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INTRODUCTION 1
                                            GREECE LEAVING 2
                        SEVERAL PROBLEM COUNTRIES LEAVING 5
                            FINLAND’S EXIT OF ITS OWN ACCORD 7
                               SPLIT OR BREAKUP OF THE EURO 8
               EFFECTS ON THE FINNISH ECONOMY AND MARKETS 10




What if the eurozone breaks up?
jos euroalue hajoaa?
OCTOBER 2012
■ Introduction




Introduction
Alternative euro break-up scenarios                             Greek banks’ capital, further decrease their access to fi-
The analysis explores four eurozone break-up scenarios:         nancial markets and lead to a full-scale deposit flight
i) Greece leaves the euro, ii) several countries in difficul-   from Greek banks. It will not be possible to pay all of the
ties leave, iii) Finland exits on its own accord, and lastly    deposits in Greek banks back. Furthermore, the purchas-
iv) the entire eurozone splits up into two or breaks up al-     ing power of Greek deposits will weaken considerably
together. The considerations take into account the effects      because the value of the new currency adopted by Greece
on both, the exiting country and the rest of the eurozone.      will devalue.
The analysis concludes with summarizing the effects of
the different scenarios on Finland's economic develop-          Exit of Greece may lead to a domino effect
ment, Finnish companies’ alternatives for interest rate         Problems in the Greek banking sector may also be re-
and currency hedging, corporate loan markets, and the           flected in the banks of the other weak eurozone countries.
equity market.                                                  Greece leaving the euro will stun the financial system,
                                                                which leads to a total halt in banks’ access to financial
We take no stand on whether the eurozone will remain as         markets in the weak countries. The banks, which are al-
it is, or will it change or break up totally. The following     ready dependent on the central bank, will have to in-
only describes what we think is likely to happen should         crease their use of central bank financing further, and
changes take place in the eurozone. There is naturally a        banks in the problem countries will suffer from a deposit
considerable degree of uncertainty associated with the          flight as speculations over their condition intensify.
scenarios. Not all alternatives are reviewed; instead, the
analysis focuses on the most interesting ones.                  Credible firewalls are vital
                                                                Getting the problems of the banking sectors of poor
The future of the eurozone depends on politicians               countries under control requires the capital situation of
The eurozone remaining in its current form is not up to         their banks to be improved. In practice, governments will
money, but rather politicians. So far, politicians in Eu-       have to support the banks. As financing needs in the
rope’s creditor countries have trusted that aid packages        problem countries increase while market access weakens,
for weak partners will not hamper their success in future       the role of crisis management framework will increase
elections. From the point of view of debtor countries, at       further. The firewall created by the European temporary
least for the time being, making the required economic          and permanent stability mechanisms, the International
reforms has been more pleasant than diving into a new           Monetary Fund (IMF) and the European Central Bank
unknown with their own currency.                                (ECB) plays a significant role in managing the crisis. In
                                                                particular, disconnecting the link between the teetering
However, the situation may change. If the composition of        banking sector and the government is essential to calm
the eurozone changes, it will begin with the break-up of        the situation down. The need for new aid packages will
Greece, because the country has clearly fallen short of         increase, but the spreading crisis will decrease the num-
the agreed economic reforms, the depression has turned          ber of countries providing support.
out to be worse than initially estimated and the need for a
third aid package is increasingly apparent. At the same         If the course of events cannot be stopped, or actually
time, the debate on the reasonability of the aid measures       there is no will to stop it, the European financial system
has intensified in the strong countries. The direct effects     will come to a complete standstill no later than when the
of Greece leaving the euro can be controlled, as many           crisis spreads to the EU founder states Italy and France.
kinds of preparations have already been made for it, such       The problem banks will not be able to pay back their
as the private sector cutting down its operations in            debts to the central bank. The problem banks’ increasing
Greece. What has a bigger effect than the direct effects        losses due to market value changes as well as the depres-
are growing market expectations of whether the remain-          sion in the real economy will consume their capital. The
ing eurozone is sustainable and which countries would be        problem banks will not be able to grant loans, and a cred-
the next to leave.                                              it crunch follows. The value of the euro will collapse.
                                                                This may result in the euro being abolished similarly to
Greece leaving the euro consumes Greek deposits                 the Soviet ruble or Yugoslavian Dinar, the collapse of the
The process of Greece leaving may lead to a series of           financial system and hyperinflation.
events, the motion of which are difficult to influence
once it has begun. Expectations of breakup will lead to         Germany’s exit destroys the euro system
even the last foreign investors leaving the country, while      In principle, the eurozone may also be changed by a
the Greek will increasingly transfer their deposits to for-     creditor country leaving the system. The exit of a small
eign banks. Greece will not be able to handle its debt if       country, such as Finland, might remain an individual
the flow of aid money stops, which will lead to signifi-        case, but a major country like Germany leaving would
cant losses in Greek banks. The losses will consume             collapse the entire euro area.



 LOKAKUU 2012


1 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012                                                           NORDEA MARKETS
■ Greece leaving the euro



Greece leaving the euro
• The new Greek currency will devalue considerably            within a few years (Figure 1). If one compares the stabil-
                                                              ity of the Greek economy to Finland at the time and takes
• Direct effects on euro countries manageable                 the considerable market mistrust in Greek political deci-
                                                              sion-making into account, devaluation clearly exceeding
Recent development in Greece                                  the devaluation of the Finnish markka would be proba-
Capital has been flowing out of the Greek financial sys-      ble. Market mistrust is evident in, for example, the mar-
tem for a long time. Foreign parties have repatriated their   ket values of the new government bonds issued after the
investments and domestic parties have withdrawn their         rearrangement of Greek government bonds, which have
deposits and transferred their investments abroad. The        decreased to below 40% of their face values.
outbound flow of currency has been substituted by loans
from the European Central Bank to Greek banks and the         Figure 1. Devaluations in previous economic crises
international support packages granted to Greece. Greek       110
                                                                                               Pre-crisis exchange
banks have been shut almost completely out of the pri-                                         rate = 100
vate funding market, so they have resorted to central          90
bank funding. Since the collateral required for central
bank funding has become scarce, banks are increasingly                  70
dependent on the emergency funding they receive from
the national central bank. In emergency funding, the
Bank of Greek creates money and loans it to banks                       50
                                                                                                     Argentina
against central government guarantees.                                                               Finland
                                                                        30
                                                                                                     Russia
Anatomy of the exit
If the emergency funding to Greek banks is stopped, the                                              Thailand
                                                                        10
banks’ liquidity will dry up and they will be forced to re-                                 91 92 92 93 94 95 96 97 98 99 00 01 02 03
strict cash withdrawals by depositors. The public will in-    Source: Reuters Ecowin
creasingly store cash under their mattresses. Greek
banks’ assets in other countries will be frozen, and inter-   Over the longer term, the exchange rate is determined on
national transactions can no longer be made through           the basis of the balance of the country’s economy. The
them. Greece will have to exit the euro system in nego-       higher the current account deficit and unemployment
tiations with the euro countries, because funding will        rate, the higher the devaluation pressure. The current ac-
end.                                                          count deficit of Greece has improved in 2007–2011 be-
                                                              cause the austerity measures have decreased imports
Greek banks’ debts to the European Central Bank will be       while exports have increased slightly (Figure 2). At the
completely rearranged or their repayment period will be       same time, however, the unemployment rate has in-
extended. Theoretically speaking, the Greek central gov-      creased to approximately 20%. In recent months, the un-
ernment is liable for any losses resulting from the emer-     employment rate in Greece has already gone up to some
gency funding operations. A country’s exit of the euro        25%. The unemployment rate could be reduced through
and/or insolvency is likely to result in losses to the cen-   stimulus measures, but funding the stimulus for an al-
tral banks of the other euro countries via the European       ready heavily indebted country is difficult.
central bank system.
                                                              Figure 2. Current account and unemployment rate,
Greek currency will devalue significantly                     2007–2011
Greece will finally make the political decision on adopt-         10
ing its own currency, the drachma. At first, various types                                                        Germany
                                                               Current account, % of GDP




of tender will be used before the new paper currency is                                     5
printed. Deposits will be converted into drachmas. The                                                          Finland
easiest way to implement the transition is to convert eu-                                                                   Ireland
                                                                                            0
ro-denominated deposits into drachmas at the rate of 1:1.
                                                                                                 0   Italy        10              20             30
The market value of the drachmas would naturally de-
                                                                                            -5                                         Spain
crease. In the initial phase, drachma-denominated bank
cheques and bearer bonds might work as the paper cur-                                                        Portugal
rency.                                                                                     -10
                                                                                                                             Greece
Drachma will initially experience clear overshoots. The
Finnish markka, for example, devalued by over 30% in                                       -15
                                                                                                                Unemployment rate, %
the 1990s after the currency was floated, until it stabi-     Source: OECD
lised at approximately 20% below the pre-crisis level




