my2cents4u

The Eurozone Crisis: Managing Risk

Uwe Bott

Athens

December 3, 2012

American-Hellenic Chamber of Commerce

Ladies and Gentlemen,

First of all I would like to thank the organizers of this conference, the American-Hellenic Chamber of Commerce, for affording me the opportunity to speak to such a distinguished audience at this critical juncture in time. As an economist by training and a risk manager by trade, I would like to make use of the time allotted to me by taking a pragmatic view of the situation on the ground in the seventeen countries which share this common currency.

In order to look forward, please allow me to take a step back, because much of what awaits us down the road is determined by decisions that were taken in the past. First, I would like to briefly review the structural flaws of the monetary union, as I see them. On my last mission for Moody’s Investors Service in 1996, I had the privilege of meeting with German policy-makers and economists of the major banks in order to assess whether the then-concept of the Euro would actually become reality. It struck me as particularly unusual at the time that it was difficult in these conversations to engage my counterparts on some of the economic challenges that the Eurozone was likely to face. Their apparent reluctance to focus on the economic viability of the Euro project, beyond the political, impacted the way in which I observed the actual introduction of the single currency and the years that followed.

Like many U.S. economists, I saw red flags with regard to the soundness of the project. It was and is my view that the Eurozone is not an optimum currency area, that the lack of political union, true labor mobility and the absence of fiscal equalization would prove to be hurdles, most likely too high to overcome, at least for some countries. In my view then and now, meeting Maastricht convergence criteria or implementing the Growth and Stability Pact and now the Fiscal Compact would not be adequate substitutes to protect the Eurozone from asymmetric shocks.

With that in mind, I was intellectually prepared for the crisis that ensued some three years ago.  The second marker of the past that determines what our options are going forward was how the crisis was managed at the outset. And here, I would like to cite two cases of debt/currency crises that were managed in an exemplary fashion. I am referring to the Mexican tequila crisis of 1994/95 as well as the Asian flu in 1997/98 with regard to Thailand and South Korea. In both instances, the affected countries as well as the international community took two important steps. First, Mexico, Thailand and South Korea let their previously fixed or quasi-fixed currencies freely float vis-à-vis the U.S. dollar in order to regain competitiveness. Second, jointly with the international community these three countries put in place outsized financial rescue packages, which beyond anybody’s doubt were sufficient to stop the bleeding of reserves and to mitigate the looming liquidity crises. The people of Mexico, Thailand and South Korea made great sacrifices, but all three countries recovered quickly and they prepaid those who had provided emergency funding.

Obviously, as Greece entered into this crisis, the confines of the monetary union did not allow it to devalue its currency, since it no longer had a currency of its own. However, the second important condition of emerging from a currency/debt crisis was also not met. In other words, there was no immediate rescue package large enough that it would have stopped all speculation in its tracks simply due to its sheer size. Economic historians and political scientists will have to determine what the reason for this breakdown was. It does not really matter, whether the magnitude of the problem was not fully understood at first or whether there was a lack of political willingness to support such funding by other members of the Eurozone or whether it was a mixture of the two.  In the end, it took us to where we are today.

In fact, the approach that was taken reminds me of the way the United States has managed its physical infrastructure over the last forty years. Under President Eisenhower, in the 1950s, the U.S. implemented a massive infrastructure program, including what we refer to as the interstate highway system. U.S. infrastructure became the envy of the world. Then in the 1970s, federal, state and local governments began to dramatically reduce their expenditures for maintaining the nation’s roads, bridges and other parts of the infrastructure in an effort to save. Today, we are doing the bare minimum. When there is a pothole on the road, we dispense a crew to throw some tar into it. Of course, a thousand cars later the pothole is back, only larger, as its fringes continue to erode. So, we send another crew. In the end, nobody realizes that we actually spent more money patching up the road than we would have, had we fully resurfaced it, not to speak of the collateral damage of broken axles, blown tires and sometimes accidents. 

