Minimizing surprises despite Eurozone uncertaintiesHighlights

The Eurozone sovereign debt crisis, regardless of the ultimate outcome, is likely to have significant consequences for many businesses.

Businesses need to reconsider their corporate strategy and operations to navigate a changing set of risks and opportunities.

Increased euro volatility and tight liquidity will require agility in financial management and reporting.

Companies should build buffers and adaptability for Eurozone consequences.

July 2012

10Minuteson the Eurozone sovereign debt crisis

Over the past several months, the Eurozone crisis has heated up, bringing the world’s attention back to the area’s troubled economy. Europe now sits at a pivotal crossroads and will likely emerge from the ongoing crisis looking quite different from the region we know today.

The run-up to the spring Greek elections and EU Summit demonstrated how quickly nearly unthinkable scenarios in the Eurozone crisis can become realistic. Political developments, economic news, and approaching debt redemptions can trigger fears of sovereign debt defaults or Eurozone exits that could materialize over the course of a weekend.

Because the world is so interconnected, most companies will be affected in some way, regardless of how this crisis unfolds. PwC’s 15th Annual Global CEO Survey found that more than half of corporate leaders say their business already has been affected financially by the Eurozone debt situation. Yet only 45% of CEOs say the crisis has triggered changes to strategy, risk management, or operational planning.

Given the pace of change and the level of volatility, companies should focus on preparing to navigate ongoing uncertainty and drastic changes in the global environment.

Are companies prepared?

1. Fewer than 25% of 1,500 global executives surveyed in May1 had a contingency plan for a Eurozone break-up. But 71% believed that a break-up could have a “somewhat” or “very” significant impact on their business.

Only about 20% of North American and Latin American executives had contingency plans in place for a Eurozone break-up.

Large companies remain vulnerable: Globally, half of the companies with more than $10bn in annual revenue did not have a solid plan in place for a Eurozone break-up.

2. The Federal Reserve and other authorities have expressed concerns that companies should reduce their exposure to European financial institutions.2

1 Sarah O’Connor, “Businesses fail to prepare for end of euro,” Financial Times, May 18, 2012.

2 Brian Blackstone, “Q&A: Philadelphia Fed President Charles Plosser,” WSJ.com, May 28, 2012.

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At a glanceImbalances have led to two EurozonesUnwinding the imbalances will require deep changes throughout the Eurozone for a prolonged period.

During the euro era, Northern Eurozone countries have run trade surpluses while others have run trade deficits…

Trade balances (% of GDP)

…and countries’ debts have grown to unsustainable levels.

2011 government debts & deficits (% of GDP)

-15%

-10%

-5%

0%

5%

10%

Netherlands

Germany

FranceItaly

Ireland

Spain

Portugal

’05’04 ’07’06 ’09’08 ’11’10

Greece

Source: Haver Analytics

0%

60%

120%

180%

3% 9% 15%0% 6% 12%

Greece

France

Germany

Italy

Portugal

Netherlands Spain

Ireland

Debt

Deficit

Axes represent 1997 Stability & Growth Pact limits

Trade surplus countries

Trade deficit countries

30%

90%

150%

Source: OECD

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01

A new real-world test of business resilience

Four scenarios dominated by uncertainty and high volatility

Actual change in Eurozone GDP and projections for the four potential scenarios (S1–S4)

-4%

-2%

0%

2%

4%

’08 ’09 ’10 ’11 ’12 ’13

S1

S2

S3

S4

Eurozone GDP growth

Source: PwC UK economics group, June 2012.

The Eurozone crisis was caused in part by fundamentally different sovereign countries sharing a currency. Differences in labor costs, for example, made some countries, such as Greece and Italy, less competitive in global trade, which led to trade and budget deficits. They were able to finance the deficits at low interest rates made possible by a perception that they were no riskier than stronger Eurozone countries. In effect, Germany and other countries financed the deficits through trade surpluses.

These deficits reached unsustainable levels by 2010. Credit markets tightened, but the deficit countries continued to borrow at increasing interest rates, rather than take drastic actions.

The resolution to the Eurozone crisis will need to go beyond fixing today’s urgent issues and provide enduring solutions to the fundamental underlying imbalances.

How the crisis could unfold in the near-term

The short-term and long-term economic performances of Eurozone countries hinge on how well political leaders and finance ministers can agree on debt-reduction paths, as well as how the populace reacts to austerity conditions and other requirements for assistance. PwC economists see the following range of most likely scenarios:3

Scenario 1: Successive phases of fiscal and monetary action hold the Eurozone together

Scenario 2: A sequence of managed defaults

Scenario 3: Greece exits but contagion avoided

Scenario 4: More countries exit Eurozone and a new currency bloc forms

Holding the Eurozone together—European leadership’s current intention—would still likely drive a European economic slowdown through 2013. But the limited success to date of actions aimed at holding the Eurozone together has made at least a partial break-up a realistic possibility. Such a break-up could cause major disruptions as well as a deep recession across the Eurozone that could persist for years.