2 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012                                                                                       NORDEA MARKETS
■ Greece leaving the euro


Determining the currency is not straightforward               creasing the costs of companies and households. Inflation
The effects of the devaluation of the currency depend         will accelerate and the unemployment rate increase, caus-
significantly on whether existing contracts remain euro-      ing social problems.
denominated or are converted into drachmas. For exam-
ple, would a Finnish travel agency have the right to pay      The revenues of home-market companies will be drach-
the agreed hotel rent in drachmas? There will be negotia-     ma-denominated. Yet the companies will still have euro-
tions, demonstrations and court rulings, also between         denominated expenses, for example, for raw materials.
domestic parties. The employees of export companies           Costs will increase as the result of devaluation and com-
and the tourism industry have better chances of receiving     panies’ profitability will decrease. To the extent that
at least part of their income in euros than the employees     loans are converted into drachmas, the direct effect on
of home market companies. Lessors and creditors will try      debt servicing ability will remain minor. On the other
to charge the agreed euro-denominated amount in euros         hand, loans that remain euro-denominated would be in-
while the tenants and debtors offer the corresponding         creasingly difficult to repay. The domestic market will
amount in drachmas. Banks are required to pay small-          not benefit from the devaluation until export companies
scale depositors a minimum amount in euros. Vehement          increase their personnel and investments.
decisions will be made in the parliament. It is likely that
agreements under Greek law will be converted to drach-        Greek government debt will be rearranged
mas, while foreign ones will remain in the euro/foreign       The public sector has both domestic and foreign debt. In
currency.                                                     Greece, government bonds are mainly held by domestic
                                                              banks that have purchased them with ECB funding. For-
Devaluation will benefit export companies                     eign debt is mainly to the other euro countries via two aid
At first, disturbances in international payments and the      packages, the IMF and ECB. The devaluation of the new
significant uncertainty over Greece’s future will hinder      currency will increase the debt burden of the Greek pub-
exports. Who will want to travel to a chaotic Greece          lic sector should the debt remain in euros and public rev-
where ATMs do not work and credit cards are not ac-           enues mainly be in drachmas. Prior to the rearrangement
cepted? However, over time the functioning of the socie-      of the loans of the Greek private sector in spring 2012,
ty will begin to recover, and the weakening of the cur-       government debt was primarily in compliance with
rency will benefit the export sector and tourism industry.    Greek law, but the new bonds issued in the arrangement
Companies can transfer the devaluation benefit fully or       follow UK legislation, making it more difficult to convert
partially to prices, which will decrease the euro-            the loans to drachmas.
denominated prices, which, in turn, will support the ex-
port demand for the products. Improving demand will           Figure 3. Consequences of Greek exit
lead to the need for hiring new employees. In addition,          Prices of imported          Unwilligness to                    Difficulties in
                                                                 goods higher in the         accept the new                     international
the improving performance will provide opportunities for            new currency              currency 1:1                        payments
new investments. From the point of view of the national
economy, devaluation is more beneficial the more its ef-                                                                     Foreign trade comes
                                                                    Accelerating inflation         Disorder, strikes
fects are channelled into higher employment rates and                                                                           to a standstill
investments. The benefits of devaluation, on the other
hand, decrease the more wages and other production                Decreasing real
costs increase.                                                   income (wages,                                                  The economy
                                                                     pensions)                                                      collapses
                                                                                             Domestic demand
                                                                                                collapses
If the liabilities of an export company are converted into      Uncertainty over the                                   Inability to service
drachmas, devaluation will decrease the liabilities in eu-        future increases                                     euro-denominated
                                                                                                                               debt
ros, making it easier to cover them. The repayment of li-
abilities that remain euro-denominated will only be made      Source: Nordea Markets

easier through the higher profitability resulting from the
devaluation. Unfortunately for Greece, the country’s ex-      Greece will announce that it cannot service its debts be-
port sector is small.                                         cause Greece will no longer receive the current support
                                                              packages after the euro exit. However, attempts will be
Home market parties suffer from devaluation                   made to negotiate on the timetables of debt servicing or
Devaluation would initially be harmful to Greek home          at least partial repayment, because exports picked up as
market companies and consumers. Wages, pensions and           the result of the devaluation increase tax revenues. Debt-
other types of income will decrease in real terms once        ors will demand their claims in courts. It is in Greece’s
converted into drachmas. Certainly, prices of domestic        interest to pay the debt partially back in order to retain its
products and services will decrease equally, but imported     EU membership. Partial repayment also contributes to
goods will still carry the same euro-denominated prices.      the return to the international financial markets.
Euro-denominated prices of imported goods may even
increase, with the uncertainty and disorders in payment       The tax revenues of the Greek public economy have not
traffic making imports more difficult. One concrete ex-       been sufficient to cover expenses, let alone debt interest,
ample is the price of fuel, which is likely to go up, in-     for a long time. Devaluation will help over time, with




3 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012                                                                             NORDEA MARKETS
■ Greece leaving the euro


