The eurozone: Dodging the falling stars

The eurozone crisis continues to weigh heavily on British companies. In spite of reassurances from European political and financial leaders that they will not allow the single currency to fail or the 17-country eurozone to fracture, the fallout from ailing economies is having far-reaching consequences for businesses.

Most companies have already had to act decisively to cope with the tougher commercial environment since the credit crisis. But just as critical are the steps they must take to prepare for what one financial expert refers to as the “known unknowns” – the possibility of further economic meltdown in the eurozone.

The latest figures clearly set out the predicament. Unemployment in the eurozone has reached a new high and inflation has increased more than expected. According to Eurostat, the EU’s statistical office, 18m people were unemployed across the eurozone in July, including more than one in five people under the age of 25. The eurozone’s inflation rate was 2.6 per cent in August compared with 2.4 per cent in July.

While economies such as Greece, Spain and Italy struggle, it remains unclear what action will be taken and when. Matthew Fell, director of markets at the Confederation of British Industry, believes many British companies have read the signs and prepared for the worst. “It varies from firm to firm, dependent on their level of exposure and sophistication,” he says, “but our impression is that the majority of firms have given active thought to this and have put in place proportionate measures to plan for the risk.”

Mr Fell says companies are classifying the risks into two broad areas: operational, which includes financial matters such as where bank deposits are held, currency exposure and contract and supply chain issues; and market risk, which includes the loss of sales caused by market contraction or temporary closure.

“Inevitably, it’s the larger firms that are most exposed to those operational risks, given the size and nature of the business,” Mr Fell says.

“But the quid pro quo is that they are the firms that have got the dedicated and active treasury functions, given the nature and scale of the business.”

Mark Gregory, chief economist at Ernst & Young, says the professional services firm has observed that the level of preparedness among companies has risen sharply in the past year, prompted by increasingly bleak signals from Greece.

“When Greece threatened a referendum, that set a few alarm bells ringing,” he says. “Over the year, the responses we’ve received have gone up from about 30 per cent of UK business saying they have a plan in place to something close to 70 per cent.”

A year ago, companies’ main priorities seemed to be reducing exposure to ailing economies such as Greece, and working on banking relationships to make sure funding was in place, Mr Gregory continues.

“Since January, they have been doing more work around indirect effects such as what might happen to the supply chain in the event of shock in the euro,” he says. “That might mean Greece leaving [the eurozone], or it might mean suppliers in Italy or Spain getting caught up in the contagion.

“In the past couple of months – driven by possible closer fiscal integration – businesses have also started to look more closely at whether their tax is organised as well as it could be.”

Currency concerns are central to the contingency plans.

Mr Fell says: “There is more of that active intervention [with currencies] going on, and companies are doing a more frequent trawl and a pull-back of holdings in euro-denominated countries, repatriating to what they see as safer currencies.”

This is a point echoed by Mr Gregory, who says businesses are increasingly working with law firms to consider the implications of a collapse in the euro, and how they might cope if a country quit the euro and began to use to its own local currency.

But he adds: “Another important thing we are seeing, especially in the banking sector, is an attempt to balance assets and liabilities in countries. Before, companies might have had internal financing that moved money around the eurozone. But now they’re trying to make sure they have assets and liabilities more closely matched so that if there was a devaluation, the value of the asset would go down but so would the liability.”

Still, many UK businesses that operate in economies such as Greece, Spain and Italy may be limited in the steps they can take to future-proof their contracts against a eurozone disaster.

“With new business, it is sensible to ensure that contracts stipulate payment must be made in euros rather than some local currency that might come into effect,” says Tim Hardy, head of commercial litigation at CMS Cameron McKenna, the international law firm.

“But a lot of the contract risk associated with the euro crisis is not new – it is the risk of doing business in these localities that has always been there and has been exacerbated by the currency crisis.

“There has always been the risk that a local court will ignore a contract that reverts disputes to an English company’s own legal jurisdiction, for example, or refuse to enforce a judgment.”

But what about hedging strategies – are there any financial instruments that companies can employ to help offset the risks of the eurozone’s uncertain future?

Robert Garwood, director of foreign exchange sales at Lloyds Bank Wholesale Banking and Markets, says: “Uncertainty surrounding the exact nature of potential future problems, either with the euro or the eurozone, makes the allocation of any specific financial instrument challenging if it is intended to be an effective hedge …A significantly weaker or stronger euro exchange rate, and the consequential exposure for a company, could depend entirely upon which member nations were intending to exit.”

But he adds: “While it is not possible to hedge against a currency that does not yet exist, it is possible to identify those financial instruments that could have the most significant change in value.”

Traditionally the “flight to quality” in foreign exchange markets sees demand for US dollars, Japanese yen and Swiss francs, Mr Garwood points out, while currencies that have a risk of exposure to eurozone crises include Australian, New Zealand and Canadian dollars, and sterling.

“Owning forex options that will increase in value – both in terms of volatility as well as exchange rate – could offer a degree of protection in this scenario,” he says. “Alternatively, a basket of equities where, in the event of a redenomination, the shares purchased are perceived likely to benefit and the shares sold to weaken, could also be used as a quasi-hedge if exposed to a single member nation exiting.”

Generally, though, a wise strategy in these uncertain times is simply a traditional one of caution and diversification.

Mr Fell of the CBI says: “I think most companies are realising that they have got to keep their powder dry in a climate like this. There is an element of a wait-and-see policy.

“But I think many are using a good degree of judgment and sensible planning to ensure that they are refocusing their operations away from what has perhaps traditionally been an over-reliance on Europe, towards higher-performing Bric countries and beyond,” he adds.