cyprus and Malta (from January 2008), Slovakia (from January 2009) and Estonia (from January 2011).

The current eurozone debt crisis, while building up over time, was triggered in April 2010 when Eurostat, the Europe Union (EU) statistical authority, revealed that Greece’s 2009 budget deficit was €32.3 billion, or 13.6% of its gross domestic product (GDP). In 2009, Greece had estimated its deficit for 2009 would come in at 3.7% of GDP. The EU’s limit is 3%.¹

Global markets have since responded to the magnitude of sovereign debt in other eurozone countries as investors question the ability of these countries to repay their debts.²

Greece, Portugal, and Ireland have requested financial assistance from the European Central Bank (ECB), the European Commission (EC), and the International Monetary Fund (IMF) to finance debt repayment. There has also been a stream of European summits to resolve the crisis.

Growing market pressure and significant tranches of sovereign debt due for refinancing hint at a possible resolution to the current phase of the crisis. However, there is no silver bullet—any solution will necessarily play out over time, step by step, via fiscal austerity to pay down debt. In addition, deep structural reforms will be necessary to restore competitiveness and boost long-term growth.

Reform momentum is growing as political leaders face up to this moment after more than two years of procrastination and wishful thinking. Arguably, some of the largest financing hurdles in the most at-risk countries have been overcome, with yields on both short- and long-term debt significantly lower than at the end of 2011, and consumer and industrial confidence beginning to improve. Nevertheless, significant operational risks remain for US firms operating in the eurozone. Contingency planning can help mitigate the risk, and the strategies adopted by US firms will depend on likely market conditions. In this publication, PwC will outline four possible scenarios for the eurozone’s future that can help guide US corporate decision-making.

Eurozone crisis

Consumer and industrial confidence

-50

-40

-30

-20

-10

0

10

20

Industrial confidence indicator, SA % balance

Consumer confidence indicator, SA % balance

2000 - Jan

2001 - Jan

2002 - Jan

2003 - Jan

2004 - Jan

2005 - Jan

2006 - Jan

2007 - Jan 2008 - Jan

2009 - Jan

2010 - Jan

2011 - Jan

2012 - Jan

Source: Haver Analytics

Consumer and Industrial Confidence

4 FS Viewpoint

1 “Can it be… the recovery?” The Economist, 17 March, 2012.

2 “Eurozone crisis live: FTSE 100 posts biggest fall of 2012 - as it happened,” Guardian Unlimited, March 6, 2012. http://www.guardian.co.uk

3 “Greece: Request for Extended Arrangement Under the Extended Fund Facility,” IMF Country Report No. 12/57, March 2012.

In March 2012, The Economist reported, “Cheered by the signs of recovery, and relieved that disaster has been avoided (particularly in Europe, which towards the end of last year seemed on the brink of a calamity of Lehman-like magnitude), financial markets have been climbing steadily higher.”¹

While financial markets have recently started to move higher, GDP data reflected a different story—confirming that the region shrank by 0.3% in the last quarter of 2011 while household spending, exports, and imports all fell.² Some fear that the eurozone may slide into deeper recession.

Many forecasters question whether Greece’s partial default on its debt and additional funding from the ECB and the IMF of €130 billion is a long-term fix or simply a way to delay the inevitable. Even with this package, Greece’s debt is still expected to be 120% of GDP in 2020 under what some consider to be optimistic economic and budget assumptions.³

As soon as the ink was dry on the Greek bailout agreement, market attention turned to debt issues in Italy, Spain, and Portugal, thereby signaling a potential continuation of the crisis and once again highlighting the historical origins of the current dilemma.

Eurozone crisis

Percent change in real GDP since 2000 Share of eurozone GDP

Greece, Ireland,and Portugal:6.1% of eurozone GDP

Spain and Italy:28.5% of eurozone GDP

Rest of eurozone:65.4%

Source: Haver Analytics, IMF, and WEO Databases.

Share of Eurozone GDP

100

110

120

130

140

150

Greece

Source: Haver Analytics and PwC analysis

Germany

Spain

Ireland

Portugal

Italy

Percent Change in Real GDP Since 2000

2000

2001

2006

2007

2008

2009

2010

2011

2002

2003

2004

2005


Current account balance (US$ billion) Manufacturing unit labor cost index

1 “European Economy News,” April 2010, European Commission Economic and Financial Affairs. Available from http://ec.europa.eu/. Accessed April 10, 2012.

Diverging competitiveness

Divergences in the competitive positions and current-account balances of eurozone countries have been building up over the past decade. Countries such as Germany and the Netherlands gained in price/cost competitiveness while others such as Greece, Ireland, Portugal, and Spain lost competitiveness.¹

This imbalance stemmed from the eurozone’s unique governance structure (part intergovernmental, part supranational) and macroeconomic policy framework (single monetary policy and devolved fiscal authorities). Additionally, there was no mechanism for regulating wider macroeconomic imbalances.