exports picking up, increasing the tax revenues. If ex-                 The European central bank system has claims of slightly
penses can also be kept under control, the public econo-                under EUR 150 billion from Greece. Slightly over two
my will begin to show a surplus. There will then be mon-                thirds are from banks, the rest from the central govern-
ey also for the expenses of servicing the rearranged                    ment. If Greece was to leave the eurozone, the extent to
loans. A summary of the consequences of Greek exit is                   which the country would be able and willing to repay its
shown in Figure 3.                                                      debts to the euro system would be unclear. According to
                                                                        the narrow definition, the capital of the European central
Direct losses from Greek exit are minor                                 bank system is only EUR 86 billion, so theoretically
The direct effects of Greece leaving the euro are limited               speaking, the losses caused by a Greek euro exit might
for Finland and also for the rest of the eurozone. Greece               consume the capital in full. However, the balance sheet
is a small country, others have already prepared for its                of the central banking system includes approximately
exit, and most of the government debt held by private in-               EUR 450 billion in revaluation accounts due to the in-
vestors has already been rearranged. Finland’s trade with               crease in the value of the gold reserve, among others.
Greece is slim, and the private sector's receivables are in-            This increase in value has not been recognised as revenue
significant. The public sector’s claims from Greece                     and therefore not as capital, either. These value changes
amount to approximately EUR 6 billion (Table 1).                        could be used to cover the losses, so instead of the nar-
                                                                        row capital alone, it makes more sense to also examine
The effects of the Greek exit will be higher in the rest of             the revaluation accounts when evaluating the balance
Europe than in Finland due to the closer trade relation-                sheet of the central bank system. In addition to utilisation
ships and higher level of direct exposure. A Greek euro                 of the revaluation accounts, the euro countries can inject
exit would hit France and Portugal the hardest, as these                capital into the central bank system.
countries have the highest claims from Greece compared
to the size of the economy. European banks will suffer                  In addition to trade relationships and direct claims,
losses due to approximately EUR 60 billion of Greek ex-                 Greece leaving the euro would increase the general un-
posure. However, in practice, most of the Greek govern-                 certainty, which will impair economic activity through-
ment bonds are most likely already recognized at market                 out Europe. Also, the development of the euro following
value. Furthermore, several banks have been reducing                    Greece’s exit will have an essential impact on exports. In
their Greece exposure in recent months, so the direct                   practice, reassuring the market after one country leaves
losses will remain considerably lower than the nominal                  that Greece will remain an isolated case will be crucial
value presented herein.                                                 and difficult, and it will require significant support
                                                                        measures by the stability mechanisms and the ECB. The
Table 1. Claims from Greece, EUR billion, 03/2012                       first reaction will be the weakening of the euro compared
               Spain Ireland   Italy   Greece Cyprus Portugal   Total   to other main currencies due to the uncertainty. The de-
Finland          1     0.4      0.4      0.0    0.0    0.2         2
Germany         110     74      105       5      6      21       322    valuation will support Finland’s and other euro countries’
Belgium          10     17       9       0.2    0.2      1        38    exports to outside the eurozone, but increasing uncertain-
France           91     19      263      31      2      16       423
Netherlands      53     11       28       2      1       4       100
                                                                        ty will impair exports more than this as a whole. After a
Austria          3       1       14       1      2       1        22    weak country has left, the euro will become stronger in
Sweden           2       1       1       0.2     1     0.2         5
Switzerland      15     10       17       2      1       2        46
                                                                        the longer term, which will make adjustments in the
UK               67    108       45       7      1      15       243    weakest countries remaining in the eurozone increasingly
Total           353    243      482      48     15      60      1202    difficult, with exports suffering from the strong currency.
Source: CEPS




4 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012                                                                    NORDEA MARKETS
■ Several problem countries leaving the euro



Several problem countries leaving the euro
• Greece leaving may trigger a domino effect                                    countries. Not all aid and claims will be lost; repayment
                                                                                depends on the severity of the economic problems and
• Significant losses to the private and public sectors                          debt negotiations. The public support paid by the EU and
                                                                                IMF in summer 2012 to problem countries amounted to
Greek exit may result in problem countries leaving
                                                                                approximately EUR 400 billion (Figure 4). Of this, Fin-
A Greek euro exit will increase uncertainty in the other                        land accounted for some EUR 7.6 billion.
problem countries in the eurozone (such as Portugal, Ita-
ly, Ireland, Spain, Cyprus and Slovenia). It may exacer-                        Finland also has liabilities via the ECB. In practice, the
bate the distress of the financial systems of the problem                       ECB's claims have emerged since 2007, when interbank
countries and accelerate deposit flight from problem                            lending dried up. Investors have withdrawn from funding
banks. The problem countries’ need for support will in-                         the banks of the problem countries and transferred their
crease, and if there is no readiness to give support, the                       assets to safer countries. The banks of the problem coun-
countries would leave the eurozone. The course of events                        tries have been forced to resort to the ECB via their own
would be similar to that in Greece, although the conse-                         central banks in order to be able to repay depositors and
quences of several countries leaving would be signifi-                          investors who are repatriating their assets. Correspond-
cantly higher due to the financial interconnectedness both                      ingly, banks in countries deemed safer have made depos-
in the countries leaving and those remaining in the euro-                       its in the ECB via their respective central banks. This
zone.                                                                           way, the central banks of the problem countries have ac-
                                                                                cumulated imputed debt in the payment system and safe
In the resulting smaller eurozone, investments and con-                         countries’ central banks imputed receivables that roughly
sumption will crash after the collapse of general confi-                        correspond to the (net) receivables and debts of the coun-
dence and the entire euro system having been called into                        tries’ financial systems to the European central bank sys-
question. Devaluation decreases the purchasing power of                         tem (Figure 5).
the countries exiting the euro, which will slow down the
exports of countries remaining in the euro. Uncertainty                         Figure 5. Receivables in the central bank system
will paralyse the economy of the eurozone, but the weak-                         800                                       Germany
ening of the euro compared to main currencies will help                                EUR billion
                                                                                 600                                       Netherlands
the export sectors. Tension in the international financial                                                                          Finland
market is increasing. Enormous credit losses will destabi-                       400                                                Slovenia
lize in particular the weakest financial institutions in the                     200                                                France
eurozone, and even the ECB will be technically bankrupt.                                                                            Belgium
The ECB will support banks by offering them an unlim-                                0                                              Austria
ited amount of liquidity. The bank system is kept run-                          -200                                                Portugal
ning, but credit losses will consume the banks' capital                                                                             Greece
                                                                                -400
and credit taps will remain dry.                                                                                                    Ireland
                                                                                -600                                                Italy
Figure 4. Claims from problem countries                                                  99    01      03    05   07   09   11      Spain
                                                           IMF                  Source: Ifo, central banks
 1400
           EUR billion
                                                           EFSF
 1200                                                                           The entire euro system shoulders the credit risk related to
                                                           EFSM                 bank financing and is liable for the repayment of deposits
 1000
                                                           ESM                  in the ECB. The national central banks act as the media-
  800                                                                           tors. If banks want to withdraw their deposits, the assets
                                                           Portugal
  600
                                                                                will be raised from the public funds of the euro system.
                                                           Ireland              If, say, a loan granted to a Spanish bank results in credit
  400                                                      Greece IMF           losses, the central banks of the system will carry the loss
  200                                                                           in line with their ownership. Any credit losses to the
                                                           Greece EU
                                                                                ECB will probably be divided among the remaining
      0                                                    ECB purchases        shareholders in accordance with their ownership. Fin-
           Subsidies      Subsidies ECB (GIIPS
             paid         promised and CYP)*                   Central bank     land’s liabilities currently correspond to its holding of
                                                               receivables      slightly under 2% in the ECB. The more countries exit
Source: Ifo *) GIIPS=Greece, Ireland, Italy, Portugal, Spain, CYP=Cyprus
                                                                                the euro, the higher Finland’s ownership and liabilities
Fate of public claims uncertain
                                                                                will increase.
It is probable that the debts of all countries leaving the
eurozone will have to be rearranged, which will result in                       The claims of the euro system from the problem coun-
losses to the public and private sectors of the eurozone                        tries are over EUR 950 billion, of which Finland’s share
                                                                                is approximately EUR 20 billion. These figures reflect




5 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012                                                                                 NORDEA MARKETS
■ Several problem countries leaving the euro