In a sense, this is what has happened in the Eurozone. The crisis has spread way beyond the borders of Greece to other countries, such as Spain, Portugal, Cyprus, and even Italy. With each attempt to correct the path taken, market confidence diminishes further with respect to the adequacy of any measures. Ultimately, the costs for both, those in need of saving and those attempting to save them grow.

Last week’s aid package of €34.4 billion for Greece, which will eventually grow to over €40 billion, was initially well received, as were previous packages. But already there is doubt, whether the conditional debt buyback goals can be met and there are concerns how such buyback would affect the balance sheets of Greek pension funds and banks. There is also lingering doubt whether the debt/GDP ratio of 124% by 2020 can be reached, and if so, whether it will even make a difference.

To be sure, Greece and other countries in the Eurozone were indeed in dire need of structural reform. The sacrifices in Greece have been immense. The budget deficit has been brought down at a dramatic clip from €36 billion in 2009 to €13 billion in 2012 with further reductions in play. Reforms in the health care and pension systems, reductions in the minimum wage, and some labor market reform have all been part of the package.

In some respects all countries, which were affected by the crisis have made similar sacrifices. And yet, the economic outlook for many of them is grim. By some analysts’ expectations Greece, Spain and Portugal, in particular, seem inextricably caught in a vicious cycle of austerity, continuous recession and hence additional need for austerity.  According to the most recent projections of the OECD, unemployment rates will peak in Spain and Greece near 27% in 2013, at 17% in Portugal and near 15% in Ireland. Youth unemployment is simply off the charts. There are no prospects for these numbers to improve any time soon. It is my view that there is a serious risk of a social tipping point that could impair governability. So what is to be done?

I leave it to the distinguished group of policy-makers at this conference and in the other Eurozone countries to discuss the options. They all have worked tremendously hard to come up with solutions. Yet, even under the most favorable circumstances, I consider a realignment of the Eurozone to be an outcome that must be seriously considered if not for the short term, then for the medium to long term.

It is at this point, that I would like put on my risk management hat. It is no state secret that large U.S. financial corporations have started to put into place contingency plans should the once-unimaginable happen, a breakup of the Eurozone.

I think it is incumbent upon large enterprises anywhere to prepare similarly. What are then the key ingredients to this corporate survival kit as I like to call it?

1)      Leadership comes from the top. Large organizations adjust slowly; they are often resistant to change. Therefore, their leaders must set an example by “suspending their disbelief”. No matter, how politically incorrect the assumptions may be, they must be evaluated.

2)      Prudent risk management develops scenarios based on two major aspects. The likelihood of a given adverse event and the severity of its impact. No matter how low a probability one might assign to a breakup of the Eurozone, the severity of that event would without question be extremely serious.

3)      In developing scenarios, large corporations and financial institutions must first choose among the most plausible scenarios of an unraveling of the Eurozone. Then, they must assess how they would be directly or indirectly affected by each of these scenarios.

4)      Under each scenario, they have to try finding solutions to optimally protect their assets. Among many things, they must also consider how they would be able to pay their employees assuming long-lasting bank holidays and currency conversions.

5)      Finally, proactive risk management leads to effective crisis management. This is so, because companies have thought through a whole range of scenarios and even if the crisis evolves differently from the way they had envisioned, which is almost always the case, the corporate survival kit will give them the tools to mitigate the impact of the crisis.

 

These are just a few guidelines. We all hope that the sacrifices made here in Greece and elsewhere, broad-based Eurozone cooperation as well as support from the IMF will succeed in creating a sustainable environment for all countries involved. But executives at large companies across the globe will sleep better, if they have a corporate survival kit in place that could limit the damage to their corporations, their employees, their shareholders and, truth be told to the global economy, should they find themselves waking up to the nightmare we so desperately seek to avoid.

Thank you for your attention.

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