The roots of the crisis go back to the inception of the euro in 1999 and two underlying problems that have gone unchecked:

0

100

200

300

400

-400

-300

-200

-100

Germany

Greece

Netherland

Spain

Portugal

France

Current account balance (US$ billion)

2000

1999

2001

2006

2007

2008

2009

2010

2011

2002

2003

2004

2005

Italy

Source: IMF

80

100

120

140

160

180

Greece

Germany

Source: OECD

Netherland

Spain

France

Q1

2000

= 1

00

Portugal

Italy

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

Manufacturing unit labor cost index

6 FS Viewpoint

Over-reliance on debt

The divergence trend has been supported by a complementary flow of credit from the surplus countries to the deficit countries. This has caused a build up in public and private debt, delayed a correction in competitiveness, and allowed the structural problems of the eurozone to be largely hidden. Many countries are now struggling to repay this debt.

The European banking sector is an important channel of transmission of the crisis because banks have large holdings of eurozone sovereign debt on their books. The ECB is leading the effort to ease this pressure with the introduction of its credit facility for the banking sector, the long-term refinancing operations (LTROs).

The roots of the crisis go back to the inception of the euro in 1999 and two underlying problems that have gone unchecked:

Pubic debt and deficit estimates for 2011 (% of GDP)

40

60

20

100

120

80

160

180

140

0

-6-9-12 -3 0 3

Greece

Portugal

France

Ireland

Spain

UK

Italy

Belgium

Source: IMF

Public debt and deficit estimates for 2011 (% of GDP)

Go

v’t

deb

t (%

of

GD

P)

Axes represent Maastricht limits

Government deficit (% of GDP)

High debtHigh deficit

Moderate debt High deficit

High debt Moderate deficit

Low debt Low deficit


Imperfect union

The 17 members of the European Monetary Union remain sovereign nations. The following timeline outlines potential trigger events during 2012 that may impact the timing and ultimate resolution of the crisis.

The resolution to the crisis will be impeded by the fact that the eurozone is not a political union.

March Apr May June… Aug Sept Oct Nov Dec

Refinancing €14.4 bn Greek bond redemption/disbursement (Mar)

€8 bn Greek bond redemption (May)

€9.5 bn Portuguese bond redemption (Jun)

€7.7 bn Greek bond redemption (Aug)

IMF review of Greek economy (Nov)

€14.6 bn IMF disbursement to Portugal (Mar)

IMF review of Greek economy (May)

Review of Greek economy by the IMF (Aug)

€5.5 bn Ireland bond redemption (Mar)

Political meetings EU Council meeting (1-2/Mar)

G20 Finance minister and central banks’ meeting (20/Apr)

EU Council meeting (28-29/Jun)

G20 Finance minister and central banks’ meeting (13-14/Sep)

EU Council meeting (13-14/Dec)

G20 Summit (18-19/Jun)

EU Council meeting

(18-19/Oct)

IMF/World Bank Annual meeting (Oct)

Elections First round of French presidential elections (22/Apr)

US presidential elections (6/Nov)

Greek elections (6/May)

Greek elections (6/May)

Greek events

Potential scenarios

9Potential scenarios

1 “What next for the eurozone - Possible scenarios for 2012.” Available from: www.pwc.co.uk. Updated scenarios published March 2012.

2 Ibid.

There are a number of ways in which the eurozone crisis could play out depending on the mix of policy responses over the next year or two. Presented below are four possible, though not necessarily exhaustive, scenarios that represent a range of potential resolutions to the crisis in 2012:

Scenario 1:

Successive phases of monetary and fiscal action hold the eurozone together at the cost of inflation.

Scenario 2:

Voluntary defaults for highly-indebted sovereigns.

Scenario 3:

Greece exits the eurozone and a firewall is built around other economies.

Scenario 4:

A new currency union is formed by the stronger economies.¹

Each scenario varies in its likelihood and impact.

The eurozone that emerges from the crisis is likely to be very different to the one we know today, with 2012 being dominated by uncertainty and high volatility.

There is a wide range of potential outcomes.

Potential scenarios for the eurozone in 2012.

Projected eurozone GDP growth under four scenarios.

-6%-5%-4%-3%-2%-1%

01%2%3%4%

Projected Eurozone GDP growth underfour scenarios

2005

2006

2007

2008

2009

2010

2011

2012

2013

Scenario 1

Source: PwC analysis.

Scenario 3

Scenario 2

Scenario 4

Scenario description Projected GDP growth (percent)2

2012 2013

Scenario 1: Successive phase of monetary and fiscal action hold the eurozone together at the cost of inflation.

0.1 0.7

Scenario 2: Voluntary defaults for highly-indebted sovereigns. -3.0 -1.5

Scenario 3: Greece exits the eurozone and a firewall is built around other economies.

-1.0 0.5

Scenario 4: A new currency union is formed by the stronger economies.

-1.5 0.6

10 FS Viewpoint

Scenario 1Successive phases of monetary and fiscal action hold the eurozone together at the cost of inflation.

Higher inflation in the core eurozone countries could restore the relative competitiveness of the periphery.

The policy response restores confidence and prevents a prolonged recession.

Spain Germany

2004

=10

0

2004

2006

2008

2010

2012

2014

2016

Source: Eurostat and PwC Analysis

Forecast

Higher inflation in the core Eurozone countries could restore the relative competitiveness of the periphery.