Beyond Eurozone borders

A disorderly resolution would weigh down businesses around the world and force slow growth in the US through 2014. Exports to the Eurozone would plummet, while concerned businesses and consumers would cut big-ticket expenses.

Financial markets are also likely to drive the crisis around the world. How so? One possibility is that lenders would pull back indiscriminately, leading to a global credit crunch. Another possibility is that capital would flee to safe havens, leading to a credit glut with its own destabilizing effects.4

A new breed of crisis calling for broader response

Focusing on only one or two likely outcomes probably won’t provide the resilience needed to cope with what actually does transpire. Rather, companies need to prepare for the potential consequences of a wide range of events, including a Eurozone break-up, by taking stock of exposures and crafting a blueprint for more than one future.

3 PwC, “Now what’s next for the Eurozone?” June 2012.4 Brian Blackstone, “Q&A: Philadelphia Fed President Charles Plosser,”

WSJ.com, May 28, 2012.

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02

Your strategies and operations in a new light

Reacting to turmoil in the Eurozone

The impact of the crisis and response to it vary by industry

0 25 50 75

Retail

Transportation/logistics

Entertainment & media

Hospitality & leisure

Healthcare

Consumer goods

Industrial manufacturing

Forestry, paper & packaging

Construction/engineering

Pharmaceuticals & life sciences

Communications

All industries

Business & professional services

Automotive

Insurance

Technology

Chemicals

Metals

Asset management

Banking and capital markets

Percent of CEOs responding that the Eurocrisis directly affected their company financially

Percent of CEOs responding that the Eurocrisis has triggered specific changes to their strategy, risk management or operational planning

4556

66

5465

5361

5260

3760

5757

4356

40

5550

5445

5343

53

51

5040

3445

3144

2942

3740

39

72

47

47

47

73

Source: PwC, 15th Annual Global CEO Survey, 2012.

When establishing their business strategies and operations, companies have typically planned on a stable Eurozone. Now, they must re-evaluate their plans, considering the volatility and risks created by the crisis.

Business model and structure

In 2009, sales by US subsidiaries in Greece, Spain, Italy, Ireland, and Portugal topped $460bn, out of a $2.1 trillion European Union total.5

Companies need to determine which circumstances put their revenue most at risk. European sales and distribution centers are likely to lose customers and find increased competition for remaining customers. They should assess how long they can survive suppressed sales in the Eurozone. And if they decide that it’s prudent to exit some countries, how can the lost revenue be replaced?

Already, for example, companies have accelerated plans for shifting European operations to promising emerging markets.

As companies shift their focus, they may cause competition and costs to increase outside the Eurozone and make emerging markets and safe havens more crowded. Companies need to think long-term about where attractive investments will come from—inside and outside the Eurozone.

Procurement

Many businesses rely on sourcing from Eurozone countries to reduce costs or to be close to the customer. They need to assess where distressed vendors can cause supply chains to break down and if they can move rapidly to alternative vendors.

Companies should also watch for opportunities. Are lower-cost sources emerging from the Eurozone?

Technology

A sudden change in currency, should Greece or another country leave the Eurozone, could stress information-technology systems.

Specifically, IT departments must ensure that systems would function seamlessly if there was a change in currency. Some companies, for example, have found that without significant planning, their systems would not support employee payroll processes after a currency disruption.

Human Resources

The crisis will force some companies to restructure their businesses. They will need to prepare to deal appropriately with compensation, as well as any headcount reductions or redeployments.

HR departments need to determine how talent will be retained in countries destabilized by the Eurozone crisis and how any labor unrest will be handled. HR also needs to develop models to cope with differing labor demands across countries.

Crisis/incident management

Companies should prepare for massive social disturbances—strikes, infrastructure outages, and violent street actions—that would likely accompany any Eurozone exit or messy break-up. Continuity plans, which may involve physical and cyber security, need to be tested and refined.

5 “Operations of U.S. Multinational Companies in the United States and Abroad,” Survey of Current Business, BEA, November 2011.

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03

Financing, reporting, and contracting during unprecedented volatility

Currency volatility has fundamentally changed, and so must business

Euro/US dollar volatility*

0%

4%

8%

12%

16%

20%

’05 ’06 ’07 ’08 ’09 ’10 ’11

Prior volatility level

New volatility level

*Implied currency volatility based on options trading data.