the current situation. If the crisis comes to a head, claims      Losses of the private sector
from the problem countries' financial systems will multi-         The private sector will also suffer credit losses from its
ply before the credit taps are turned off. In addition to the     exposure. Finnish banks had slightly under EUR 2 billion
problem countries, the European Central Bank has claims           of claims from the problem countries in March 2012. The
from other countries' financial institutions whose solven-        highest exposure is to Spanish banks.
cy would falter should the problem countries exit the eu-
ro.                                                               Should the problem countries leave, their debt will be re-
                                                                  arranged and their bank systems will suffer. Companies’
How the ECB’s credit losses are managed?                          opportunities for servicing euro-denominated loans are
The ECB’s credit losses can be managed in two ways.               poor, and the number of bankruptcies will surge. The re-
The first alternative is that the countries remaining in the      maining eurozone will carry considerable losses from
eurozone will inject more capital into the ECB in order to        these claims. However, the exposure is not only unidirec-
strengthen its balance sheet. Obtaining capital from the          tional. The problem countries’ companies and citizens
market in one go is not sensible, and the ECB would               have deposits in the banks of the remaining eurozone,
probably accept government bonds as a payment.                    and these deposits and cash moved to safe havens will
                                                                  begin to be repatriated after the adoption of their own
Alternatively, the ECB could be allowed to continue to            currency.
operate with negative capital or keep the capital positive
through bookkeeping means. The central bank can well              This may result in a situation in which the indebted sec-
operate even if the liabilities recognised on the balance         tors of the problem countries firstly fail to service their
sheet exceed the assets, since the liabilities mainly con-        debts to the core countries, and surplus companies and
sist of euro-denominated paper currency and banks’ de-            households subsequently aim to repatriate their assets
posits in the central bank. However, keeping inflation at         held safe as deposits in the core countries.
bay would be challenging for a central bank system oper-
ating with negative capital. The central bank is a net            Table 2. Bank exposure to the problem countries,
debtor to the bank system, so interest payments to banks          EUR billion
will have to be financed by creating new money. This is                        Public,      Private
                                                                                                        Total      % of GDP
no problem with zero interest rates, but the losses of the                    EFSF/ECB       (BIS)
                                                                  France          67           35        101            5.1%
central bank system will increase if interest rates are in-       Germany         89           11         99            3.9%
creased in order to curb inflation. The ECB can change            Italy           58           2          60            3.8%
the situation by increasing banks' reserve requirements           Spain           39           1          40            3.7%
considerably and stopping the payment of interest on re-          Netherlands     19           3          21            3.6%
serves. In this case, the central bank system will be capi-       Belgium         11           1          12            3.2%
                                                                  Portugal        5            6          12            6.8%
talised by, in practice, taxing banks. Reserves currently         Austria          9           2          11            3.6%
amount to only EUR 100 billion, so this would require             Finland         6            0          6             3.1%
multiplying the reserve requirements.                             Ireland          3           0           4            2.1%
                                                                  Total          306          59         365
Amount of paper currency will be reduced                          Source: BIS

In addition to credit losses, the amount of paper currency
will be a problem for the ECB. The amount of issued pa-
per currency must be reduced as the eurozone gets small-
er to match the needs of a smaller economic area. Infla-
tion will accelerate if the cash in circulation in the exit
countries enters circulation in the remaining eurozone
countries. The Italians alone are estimated to have EUR
150 billion in cash, which accounts for almost one sixth
of the amount of cash in the entire eurozone. However,
this sum is only three per cent of the total sum of cash
and demand deposits.




6 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012                                                               NORDEA MARKETS
■ Finland’s exit of its own accord



Finland’s exit of its own accord
• Finland can have two currencies in the beginning            whole, Finland’s foreign liabilities and receivables are
                                                              fairly balanced, so the need for exchanging euros to
• The development of the markka is not self-evident           markkas and vice versa would neutralize each other, and
                                                              the central bank’s need for action to stabilise the ex-
Uncertainty over economic policy and currency
                                                              change rate of the markka against the euro remains small.
A strong country may also leave the eurozone if the lia-
bilities related to the support packages need to be in-       The development of the markka is not self-evident
creased further. Finland’s exit of its own accord would       Right after the currency peg ends, the exchange rate of
differ from a Greek exit, because a balanced national         the markka may fluctuate even to a considerable extent,
economy may, theoretically speaking, have two curren-         depending on whether Finland is seen as a safe haven in
cies even for a long transition period, and peg the new       the euro crisis or whether investors will withdraw their
markka to the euro at a rate of 1:1 during the transition     assets from the small illiquid marginal market. In the
period. In the best case scenario, the uncertainty would      longer term, the development of the markka will depend
be temporary and impacts on Finnish economic devel-           in particular on the growth outlook, inflation-related ex-
opment remain limited. In practice, however, the impacts      pectations and investors’ attitude towards the exchange
depend on investors’ moods and the general economic           rate risk of a small currency. In any case, the value of the
development, so the transition period may be problemat-       markka will fluctuate more than that of the euro.
ic.
                                                              A minor strengthening caused by the relatively good bal-
Initially, both currencies could be legal tender. Euros are   ance of the Finnish economy may lead to a mass move-
not automatically converted into markka. Instead, all de-     ment of investors, which strengthens the currency strong-
posits, debt and other agreements remain in euros until       er than warranted by the situation of the real economy.
deposits are transferred to markka-denominated accounts       Such a positive cycle keeps interest rates low and sup-
and parties amend their contracts. During the transition      ports indebtedness and domestic demand. The recent
period, the Bank of Finland exchanges euros and mark-         weakening of the balance of current accounts intensifies,
kas at a rate of 1:1 both ways. Eagerness to exchange will    making the Finnish national economy increasingly de-
depend on people's expectations of the development of         pendent on the moods of foreign investors.
the value of the markka after the transition period. The
financial markets may have doubts as to the consistency       Corporate and government funding more expensive?
of Finnish economic policy, since Finland was known for       On the other hand, the value of the markka may decrease
its devaluation cycles prior to joining the EU. Therefore,    considerably because a small currency is not needed for
an immediate liquidity crisis may emerge as early as in       balancing investment portfolios in the same way as the
the transition period if eurozone investors withdraw their    euro, a major currency. A significant proportion of the
assets for fear that euros will not be safe in Finland.       money invested in Finland during the euro era columns
Risk-averse eurozone investors who currently have in-         from investors who have been looking for safe euro-
vested in Finland to be safe might not be willing to carry    denominated investments and are not willing to carry the
the exchange rate risk. In addition, the European Central     exchange rate risk associated with a small fringe curren-
Bank might not be willing to secure liquidity by lending      cy.
to a country that is about to leave the eurozone.
                                                              If foreign investors leave the small Finnish market, the
Currency risk related to euro-denominated funding             liquidity of Finnish markka-denominated listed equity
Following the transition period, the markka will be al-       and bond markets decreases, risk premiums increase and
lowed to float against the euro and the markka will be        high fluctuations in prices become more frequent.
made the only legal tender. Existing commitments may          Funding of banks, companies and the central government
remain euro-denominated, because their unilateral             becomes more difficult and expensive. Increasing finan-
amendment would collapse Finland’s credit rating, and         cial costs decrease consumer spending and willingness to
the balance of the Finnish national economy in any case       invest. General confidence weakens, and it will be diffi-
supports the rate of the markka against the euro remain-      cult to restore it. Credit taps are tightened, the economy
ing close to 1:1.                                             enters a recession, and the debt servicing capacity of the
                                                              public sector weakens. The credit rating of Finland will
Finnish banks have more loans granted to the public than      be placed under credit watch due to the exit-related un-
deposits, and some of the loans have been financed by         certainty, and the risk of the credit rating being lowered
borrowing from the euro market. This results in an ex-        will increase. Leaving the euro without exit from the EU
change rate risk to the banks. The Bank of Finland may        is not simple.
carry part of the currency risk by making long-term for-
ward contracts with the banks, i.e. committing to ex-
change the markka at a fixed rate in the future. On the




7 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012                                                          NORDEA MARKETS
■ Split or breakup of the euro