100

110

120

130

140

Con

sum

er P

rice

Ind

ex

Policy action • Crisis is initially contained by ECB bank financing and agreement on Greek debt haircut.

• Greece fails to meet the conditions of the deal, triggering another round of ECB financing coupled with fiscal transfers to peripheral economies in exchange for austerity measures.

• A looser monetary policy is adopted at the end of 2012 to help restore the competitiveness of the peripheral economies.

Short-term outcomes • No or low growth will put downward pressure on inflation, signalling a looser monetary policy in 2013.

• “Internal appreciation” of Germany in relation to the periphery helps alleviate recessionary pressure in peripheral economies by improving their trade balances.

• Improved credit conditions and confidence could support GDP growth of 2% in 2014, as the survival of the euro looks increasingly certain.

Medium-term outcomes • Higher inflation should ease debt restructuring, and improve competitiveness of peripheral European economies.

• ECB raises interest rates to bring down inflation in the medium-term and restore credibility.

• Most eurozone countries will be running primary surpluses for many years, putting a drag on growth.

Eurozone 2012 2013 2014 2015 2016

GDP growth 0.1 0.7 2 1.5 1.5

Inflation 1.5 3.0 3.5 3 2


Scenario 2 Voluntary defaults for highly-indebted sovereigns.

Bank losses could total over €100 billion, which could precipitate a contractionary debt spiral...

...such a credit contraction could lead to a deep recession

Bank losses could total over €100 billion, which could precipitate a contractionary debt spiral...

Source: EBA. *Data as at 30 Dec, 2010

0

€ 5,000

€ 10,000

€ 15,000

€ 20,000

€ 25,000

€ 30,000

€ 35,000

Italy

Greece*

Portugal

UK

Ireland

France

Germ

any

Sp

ain

Eurozone 2012 2013 2014 2015 2016

GDP growth -3 -1.5 -0.5 1 2

Inflation 1 0 0 1 2

Policy action • Following the Greek precedent, other highly-indebted economies seek to restructure their debts.

• We assume a 50% default on Portuguese and Irish sovereign debt and a 25% default on Italian debt.

• In parallel, we assume leaders agree to measures aimed at insulating the rest of the eurozone from a collapse in confidence.

Short-term outcomes • We estimate that the restructuring will cause a private sector wealth loss of up to €800bn, including €100bn to banks.

• Bank losses would be partially recapitalized by governments, the European Financial Stability Facility (EFSF), and the European Stability Mechanism (ESM), but lending would also need to be reduced.

• We expect that this would precipitate a contractionary debt spiral dragging the eurozone into a deep and protracted recession.

Medium-term outcomes • We expect that restructuring governments will be locked out of credit markets and require long-term support from the rest of the eurozone and other bilateral institutions.

• Over time, these countries would have to reestablish credibility with investors.

12 FS Viewpoint

Scenario 3Greece exits the eurozone and a firewall is built around other economies.

Historical devaluations have led to a sharp contraction in GDP lasting one to two years.

The region would suffer an immediate but short-lived recession and growth would resume after 18 months.

Historical devaluations have led to a sharp contraction in GDP lasting 1 to 2 years

Sweden (1992)

Source: IMF, PwC analysis

Thailand (1997)

Korea (1997)

Argentina (2001)Indonesia (1997)

80859095

100105110115120

0 1 2 3

GDP index (100 = year of devaluation) 2012 2013 2014 2015 2016

GDP growth

Greece -5 -1.5 0 2.6 2.8

Rest of eurozone

-1 0.5 1 1.6 1.8

Inflation Greece 10 8 8 6 6

Rest of eurozone

1.5 1.8 2 2 2

Policy action • Greece exits the eurozone by imposing temporary capital controls and redenominating all new and existing contracts in new drachma.

• The eurozone commits to saving the euro and uses the ECB and EFSF to build a firewall around other vulnerable economies.

Greece outcomes • We expect that the new drachma could depreciate by as much as 50%, constituting an implicit default on debt.

• Inflation would soar, potentially averaging 10% in 2012.

• 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.

Rest of eurozone outcomes • We expect this would cause an 18-month recession in the eurozone as investors’ losses and shaken confidence lead to capital flight and deteriorating credit conditions.

• But the Greek exit also would provide an impetus for other vulnerable countries to bring forward fiscal and structural reforms to “avoid the Greek fate,” improving longer-term growth prospects.


Scenario 4A new currency union is formed by the stronger economies.

Countries with weak economic fundamentals are most at risk if the euro were to break up.

The new eurozone will experience a boost in domestic demand while the periphery contracts in 2012.