Source: Bloomberg.

In PwC’s 15th Annual Global CEO Survey, more than half—58%—of the respondents said they consider exchange rate volatility a threat to their business.

Indeed, the euro is the world’s most abundant currency based on the value of banknotes and coins in circulation.6 Its destabilization could send financial shock waves.

Treasury and finance

Companies need to determine how dependent they are on the euro. They can start with analyzing the liquidity of their euro assets and how concentrated they are in distressed countries. Some companies are making “daily sweeps” to remove cash from vulnerable Eurozone countries.

Companies may also want to use derivatives or other means to hedge against income declines or fluctuations caused by exchange rate volatility that impact the value of euro revenue.

Many scenarios would likely squeeze credit in the Eurozone. Already in the first quarter of 2012, a major European bank reduced its exposure to Spanish, Italian, Portuguese, Irish, and Greek debt by 16% and cut back on lending in these countries.

The impact of a credit squeeze could be aggravated by operations, as distressed suppliers and customers strain the company’s working capital.

Finance managers also need to address increased reporting requirements that account for impairment or uncertainty in valuations caused by Eurozone upheaval. Regulators such as the SEC are asking for specific, disaggregated disclosures and reports on how firms are managing and mitigating Eurozone exposure.7

Finance teams will need to develop a new paradigm to plan for the future. Should companies borrow in the Eurozone? How do they know when they should lend in the Eurozone? Will safe-haven countries experience a credit freeze or flood?

Legal, contracting, and tax

Many sales, supply, employment, and other contracts are based on existing EU law and the premise of a stable currency. They may become unenforceable or have terms that become unreasonable if the euro fails to stabilize.

To minimize problems, companies should consider the impact of converting the denomination of euro contracts to a stable currency.

Tax implications of the crisis could prove quite thorny. Tax and treasury officers should coordinate closely to monitor contract changes, hedging programs, foreign currency gains and losses, and other developments such as write-offs of investments or loans, repatriation of cash, and early debt refinancing.

6 “Cash in hand,” www.economist.com, April 2, 2012.7 PwC, “The Quarter Close – Q1 2012,” March 22, 2012.

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04

Prepare for more than one future

Be ready to answer these questions from the board:

1. How broad are the risks that we are considering? Considering broader risks allows companies to navigate strategy through more potential consequences.

2. What risk scenarios have we considered to test our plans? Scenario analysis with board input can clarify the impact of various risks.

3. Have we mapped our risks to key performance and value measures? Common metrics for risk and performance can help prioritize action plans and gain buy-in.

The future of the Eurozone, including the resolution of the immediate sovereign debt crises, depends on the interactions among political leaders, financial markets, and citizens being asked to make personal sacrifices. That means uncertainties and unknown dependencies abound.

Assemble a cross-functional team

Since 2008, companies have learned that preparing for uncertainty is about focusing on the consequences of business disruptions. They must bring risk discussions to a more strategic and integrated level, rather than leave them solely in the domain of risk managers.

That means companies need to assemble a cross-functional team of managers who will be poised to respond to the many potential disruptions and stresses caused by emerging Eurozone events. Discussions should occur among managers in strategy, finance, operations, risk management, treasury, tax, business continuity management, IT, HR, and legal departments. It may even be appropriate to include partners, suppliers, and other external resources.

Create a blueprint for resilience

The team can develop an action plan by:

1. Converting the Eurozone macro scenarios into a set of most significant outcomes for the business (for example, severe liquidity crunch, loss of supplier, plummeting sales, or even the opportunity to acquire a weakened company).

2. Preparing a plan to mitigate negative consequences and capitalize on opportunities.

3. Assessing immediate needs for buffers or shock absorbers, such as moving to more liquid assets or diversifying funding sources and suppliers.

4. Determining how to increase the organization’s adaptive capacity (for example, increasing collaboration among the cross-functional team members or more closely monitoring key suppliers).

5. Communicating commitment to the plan and its payoff to stakeholders.

6. Assigning responsibilities and walking through plans to ensure they can be put in action.

Teams that do this will be a crucial resource for building the resilience needed not just to manage the risks, but also to craft a longer-term plan that captures the opportunities in the Eurozone that emerges.8

8 PwC, “Prospering in an era of uncertainty – The case for resilience,” May 2012.

Source: Armoghan Mohammed and Richard Sykes, “Sharpening strategic risk management,” Resilience – Winning with risk, PwC, Vol. 1, No. 1 June 2012: 14-17.

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How PwC can help

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To have a deeper discussion about managing the Eurozone crisis, please contact:

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