Split or breakup of the euro
• Germany’s exit leads to the breakup of the eurozone           Domino effect or German exit may collapse the euro
                                                                A chain reaction starting with the exit of weak countries
• An imputed euro and euribor will be created                   may lead to the entire eurozone breaking up. When ex-
                                                                pectations of the exit of weak countries increase, capital
Northern euro strengthens against the southern one
                                                                flight to safe countries will accelerate, and the central
If the eurozone splits up into northern and southern euro-      banks of the weak countries will have to support their fi-
zones, the northern euro will retain the current euro and       nancial systems by printing more euros. There is the risk
institutions because the head office of the ECB is in           of a total collapse in the value of the currency with the
Germany. The problem countries adopting the southern            central banks printing euros without limits.
euro will have to be able to establish a central bank sys-
tem and paper currency of their own. Splitting the central      The eurozone may also break up due to the exit of Ger-
bank system of the old eurozone in two and clarifying the       many, a large and strong financing country. If Germany
claims will be a painstaking process.                           decides to leave, the other strong countries will follow in
                                                                its footsteps. The entire eurozone will break up because
The northern euro will weaken against the other main            the remaining countries in crisis will not have the com-
currencies with significant uncertainty shaking all of Eu-      mon political will to build the required institutions.
rope. However, the northern euro will strengthen against
the southern euro as capital flows to a safe haven in the       Germany leaving the eurozone will plunge the country’s
markets of the relatively stronger countries. Northern eu-      own financial system to a chaos, even though the country
ro countries seem more stable compared to the southern          as a whole is at a surplus. Germany will suffer losses
ones, and they will not suffer from the outflow of capital      when the private and public problem country exposures
to the same extent.                                             have to be rearranged. The German economy will suffer
                                                                from the tightening credit taps of the banking sector,
The northern economies will suffer considerable losses          weakening demand in the export demand in the former
due to their receivables from the southern eurozone. The        eurozone and the strengthening currency.
northern financial system will require significant support,
which will increase the countries' national debts. Fur-         German banks have received safe-haven deposits from
thermore, the northern economies’ exports to the south          the southern eurozone, which will begin to be repatriated
will suffer due to the strengthening currency and fall in       when the situation clears up. There will be disputes over
demand in the southern eurozone. The economy will en-           whether deposits moved from southern Europe to Ger-
ter a recession, but it will benefit slightly from low inter-   many can be converted to D-Marks. Their conversion to
est rates and the weakening of the currency against other       the new domestic currency would lead to a decrease in
major currencies.                                               the value of the deposits because the new domestic cur-
                                                                rency will devalue. Germany, on the other hand, wants
The euro of the southern eurozone would devalue
                                                                only domestic deposits to be converted to the new, strong
The value of the southern euro made up of the weaker            D-Mark. In this case, the amount of money in Germany
countries will decrease. Foreign capital will flee the          will not increase exponentially, which will restrict the in-
southern eurozone, frightened by devaluation pressures,         flation pressure.
and the bank system will suffer with deposits fleeing to
safety, stuffed into mattresses or moved abroad. The            Breaking up of the eurozone will be chaotic
economy of the southern eurozone will fall all the way          If the entire eurozone breaks up, the European Central
into a depression, as the debt rearrangements of the cen-       Bank will be closed down and its tasks will be trans-
tral governments and the increasing number of bankrupt-         ferred back to the national central banks. The European
cies will consume banks' capital and accelerate the credit      financial system will collapse and Europe will end up in
depression. Gradually, the weak currency will support           a credit depression, from which it will not recover for a
the exports of the southern economies.                          long time. The central banks of all former member states
                                                                will provide their banks with unlimited liquidity. The
If the debt of the southern eurozone countries is convert-      banks will need new capital. The complete breakup of the
ed into southern euros, their value in northern euros will      eurozone will plunge the entire global financial system
decrease. This will make it easier to repay the debt of the     into full-scale chaos. The entire eurozone will enter a de-
southern area, but the devaluation of the currency will re-     pression, which will have long-lasting effects in all coun-
sult in increasing losses to the north in the southern euro-    tries.
zone. On the other hand, if the debt remains in northern
euros, the debt burden of the southern eurozone will in-
crease, which will increase the probability of debt rear-
rangements.




8 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012                                                            NORDEA MARKETS
■ Split or breakup of the euro


An enormous extent of negotiations on the currency to be      Euribor is the most common reference rate in the eur-
used in agreements will follow. One option is to adopt an     zone, and the quoting of euribor interest rates would end
imputed euro exchange rate, determined as the weighted        in case of a complete breakup of the eurozone. In this
average of the new currencies of the euro countries. Such     case, a substitute should be found for the euribor rates. In
a currency already existed before the euro in the form of     practice, the substitute could be formed out of the new
the ”ECU basket currency,” which was exchanged into           national interbank interest rates as an imputed interest
euros at a rate of 1:1. The exchange rates of the strong      rate.
surplus countries will strengthen in proportion to the oth-
er former eurozone countries. If the debt is in imputed
euros, the strengthening of the new currency would de-
crease the euro-denominated debt. The debt of weak def-
icit countries would have the same fate as Greece’s debt
in case of a Greek exit.




9 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012                                                          NORDEA MARKETS
■ Effects of the scenarios on the Finnish economy and market



Effects of the scenarios on the Finnish economy and markets
Table 3. Impacts on the Finnish economy

 Nordea’s base line      Greece leaves              Problem countries        Only Finland leaves      The entire eurozone
                                                    leave                                             breaks up
 Economic growth         Effects on Finland         The direct effects on    Effects on the           Direct effects on
 will accelerate         are minor, because         Finland are higher       development of the       Finland are
 gradually from this     direct Finnish trade       than in the previous     Finnish economy are      extremely high
 year’s below 1% to      with and Greek             scenario, because the    minor in the best
 almost 3% in 2014       exposure are small         problem countries        case scenario            The European
                                                    account for a large                               financial system will
 Unemployment will       The indirect effects       proportion of the        Finland’s exit will      collapse
 remain at               will also be minor to      eurozone and 30% of      escalate the crisis of
 approximately 8%        Finland because            Finland’s exports are    the eurozone and the     Credit depression
 until 2014              Greece is a small          to the eurozone          outlook for
                         country and many                                    economic growth          After a very deep
 Inflation will remain   preparations have          Eurozone will enter      will become              plunge, the economy
 at slightly over 2%,    already been made          a financial crisis and   gloomier                 will begin to recover
 but will not exceed     for a potential Greek      depression that will                              around the third year
 3% even in 2014         exit                       be more severe and       The currency may         following the
                                                    longer than the 2009     fluctuate greatly        breakup
 Current account         Finland's export           crisis                   after the transition
 deficit will remain     demand will begin to                                period                   Risk of increasing
 moderate                recover from the           Finland’s losses                                  inflation
                         slump caused by the        from the                 Once the temporary
                         exit within as little as   rearrangement of         uncertainty clears
                         a year                     bailout packages,        up, Finland begins to
                                                    euro system and          recover from the
                                                    private sector claims    euro exit within a
                                                    will be significant      year

                                                    The remaining
                                                    eurozone and
                                                    Finland will begin to
                                                    recover from the
                                                    breakup of the euro
                                                    around the third year
                                                    after the exit




10 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012                                                            NORDEA MARKETS
■ Effects of the scenarios on the Finnish economy and market


Table 4. Effects of the breakup of the eurozone on the interest rates and interest rate derivatives

 Greek exit                    Problem countries            Only Finland leaves          The entire eurozone
                               leave                                                     breaks up