Countries with weak economic fundamentals are most at risk if the euro were to break up

Indicative scorecard of economic and fiscal fundamentals (selected eurozone countries)

GreecePortugalIrelandItalySpainBelgiumFranceGermanyNetherlandsFinland

10-yearyield

s

Exp

ectedG

DP

growth

Ratings

outlook

Gross general

government d

ebt

Bud

get deficit

(% of G

DP

)

Str

onge

r fu

ndam

enta

ls

2012 2013 2014 2015 2016

GDP growth

New euro 0.3 2.5 2.5 2 2

Periphery -5 -2 0 2 3

Inflation New euro -1 0 0 2 2

Periphery 10 8 7 5 3

Policy action • A Franco-German acknowledgement that the existing eurozone is unsustainable paves the way for a new, smaller, and more tightly regulated currency bloc.

• The new bloc includes: Germany, France, the Netherlands, Finland, and some of the stronger new member states.

• More stringent rules are set out for members on fiscal union and structural positions.

“New euro” bloc outcomes

• New bloc benefits from an inflow of capital in the first year.

• However, transition costs and a loss of competitiveness as a result of the stronger currency would drag on growth in 2012.

• The new euro exchange rate could be permanently higher by up to 15% compared to the exchange rate for major trading partners.

Periphery outcomes • Economies that break away from the euro face challenges of depreciating exchange rates, soaring inflation, and falling output.

• Future success will depend on their ability to rebuild credible fiscal and monetary institutions.

14 FS Viewpoint

A country leaving the eurozone may need to do the following:

• Announce and immediately impose capital controls.

• Impose immediate trade controls to limit capital outflows.

• Impose immediate border controls to prevent a flight of cash.

• Implement a bank holiday to prevent a “run on the bank.”

• Announce a new exchange rate (presumably not floating at the beginning, given capital and exchange controls) so that trade could continue.

• Convert all euro-denominated notes and coin to a new currency.

• Decide how to deal with existing outstanding euro-denominated debt, which would probably entail a major government and private-sector debt restructuring (i.e., default).

• Recapitalize the insolvent banks to make up for losses from defaults.

• Determine what to do with the non-bank financial sector and the stock and bond markets.

• Determine how to handle commercial contracts that are written and denominated in euros and now may be in the new currency.

Exit of a country from the eurozone will have broad and far-reaching impacts.

Implications for US corporations

16 FS Viewpoint

How does all this impact US corporations?

Eurozone restructuring has the potential to create significant change and disruption to the operations of many firms. These changes would potentially materialize when the broader economic and market environment create conditions in which many companies cannot afford the direct and indirect costs to their businesses of carrying out such changes.

Many of the specific actions required at the organization level following a complete or partial eurozone restructuring will be intrusive to the processes, systems, and operations of an organization and will have to be executed quickly and with minimal lead time for impact assessment and action planning.

Thus, companies should be more fully prepared for a range of unpredictable outcomes. One way to accomplish this is to focus on the potential consequences of the four scenarios outlined to determine what actions would be required at an organizational level based on likely market conditions, such as a credit crunch or currency devaluation.

Based on this analysis, companies can proactively develop contingency plans to address the potential consequences of various potential eurozone scenarios and begin to take steps to help minimize the risks today.

17Implications for US corporations

Potential actions required We expect the euro crisis to have a broad and profound impact on US-based multinational companies in the following areas, among others:

Business model and structure1

Revenue2

Treasury3

Legal4

Procurement and supply contracts5

IT6

Finance7

HR/people8

Tax9

Crisis/incident management10

18 FS Viewpoint

Problem statement In setting long-term business strategy—what products to make, what markets to target, where to source and manufacture, how to organize the company, where to raise and deploy capital—companies have typically planned based on the assumption of a stable eurozone and regulatory environment with stable, moderate growth and the free flow of goods, capital and people. The current crisis has called many of these assumptions into question. As a result, many companies, particularly those with heavy business activities in Europe or significant European stakeholders, will need to question many of the fundamental assumptions that have formed the basis of their strategies, business models, and organizational structures.

Critical questions • How might the various potential outcomes for the euro impact overall corporate strategy?

• Where do we want to invest capital going forward? Which countries (inside and outside the eurozone) will present attractive investment opportunities going forward?

• How will the crisis impact ability to effectively borrow and invest in the eurozone?

• Could the break-up of the eurozone result in increased regulatory costs and additional friction in the flow of goods and services within the region?

• Will the declining attractiveness of European markets increase the level of competition in other developed and developing markets?

• How should companies best alter their European footprint under various potential outcomes?

Key areas of exposure and impact for corporations

• Significant declines in economic growth reduces the attractiveness of European markets.

• Reduced growth and higher costs result in impairment of prior investments.

• Constrained capital markets result in further challenges to fund European growth and investment.

• Reduced growth and constrained credit weaken the supplier base and create significant operational risks.

1. Business model and structure

1


Problem statement Corporate revenue and profit margins are based on uninterrupted global demand and supply as well as free flows of capital, labor, and goods throughout the eurozone. Should these be disrupted by the crisis (e.g., through a collapse in sales, FX movements, or capital controls), the impact on revenues will be significant and could undermine the viability of businesses.

Some countries may impose some form of currency controls in order to limit the shocks to their economies. Countries with strong currencies but small economies (e.g., Swiss franc) will also try to suppress the value of their currencies through the use of market mechanisms.

Critical questions • Under what scenario and in what circumstances is revenue most at risk? How long can businesses survive with below-average sales in the eurozone?

• Under what scenarios do eurozone countries become unattractive to sell to or produce in?

• Can potential exposures be hedged? Have non-traditional/natural hedging strategies been considered?

• Have alternative growth strategies been identified and reviewed?

• Can the business still afford to serve clients in euros in the short—and medium—term? Do margins need recalculating and pricing pegged to a more “stable” currency?


• A collapse in sales could occur as a result of severe recession or unfavorable price and foreign exchange movements.

• Liquidity shortages as a result of sales collapse and regulatory measures could limit cross-border transfers.

• Revenue streams could be significantly impacted through sharp foreign exchange movements.

2. Revenue2

20 FS Viewpoint

Problem statement Treasury must be prepared for the significant and difficult changes that would occur under each scenario. A credit squeeze is likely to result. Possible capital and foreign exchange controls may need to be invoked at short notice and eurozone hedging strategies may need to be disaggregated by country, with aspects no longer effective as new currencies are created. Additionally, treasury should understand which scenarios will cause covenants to be triggered and cash to be trapped, and set parameters for exchange rate appetites if volatility increases and new currencies are created.

Critical questions • Is there an appropriate forum for discussing working capital and cash forecasting? Have counterparty risk policies and credit scoring processes been reviewed? Is the business appropriately hedged?

• How is credit risk currently monitored? Should changes be made to better predict and/or react to declining credit?

• How legally enforceable are netting arrangements to reduce exposure?

• What cash can be moved to neutralize euro exposures, surplus repatriated? Facilities redenominated?

• Will weaker eurozone banks be able to provide local funding?

• What will become of local deposits, if banks are no longer functioning?

• How might a company redirect/collect customer payments outside high risk countries?

• Will cash pooling structures continue to be viable and efficient?

• How might increasing currency volatility impact FX hedging programs?


• Diversity of funding arrangements, credit risk, trapped cash risk, off balance sheet contingencies triggered

• Forecasted internal cash reserves, intercompany balances

• Debt arrangements upon currency restriction events, covenant implications

• Cross-border cash management structures and credit facility interaction

• Working capital strain as customers take longer to pay, suppliers weaken without prompt payment, and foreign exchange rates change or become increasingly volatile

• Enforceability of euro derivatives/country of bank counterparty

• Volatility arising from ineffective hedging strategies or hedge accounting

3. Treasury3


Problem statement For many organizations, legal contracts are based on existing EU law and the premise of a stable single currency, governed by the ECB. Should any of the four scenarios occur, sales, supply, and employment contracts (among others) are likely to require review and some revision. In extreme circumstances, contracts may become unenforceable. The consequences will vary dependent on applicable governing law and jurisdiction. Payment obligations will be dependent on applicable exchange rates. This in turn could cause defaults to occur. The potential for associated disputes could also increase.

Critical questions • Is the potential impact on key contracts fully understood?

• In the event of changes to either the currency of payment or the reference/regulatory bodies, are the associated contractual obligations and flow down provisions clear?

• Are the definitions within existing contracts still valid?

• Have the potential commercial risks been considered, as well as how these risks can be avoided or mitigated?

• Has the financial impact of employment contracts and packages been evaluated?

• Is there a plan in place to identify and solve legal exposures?


• All key commercial contracts including supply contracts, sales contracts, joint-venture agreements, distribution agreements, and IP licensing arrangements

• Payment arrangements and systems and support service agreements

• Transfer pricing

• Impact on cross default provision arising from contractual default

• Currency hedging and treasury management

• Referencing in all contracts (for example, euro-dependent provisions, reference to bodies such as ECB or eurozone, Material Adverse Change)

• Employee terms and conditions (such as salary, bonus, and other remuneration)

4. Legal4

22 FS Viewpoint

Problem statement Many global organizations, especially large consumer products companies, rely on sourcing raw materials, products and services needed for their operations from the eurozone countries. They also supply clients across Europe from different EU and non-EU hubs. With the four scenarios in mind, the changes could result in the creation of European low-cost countries. For US Companies, these changes could imply:

• Strategic sourcing decisions may need to be revisited with changes to price or availability conditions.

• Supply models may need changes in pricing, logistics, invoicing, and transportion.

• Alternate vendors may be needed or activities may need to be brought in-house if the vendors are unable to survive the outcome of the crisis.

Critical questions • Will there be low-cost country opportunities created as a result of eurozone restructuring?

• Are there supply-chain risks as a result of rising material costs for suppliers no longer in the eurozone?

• Can the impacts of those moves be reliably modelled (e.g., on cost or profit margin)?

• Can the impact of supply-side changes on key clients’ supply chains be anticipated?

• Are there alternative sources of supply for critical products and services? Are rapid moves to an alternative supplier feasible?

• Are multiple critical suppliers in the same situation (i.e., could an organization experience multiple vendor failures)?

• How might a company redirect/collect customer payments outside high-risk countries?


• The cost of producing and operating could change dramatically as a result of sharp economic and foreign exchange movements.

• Potential cost reduction opportunities may arise.

• Supply continuity for critical raw materials and products may need to be monitored.