 If the Greek exit is          The capitalisation need      If Finland’s euro-           The euro will be replaced
 controlled and based on a     of banks is considerably     denominated bonds are        with an accounting
 mutual decision in the        higher than in the           converted into markka-       currency similar to its
 eurozone, it is likely that   preceding scenario. The      denominated bonds,           predecessor, the ECU,
 the capitalisation of the     problem countries will       being marginal               which is calculated by
 banks of each eurozone        adopt their own              investment, they will be     weighing the national
 country will be secured if    currencies, and with the     subject to selling           currencies.
 capitalisation is             devaluation, covering the    pressures, and Finland’s     The ECU interest rate
 perceived necessary. In       existing euro-               interest rates will          calculated on the basis of
 this scenario of a            denominated debt will        increase.                    the national currencies
 controlled Greek exit, the    become impossible. If                                     will be higher than the
 economic outlook will         the debts of the problem     The same phenomenon          Euribor rate. This will
 improve. The interest         countries are converted      will apply to the issuance   result in upside pressure
 rates will normalise and      into their own currencies,   of new markka-               to fixed interest rates.
 long-term interest rates      this will result in losses   denominated bonds, even
 will increase more than       to the bearers of the        if the old debt remains      The consequences of the
 short-term rates.             bonds due to the             euro-denominated.            entire eurozone breaking
                               weakening of the                                          up will be of such a scale
 If Greece exits in an         currency.                    The risk of devaluation      that the market reactions
 uncontrolled way, the                                      of the markka and            will be considerable and
 market will begin to          Increasing risks for the     accelerating inflation.      significant uncertainty is
 price the possible exit of    banking sector will          Receive Finnish              associated with
 other problem countries.      create upside pressure on    inflation.                   predicting them.
 Interest rates will remain    Euribor interest rates,
 low, and the European         increasing the difference                                 Pay long-term fixed
 stability mechanisms and      with the overnight Eonia                                  interest. Receive Finnish
 the ECB will secure the       interest rates.                                           inflation.
 financing needs of the
 problem countries. This       Receive expanding
 will subsequently             Euribor-Eonia interest
 increase the inflation        rate differential. Receive
 pressure.                     inflation (eurozone or
                               Finland).
 Pay long-term fixed
 interest. Receive
 inflation (eurozone or
 Finland).




11 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012                                                           NORDEA MARKETS
■ Effects of the scenarios on the Finnish economy and market


Table 5a. Effects on a Finnish company’s foreign exchange hedging: company exports

 Greek exit                   Problem countries            Only Finland leaves           The entire eurozone
                              leave                                                      breaks up
 There is the risk of euro-   If all of the problem        The markka will be            The markka will be
 denominated receivables      countries exit, the          adopted as the expense        adopted as the expense
 from Greece being            situation has a rather       currency, and the             currency, and the
 converted to the new         similar logic to that of a   strengthening of the          strengthening of the
 Greek currency, which        Greek exit. The new          markka is a risk. It is not   markka is a risk. It is not
 will devalue                 currencies of these          currently possible to         currently possible to
 considerably against the     countries would probably     hedge against                 hedge against the new
 euro.                        devalue against the euro     fluctuations in the value     currencies. Hedging
                              (of the remaining strong     of the markka.                using derivatives
 Demand will fall             countries).                                                correlating with credit
 considerably due to both                                  Hedging exports to            risk could be considered.
 the economic situation       Direct hedging against,      outside the eurozone
 and the weakening of the     for example, the             (e.g. USD) carries the        Hedging exports to
 drachma.                     weakening of the Italian     risk of the hedging being     outside the eurozone
                              lira is impossible.          for changes in the            (e.g. USD) carries the
 With regard to foreign       Utilising the country’s      exchange rate of the euro     risk of the hedging being
 exchange risks, one          bankruptcy probability       but not of the markka.        for changes in the
 should consider, for         could be considered as a                                   exchange rate of the new
 example, if it could be      hedging option. The          The most problematic          basket currency ECU but
 possible to ensure the       probability of Italy’s       scenario is that the euro     not of the markka.
 payment of the least         euro exit is likely to       will weaken significantly
 open deals in euros          correlate with the           and hedging with a            The most problematic
 through contractual          country’s bankruptcy         forward contract results      scenario is that the new
 arrangements. Risk of        probability, in which        in costs while the markka     ECU basket currency
 the customer’s               case credit risk             strengthens.                  will weaken significantly
 insolvency.                  derivatives could be used    Options are useful for        and hedging with a
                              for hedging against the      this problem instead of a     forward contract results
                              exit.                        binding (forward, etc.)       in costs while the markka
                                                           hedge.                        strengthens.
                                                           An option would hedge
                                                           against the weakening of      Options are useful for
                                                           USD, for example, but         this problem instead of a
                                                           would not be binding in       binding (forward, etc.)
                                                           the event of a Finnish        hedge.
                                                           exit.




12 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012                                                            NORDEA MARKETS
■ Effects of the scenarios on the Finnish economy and market


Table 5b. Effects on a Finnish company’s foreign exchange hedging: company imports

 Greek exit                   Problem countries           Only Finland leaves          The entire eurozone
                              leave                                                    breaks up
 The drachma weakens          The situation has a         The markka will be the       The markka will be the
 and provides an              similar logic to a Greek    income currency, and         income currency, and
 opportunity for              exit.                       there is a risk of the       there is a risk of the
 decreasing import prices.                                markka weakening             markka weakening
 Specific hedging against     The supplier’s expense      against the purchase         against the purchase
 this currency scenario is    currency weakens and        currencies.                  currencies.
 probably not as              provides an opportunity
 necessary as for, e.g., an   for decreasing import       Forward contract involve     Forward contracts
 export company.              prices.                     the risk of the euro and     involve the risk of the
                                                          the markka developing in     new ECU and the
 One could, for example,                                  different directions.        markka developing in
 as a contractual way                                     Options, for example,        different directions.
 consider how to reserve                                  could be considered as       Options, for example,
 an opportunity for                                       the solution.                could be considered as
 quickly renegotiating the                                                             the solution.
 purchase prices.                                         Hedging purchases from
                                                          the current eurozone         Hedging purchases from
                                                          countries is not directly    the current eurozone
                                                          possible.                    countries is not directly
                                                                                       possible.


Table 5c. Effects on a Finnish company’s foreign exchange hedging: foreign subsidiary

 Greek exit                   Problem countries           Only Finland leaves          The entire eurozone
                              leave                                                    breaks up
 Local demand will            Similar risks to a Greek    The group’s home             The group’s home
 decrease. In addition,       exit. The risk of the       currency will be the         currency will be the
 there is a risk of the       currency weakening          markka, and there is a       markka, and there is a
 drachma weakening and        decreasing the value of     risk of the markka           risk of the markka
 decreasing the value of      the holding. If the         strengthening against the    strengthening against the
 assets. One should           national currency           currency of the holdings.    currency of the assets. In
 prepare for strong           overshoots, the impact                                   the event of a complete
 fluctuation, which has a     could quickly affect the    The impact in the event      breakup of the euro, the
 considerable effect on       group’s equity and          of a Finnish exit will       effect could be rapid and
 the group’s equity and       balance sheet covenants.    probably be not as great     preparations for the
 balance sheet covenants,                                 as, for example, in the      weakening of, e.g.,
 for instance.                Local lending can be        breakup of the entire        equity and balance sheet
                              considered as a potential   eurozone, but there is a     covenants would be
 As a sort of option, one     natural hedge.              risk of major changes on     useful. Changes in the
 might think about                                        the balance sheet.           value of assets in
 whether a euro-                                                                       Germany and other
 denominated loan taken                                   To the extent that the       strong countries might
 by the subsidiary locally                                Finnish parent’s external    partly offset this.
 could function as a                                      euro-denominated loans
 natural hedge: would the                                 finance subsidiaries in      Local funding could be a
 euro-denominated loan                                    other Eurozone               natural hedge.
 taken in Greece be                                       countries, it is essential
 converted into drachmas,                                 that the loans remain
 which would compensate                                   euro-denominated.
 for the decrease in the
 euro-denominated value
 of the drachma assets?




13 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012                                                         NORDEA MARKETS
■ Effects of the scenarios on the Finnish economy and market


Table 6. Effects on corporate bonds

Greek exit                      Problem countries            Only Finland leaves        The entire eurozone
                                leave                                                   breaks up

 A majority of Greek            The European corporate       If Finland exits of its    The number of
 companies will find            bond market is already       own accord, increasing     bankruptcies and credit
 themselves in financial        considerably mixed up,       uncertainty and possible   events will be extremely
 difficulties and a credit      and the number of credit     speculation concerning     high – applies to all euro-
 event.                         events is significant also   the next exit decisions    denominated bonds.
                                outside the problem          are the most significant   Because refinancing is
 For credit rating agencies,    countries.                   indirect effect on the     practically impossible,
 the conversion of the                                       corporate bond market.     there will also be
 currency of the bond           The same principles as in                               defaults in bonds in other
 alone gives rise to a credit   the case of Greece:          Finnish export-driven      currencies than euro.
 event.                         companies whose              companies would suffer
                                operations take place        from continuous            In contrast with the
 In the slightly longer         outside the eurozone and     uncertainty in Finland     previous scenarios, the
 term, export companies         Europe to a significant      and the rest of Europe     consequences to
 and subsidiaries of large      extent are in the best       alike.                     corporate bond markets
 international corporations     position.                                               are enormous also
 would be in the best                                        In contrast with, for      outside the eurozone and
 position. Sufficient           Because the European         example, the Greek exit    Europe.
 liquidity plays a key role.    financial market is mixed    scenario, the transition
                                up, an extensive funding     period from the euro to    In the longer run, the
 The effects on most            base plays a key role,       the markka could be        normal regularities will
 Nordic companies would         which includes a good        long, and existing loans   apply: extensive funding
 probably remain more           relationship with major      could possibly remain      base, geographic
 limited than on French         banks and access to          euro-denominated.          distribution, cyclicality
 companies, for example,        financial markets outside                               and competitive
 due to the lower volume        the eurozone                 The risks of Finnish       situation.
 of exports and banks’                                       companies will increase
 risks.                         Non-cyclical companies       in the form of currency    Companies that are
                                will fare better             risks.                     critical for public activity
                                operationally, but                                      and safety and have
                                taxation pressure on                                    operations across borders
                                these companies will                                    are in the best position.
                                increase hand in hand
                                with the governments’
                                difficulties. Furthermore,
                                the creditworthiness of
                                state-linked companies
                                will, relatively speaking,
                                weaken the most due to
                                no longer being
                                supported by the
                                government ownership.




14 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012                                                          NORDEA MARKETS
■ Effects of the scenarios on the Finnish economy and market


Table 7. Effects on the equity market

Greek exit                     Problem countries           Only Finland leaves         The entire eurozone
                               leave                                                   breaks up


 The market is turbulent       The markets will price in   The short-term reactions    Risk premiums will
 until the Greece-related      a considerably higher       are remarkable              increase considerably,
 liabilities of companies      risk than in the exit of    turbulence, high risk       and the pressures are
 and financial institutions    Greece alone.               premium and flight of       comparable to the
 are fully known.                                          foreign capital.            development in 2008–
                               Risk premiums will                                      2009.
 For Finnish companies,        increase significantly,     The longer-term
 the direct Greek              and with particular         consequences depend on      Finland will remain
 exposure is small, and        regard to cyclical and      the value (and stability)   underweighted in the
 pressure on valuation is      indebted companies, the     of the currency. The risk   allocation of
 mainly caused by the          pressures are comparable    premium, however, will      international investments
 general uncertainty.          with the development in     remain higher.              (foreign ownership
                               2008-09.                                                decreased following the
 Since the possibility of                                                              Lehman crisis and has
 an exit has already been      The competition field                                   not increased to a
 assessed and it has been      will transform in sectors                               significant extent).
 possible to prepare for it,   with competing capacity
 the market turbulence         in southern Europe (e.g.,                               Consumption and
 may remain short-lived.       paper, steel). The strong                               investment demand will
                               euro of the strong                                      weaken significantly.
                               countries will burden the
                               competitiveness of                                      The risk premium of
                               exports.                                                shares listed in Finland
                                                                                       will increase at a steeper
                                                                                       rate than the risk
                                                                                       premiums of companies
                                                                                       listed in capital markets
                                                                                       perceived safer.




15 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012                                                         NORDEA MARKETS
For further information:

Aki Kangasharju, Director, Head of Research
aki.kangasharju@nordea.com                                          +358 9 165 59952


Suvi Kosonen, Analyst
suvi.kosonen@nordea.com                                             +358 9 165 59002




Nordea Markets
Research Finland

Aleksis Kiven katu 9, 00020 NORDEA
nordeamarkets.com

Tel (09) 1651



Nordea Markets is the name of the Markets departments of Nordea Bank Norge ASA, Nordea Bank AB (publ), Nordea Bank Finland Plc and Nordea Bank Danmark A/S.

The information provided herein is intended for the sole use of the intended recipient. The views and other information provided herein are the current views of Nordea Markets as of
the date of this document and are subject to change without notice. The views have been provided solely based on the information made available to Nordea Markets and for the
purposes of presenting the services made available by Nordea Markets. This notice does not substitute the judgement of the recipient.

Nordea Markets is not and does not purport to be an adviser as to legal, taxation, accounting or regulatory matters in any jurisdiction. Relevant professional advice should always be
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What if-the-eurozone-breaks-up ? Finland’s exit of its own accord