• Supply chain reviews should be considered for the most price-sensitive products and services, resulting in potential service model changes.

• Different cost and margin scenarios may need to be evaluated, and alternative suppliers may be needed if the impact is material.

• Make/buy decisions may need to be revisited across a range of products, and new efficiencies should be realized.

5. Procurement and supply contracts

5


Problem statement Regardless of size, complexity, or industry, companies are becoming increasingly reliant on IT/IS systems—both within their own companies as well as with customers, suppliers, and vendors—to conduct business operations. This reliance will create challenges for organizations to:

• Understand the impact that the different scenarios will have on the IT environment and the various interfaces between systems (both external and internal)

• Ensure that internal systems can remain flexible and adaptable enough to meet the demands of new and changing regulations and market environments

• Ensure that external vendors of hardware, software, and services have developed plans to deal with each potential scenario and are able to maintain continuity of operations

• Implement potentially significant master and transaction data changes

In addition to these challenges, organizations should gauge their readiness to exploit the opportunities presented (such as integration, renegotiation of support deals, and relocation).

Critical questions • Which systems and business areas are most exposed to the changes set out in the scenarios?

• Do company systems have the ability to be modified to handle new currencies?

• Can company systems handle the redenomination of historical transactions?

• Have systems and vendors critical for survival of the organization been identified?

• Do external vendors have plans in place to ensure continuity of IT and communications infrastructure and services?

• Are transactions and reporting set up to accommodate a high-inflation environment?


• Work required to amend existing applications and data

• Lack of control over IT systems due to contractual or physical limitations in the ability to reconfigure

• Inability of systems to cope with extreme changes in inflation and valuations, including the ability to forecast and restate past performance

• Inability of outsourced service providers to maintain continuity of their systems and to provide agreed-upon services

• Potential increase in capacity from institutions switching businesses to non-impacted countries

• Collapse of IT service providers, or inability to honor contractual obligations around IT service provision

6. IT6

24 FS Viewpoint

Problem statement The Finance function is heavily exposed to eurozone challenges in terms of:

• Accountability for planning, budgeting, and forecasting in very uncertain times by building scenarios and securing board agreement with them.

• Managing increased costs (both of finance and the whole organization) and interpreting their impacts to the organization.

• Keeping statutory reporting in line without major increases of effort.

• Dealing with increased reporting requirements and new types of what-if analyses and complex simulations.

Critical questions • Is your Finance operating model still relevant?

• Is the sourcing strategy still optimal, does the restructuring provide opportunities to revisit shared-service locations and outsourcing contracts?

• Would outsourcing transactional activity mitigate risk in volatile markets during eurozone restructuring?

• How quickly could the organization exit outsourced or shared environments within unstable economies?

• Can statutory and management reporting be produced with current resources and without compromising quality?

• Is the function set up to deal with inflation, currencies leaving the eurozone, and the introduction of a significant number of new currencies?

• Can costs arising from the changes described in the four scenarios be modeled reliably?

• Is finance ready to take on a much bigger role in communicating these changes to the rest of your organization?

• Do you understand the potential financial reporting impacts of each scenario, including matters like revenue recognition, asset impairment, and hedge accounting?


• Service agreements with outsourced providers

• Continued availability of qualified staff

• Continued robustness and adequacy of the control environment

• Shared-service center (SSC) location, setup, and internal pricing

• Enterprise resource planning (ERP) and reporting systems

• Current data models

• Accounting policy matters and financial reporting impacts

7. Finance7


Problem statement For businesses operating in Europe, the HR function is key to supporting the business strategy while adapting to the impact of economic and legislative change on staff operations. With differences in specific HR needs among countries likely to increase, HR functions should be equipped to deal with increasing complexity while managing limited resources. Resources will be stretched to balance both short-and long-term measures in dealing with rapid change while facing sustained pressure to cut costs.

Critical questions • With sustained pressure on cost reduction, how will HR operating models and structures cope with differing demands across territories?

• How will talent be retained in less stable countries while dealing with sustained financial pressure and rapid change?

• Will businesses need restructuring in response to changes in the eurozone? How will the impact of this be addressed with respect to human resource operations?

• Have you defined your duty of care and responsibility to your employees in the event of collective actions in which they are impacted?

• Is your team clear on how you will communicate to employees in the event of collective actions which keep them from work?

• Do business continuity plans consider the potential for civil unrest or even military conflict?


• Managing a mobile and global workforce could become increasingly complex, with less standardization across Europe in terms of tax and employment law. Businesses should be equipped to deal with the increased risks associated with these changes, including areas such as rewards and pensions.

• Those operating in less stable European countries may find themselves struggling to retain talent as employees seek more secure environments.

• Some companies will need to respond to changes in the eurozone by restructuring their businesses and contracting for high-risk operations. The implications for HR and people activity should be dealt with appropriately, for example when redeploying or making headcount reductions.

8. HR/people8

26 FS Viewpoint

Problem statement Companies should understand the immediate tax consequences arising from various scenarios regarding the future of the eurozone. It will be important for companies to weigh the tax efficiencies of their proposed mitigation strategies.

Critical questions • Do the changes give rise to a new contract from an accounting perspective? This may result in the recognition of profit or losses for accounting purposes that could also be taxable or relievable.

• Do the changes give rise to a new contract from a legal and tax perspective? Modification of an existing contract could potentially represent the termination of the original contract and the creation of a new contract. This could crystallize a taxing event (i.e., the changes could trigger a disposal for capital gains purposes).

• Where the contracts are between related parties, then an additional question is whether an arm’s length fee should be paid to the counterparty as compensation for the change in terms. The tax treatment of this fee would need to be considered from both parties’ perspectives, and whether this payment would be taxable on one side and deductible on the other.

• Will any losses be tax-deductible and can they be utilized or will they become “trapped?” How does this change the tax profile of the group?

• What happens if any foreign exchange gains should arise (e.g., due to a smaller, stronger euro)?

• What will be the impact on business if it cannot defer foreign exchange gains or losses under the tax matching rules, where the hedge becomes ineffective from a tax perspective?

• Has taxation been factored into contingency plans such that they are as tax efficient as possible?


• Different scenarios may create losses; it is important to understand whether these are foreign-exchange losses or impairment losses and the deductibility of these for tax purposes.

• Redenomination of foreign assets and liabilities may result in hedges becoming ineffective from a tax perspective.

• If the changes cause new contracts, especially loans, to be brought into existence, this may impact existing agreements with the taxing authorities (e.g., withholding tax clearances may be affected). It may also affect other taxes (e.g., VAT if there is a change in value of the contract).

9. Tax9


Problem statement Companies should prepare for massive social disturbances that would likely accompany any eurozone exit or messy break-up. Strikes, infrastructure outages, demonstrations, and other violent street actions are likely, especially if the crisis is seen as unfairly impacting and further impoverishing certain populations, especially in the southern EU states.

Critical questions • Is the team prepared for potential collective actions (e.g., strikes or riots)?

• Are crisis management and contingency plans in place and have they been reviewed to help ensure no elements are missing?

• Have supporting plans been tested to help ensure teams are ready to respond?

• Have critical vendors been identified and assessed?

• Are there vendor resiliency programs in place?

• What strategies have been considered to help ensure the ongoing success of the business in cases where vendors may be impacted?


• Response effort to eurozone crisis not coordinated across the organization

• No integrated crisis management team in place to play point and coordinate the response

• Failure to consider vendor resiliency

• Lack of contingency plans if key suppliers become insolvent

• Lack of insight into the criticality of vendor population and no identification of alternative options

• No consideration of other impacts such as collective events (such as riots or demonstrations)

• Lack of comprehensive and tested business continuity plans

10 Crisis/incident management

10

What companies are doing now

29What companies are doing now

Companies are already taking action

The complexity of the eurozone ecosystem and the political, financial, and cultural drivers that shape it make predicting the outcome of this crisis nearly impossible.

The countless scenarios that could arise and the myriad implications of these scenarios make contingency planning a daunting proposition for any organizations trying to identify, size, and mitigate the potential risks.

However, some organizations have started anticipating the risk consequences in hopes of mitigating the effects of those risks.

As a first step, many companies have developed a cross-functional team—often supplemented with external resources—of senior staff to identify, assess, and mitigate risks to their organizations.

Many boards of directors and audit committees have been engaged on the topic and are closely reviewing management’s plans to prepare for and respond to any potential outcome.

In an effort to better understand the risks and plan for the future, many companies are employing a structured process to distill the available information and assess, define, and execute plans to mitigate risks.

30 FS Viewpoint

Some companies are already taking action

Some organizations are proactively taking steps to mitigate the risk of the crisis.

De-risking foreign currency holdings—moving cash out of the eurozone into “safer” currencies or investments1

Managing supplier exposure in the eurozone—no long-term contracts2

Mitigating refinancing risks—setting cash aside for upcoming bond repayment or expediting refinancing3

Increasing cash reserves by controlling non-essential expenditures4

Performing assessment of net euro exposure by country5

Preparing for volatility in the exchange market by reassessing hedging strategies6

Analyzing impact of new currency introduction on procurement and sales contracts as well as IT support systems7

Reassessing current crisis and contingency management plans to ensure teams are ready to respond8


Approach to assessing and managing eurozone risk

Companies are identifying and assessing the potential risks they face as a result of the eurozone crisis and developing contingency plans to proactively mitigate these risks.

Assess situation Define scenarios Execute

• Look at European business operations and financial assets and liabilities. Assess the exposures and risks on a country-by-country basis from a strategic, operational, and financial perspective.

• How much exposure does the company have? Where are the concentrations of companies and vendors? How much exposure can the company bear?

• Develop a high-level diagnostic to identify and prepare for the impacts of the crisis in the short term.

• Define potential eurozone outcomes—include several different scenarios, from optimistic to worst-case scenarios, looking at the short term and long term.

• Quantify how the company would be impacted by each scenario.

• Determine which risks are acceptable and which need to be mitigated.

• For the risks that need to be mitigated, develop a contingency plan including financial and operational mechanisms to reduce risk exposure.

• Assign ownership for plans and monitor effectiveness of mitigation plans over time.

• Revisit scenarios as conditions change and make adjustments to the risk mitigation plan if necessary.

32 FS Viewpoint

Assess the situation For each potential scenario, companies should ask themselves: what are the likely impacts?

What can we be doing now to reduce potential consequences?

Do we have the right plans in place to respond to events?

Is the board adequately involved to ensure priorities are appropriately set?

Have responsibilities been allocated?

Do we have appropriate levels of cross-functional and corporate/business coordination?

Do we understand the vulnerabilities of our key vendors?

Have we assessed our risk of being in an area where collective actions could occur?

Are crisis management plans in place and will they address these situations?

Have the plans been rehearsed?

Have we communicated our plans and requirements to our key vendors?

Developing a high-level diagnostic can assist with the assessment:

Engage with key stakeholders across the business to identify key areas of exposure, issues, and the potential impacts of those issues.

Outline the critical nature of these issues and assign a risk rating to each issue.

Assess current crisis management and vendor resiliency programs and plans to identify any gaps in the ability to respond to this crisis.

Produce a prioritized set of 10 actions that will assist in responding to the eurozone challenge.

Produce a 100-day roadmap outlining the interdependencies of these actions and the time frames for completing them.

This analysis will help corporations prepare for possible scenarios, minimizing their reaction time in the event that one of the scenarios occurs.


Define risk scenarios Organizations should make effective use of scenario analysis and stress testing to determine the company’s ability to respond to identified risk scenarios and withstand various stresses.

Proactive and robust downturn scenario and stress testing can help an organization formulate plans to deal with a range of outcomes, enabling the organization to be ahead of the game in terms of strategy and implementation. Such scenario analysis and stress testing can also help an organization understand those risks that require additional investment or attention and monitor them effectively and regularly.

Leading companies have a clear plan on how to handle the loss of critical vendors.

Assessing the situation and defining the scenarios will allow an organization to develop a matrix that sets out a list of possible scenarios, associated risks, and the company’s approach to mitigating these risks. A firm can then develop an associated procedures manual, oversight mechanisms, and detailed contingency plans.

34 FS Viewpoint

Prepare to execute The consequences of a eurozone break up go beyond those organizations directly exposed to countries that may exit the euro. The risk of contagion and fear of financial institutions’ exposures to these countries remain and may lead to reduced liquidity and other consequences. Furthermore, some of these actions remain good practice—even if there are no crises.

Leading-edge corporations have developed contingency plans that have considered the potential risk combinations associated with the break up of the eurozone. These plans have been integrated into leading organizations’ governance and risk management arrangements. This provides a more complete view of the risks faced and helps corporations ensure that they plan accordingly. By doing so, organizations may be able to weather the resulting crisis and economic downturn by acting quickly and decisively, and making hard decisions early on.

Additionally, organizations are embedding eurozone risk management into their governance documents. Often, the governance team is leading the company’s preparation effort.

Corporations are mobilizing specific eurozone program management teams with defined operating parameters, timelines, resources, steering committee oversight, and scheduled report-outs.

Prepared organizations also make effective use of early warning indicators to prevent or limit the consequences of high-impact risks. These indicators can help illustrate the emergence of risk and enable a timely and planned response, even if those risks cannot be prevented.


Pulling it together– Starting with a high-level diagnostic

The diagram below sets out the main stages and activities in the high level diagnostic. The outcome of the analysis is to define the top 10 actions that can help mitigate risk.

High-level diagnostic and vision

High-level diagnostic and vision

Interview keystakeholders from:

Revenue

Treasury

Legal

Procurement andsupply contracts

IT/IS

Finance

HR/people

Tax

Develop action listsaddressing each of the following areas:

Temporary/quick-fix solution

Long-term solution

Data

Process

Systems

People

Risk

Rank actions by criticality and risk score:

High

Medium

Low

Prioritize top 10 actions:

Develop 100-dayroadmap

1

2

3

4

5

6

7

8

9

10

Vis

ion

stat

emen

t an

d g

uid

ing

pri

ncip

les

www.pwc.com/fsi

“Breaking Up is Hard to Do: The Eurozone Crisis–Possible Implications and Contingency Planning for US Companies,” May 2012. www.pwc.com/fsi

© 2012 PricewaterhouseCoopers LLP, a Delaware limited liability partnership. All rights reserved. PwC refers to the US member firm, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This content is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.

PM-12-0307 FS Viewpoint Eurozone

To have a deeper conversation, please contact:

Miles Everson [email protected] +1 646 471 8620

Harry G. Broadman [email protected] +1 703 918 6655

Peter Frank [email protected] +1 646 471 2787

Brian Kinman [email protected] +1 314 206 8096

Shyam Venkat [email protected] +1 646 471 8296

A joint publication of PwC’s Financial Services Institute and PwC’s Products and Services Industries group.

eurozone crisis: strategies for risk mitigation

Documents

rest of eurozone

eurozone gdppercent

greeces debt

real gdp

us magnitude of sovereign

gdp data

atand longterm debt

tranches of sovereign