  • 1. INTRODUCTION 1 GREECE LEAVING 2 SEVERAL PROBLEM COUNTRIES LEAVING 5 FINLAND’S EXIT OF ITS OWN ACCORD 7 SPLIT OR BREAKUP OF THE EURO 8 EFFECTS ON THE FINNISH ECONOMY AND MARKETS 10 What if the eurozone breaks up? jos euroalue hajoaa? OCTOBER 2012
  • 2. ■ Introduction Introduction Alternative euro break-up scenarios Greek banks’ capital, further decrease their access to fi- The analysis explores four eurozone break-up scenarios: nancial markets and lead to a full-scale deposit flight i) Greece leaves the euro, ii) several countries in difficul- from Greek banks. It will not be possible to pay all of the ties leave, iii) Finland exits on its own accord, and lastly deposits in Greek banks back. Furthermore, the purchas- iv) the entire eurozone splits up into two or breaks up al- ing power of Greek deposits will weaken considerably together. The considerations take into account the effects because the value of the new currency adopted by Greece on both, the exiting country and the rest of the eurozone. will devalue. The analysis concludes with summarizing the effects of the different scenarios on Finland's economic develop- Exit of Greece may lead to a domino effect ment, Finnish companies’ alternatives for interest rate Problems in the Greek banking sector may also be re- and currency hedging, corporate loan markets, and the flected in the banks of the other weak eurozone countries. equity market. Greece leaving the euro will stun the financial system, which leads to a total halt in banks’ access to financial We take no stand on whether the eurozone will remain as markets in the weak countries. The banks, which are al- it is, or will it change or break up totally. The following ready dependent on the central bank, will have to in- only describes what we think is likely to happen should crease their use of central bank financing further, and changes take place in the eurozone. There is naturally a banks in the problem countries will suffer from a deposit considerable degree of uncertainty associated with the flight as speculations over their condition intensify. scenarios. Not all alternatives are reviewed; instead, the analysis focuses on the most interesting ones. Credible firewalls are vital Getting the problems of the banking sectors of poor The future of the eurozone depends on politicians countries under control requires the capital situation of The eurozone remaining in its current form is not up to their banks to be improved. In practice, governments will money, but rather politicians. So far, politicians in Eu- have to support the banks. As financing needs in the rope’s creditor countries have trusted that aid packages problem countries increase while market access weakens, for weak partners will not hamper their success in future the role of crisis management framework will increase elections. From the point of view of debtor countries, at further. The firewall created by the European temporary least for the time being, making the required economic and permanent stability mechanisms, the International reforms has been more pleasant than diving into a new Monetary Fund (IMF) and the European Central Bank unknown with their own currency. (ECB) plays a significant role in managing the crisis. In particular, disconnecting the link between the teetering However, the situation may change. If the composition of banking sector and the government is essential to calm the eurozone changes, it will begin with the break-up of the situation down. The need for new aid packages will Greece, because the country has clearly fallen short of increase, but the spreading crisis will decrease the num- the agreed economic reforms, the depression has turned ber of countries providing support. out to be worse than initially estimated and the need for a third aid package is increasingly apparent. At the same If the course of events cannot be stopped, or actually time, the debate on the reasonability of the aid measures there is no will to stop it, the European financial system has intensified in the strong countries. The direct effects will come to a complete standstill no later than when the of Greece leaving the euro can be controlled, as many crisis spreads to the EU founder states Italy and France. kinds of preparations have already been made for it, such The problem banks will not be able to pay back their as the private sector cutting down its operations in debts to the central bank. The problem banks’ increasing Greece. What has a bigger effect than the direct effects losses due to market value changes as well as the depres- are growing market expectations of whether the remain- sion in the real economy will consume their capital. The ing eurozone is sustainable and which countries would be problem banks will not be able to grant loans, and a cred- the next to leave. it crunch follows. The value of the euro will collapse. This may result in the euro being abolished similarly to Greece leaving the euro consumes Greek deposits the Soviet ruble or Yugoslavian Dinar, the collapse of the The process of Greece leaving may lead to a series of financial system and hyperinflation. events, the motion of which are difficult to influence once it has begun. Expectations of breakup will lead to Germany’s exit destroys the euro system even the last foreign investors leaving the country, while In principle, the eurozone may also be changed by a the Greek will increasingly transfer their deposits to for- creditor country leaving the system. The exit of a small eign banks. Greece will not be able to handle its debt if country, such as Finland, might remain an individual the flow of aid money stops, which will lead to signifi- case, but a major country like Germany leaving would cant losses in Greek banks. The losses will consume collapse the entire euro area. LOKAKUU 2012 1 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012 NORDEA MARKETS
  • 3. ■ Greece leaving the euro Greece leaving the euro • The new Greek currency will devalue considerably within a few years (Figure 1). If one compares the stabil- ity of the Greek economy to Finland at the time and takes • Direct effects on euro countries manageable the considerable market mistrust in Greek political deci- sion-making into account, devaluation clearly exceeding Recent development in Greece the devaluation of the Finnish markka would be proba- Capital has been flowing out of the Greek financial sys- ble. Market mistrust is evident in, for example, the mar- tem for a long time. Foreign parties have repatriated their ket values of the new government bonds issued after the investments and domestic parties have withdrawn their rearrangement of Greek government bonds, which have deposits and transferred their investments abroad. The decreased to below 40% of their face values. outbound flow of currency has been substituted by loans from the European Central Bank to Greek banks and the Figure 1. Devaluations in previous economic crises international support packages granted to Greece. Greek 110 Pre-crisis exchange banks have been shut almost completely out of the pri- rate = 100 vate funding market, so they have resorted to central 90 bank funding. Since the collateral required for central bank funding has become scarce, banks are increasingly 70 dependent on the emergency funding they receive from the national central bank. In emergency funding, the Bank of Greek creates money and loans it to banks 50 Argentina against central government guarantees. Finland 30 Russia Anatomy of the exit If the emergency funding to Greek banks is stopped, the Thailand 10 banks’ liquidity will dry up and they will be forced to re- 91 92 92 93 94 95 96 97 98 99 00 01 02 03 strict cash withdrawals by depositors. The public will in- Source: Reuters Ecowin creasingly store cash under their mattresses. Greek banks’ assets in other countries will be frozen, and inter- Over the longer term, the exchange rate is determined on national transactions can no longer be made through the basis of the balance of the country’s economy. The them. Greece will have to exit the euro system in nego- higher the current account deficit and unemployment tiations with the euro countries, because funding will rate, the higher the devaluation pressure. The current ac- end. count deficit of Greece has improved in 2007–2011 be- cause the austerity measures have decreased imports Greek banks’ debts to the European Central Bank will be while exports have increased slightly (Figure 2). At the completely rearranged or their repayment period will be same time, however, the unemployment rate has in- extended. Theoretically speaking, the Greek central gov- creased to approximately 20%. In recent months, the un- ernment is liable for any losses resulting from the emer- employment rate in Greece has already gone up to some gency funding operations. A country’s exit of the euro 25%. The unemployment rate could be reduced through and/or insolvency is likely to result in losses to the cen- stimulus measures, but funding the stimulus for an al- tral banks of the other euro countries via the European ready heavily indebted country is difficult. central bank system. Figure 2. Current account and unemployment rate, Greek currency will devalue significantly 2007–2011 Greece will finally make the political decision on adopt- 10 ing its own currency, the drachma. At first, various types Germany Current account, % of GDP of tender will be used before the new paper currency is 5 printed. Deposits will be converted into drachmas. The Finland easiest way to implement the transition is to convert eu- Ireland 0 ro-denominated deposits into drachmas at the rate of 1:1. 0 Italy 10 20 30 The market value of the drachmas would naturally de- -5 Spain crease. In the initial phase, drachma-denominated bank cheques and bearer bonds might work as the paper cur- Portugal rency. -10 Greece Drachma will initially experience clear overshoots. The Finnish markka, for example, devalued by over 30% in -15 Unemployment rate, % the 1990s after the currency was floated, until it stabi- Source: OECD lised at approximately 20% below the pre-crisis level 2 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012 NORDEA MARKETS
  • 4. ■ Greece leaving the euro Determining the currency is not straightforward creasing the costs of companies and households. Inflation The effects of the devaluation of the currency depend will accelerate and the unemployment rate increase, caus- significantly on whether existing contracts remain euro- ing social problems. denominated or are converted into drachmas. For exam- ple, would a Finnish travel agency have the right to pay The revenues of home-market companies will be drach- the agreed hotel rent in drachmas? There will be negotia- ma-denominated. Yet the companies will still have euro- tions, demonstrations and court rulings, also between denominated expenses, for example, for raw materials. domestic parties. The employees of export companies Costs will increase as the result of devaluation and com- and the tourism industry have better chances of receiving panies’ profitability will decrease. To the extent that at least part of their income in euros than the employees loans are converted into drachmas, the direct effect on of home market companies. Lessors and creditors will try debt servicing ability will remain minor. On the other to charge the agreed euro-denominated amount in euros hand, loans that remain euro-denominated would be in- while the tenants and debtors offer the corresponding creasingly difficult to repay. The domestic market will amount in drachmas. Banks are required to pay small- not benefit from the devaluation until export companies scale depositors a minimum amount in euros. Vehement increase their personnel and investments. decisions will be made in the parliament. It is likely that agreements under Greek law will be converted to drach- Greek government debt will be rearranged mas, while foreign ones will remain in the euro/foreign The public sector has both domestic and foreign debt. In currency. Greece, government bonds are mainly held by domestic banks that have purchased them with ECB funding. For- Devaluation will benefit export companies eign debt is mainly to the other euro countries via two aid At first, disturbances in international payments and the packages, the IMF and ECB. The devaluation of the new significant uncertainty over Greece’s future will hinder currency will increase the debt burden of the Greek pub- exports. Who will want to travel to a chaotic Greece lic sector should the debt remain in euros and public rev- where ATMs do not work and credit cards are not ac- enues mainly be in drachmas. Prior to the rearrangement cepted? However, over time the functioning of the socie- of the loans of the Greek private sector in spring 2012, ty will begin to recover, and the weakening of the cur- government debt was primarily in compliance with rency will benefit the export sector and tourism industry. Greek law, but the new bonds issued in the arrangement Companies can transfer the devaluation benefit fully or follow UK legislation, making it more difficult to convert partially to prices, which will decrease the euro- the loans to drachmas. denominated prices, which, in turn, will support the ex- port demand for the products. Improving demand will Figure 3. Consequences of Greek exit lead to the need for hiring new employees. In addition, Prices of imported Unwilligness to Difficulties in goods higher in the accept the new international the improving performance will provide opportunities for new currency currency 1:1 payments new investments. From the point of view of the national economy, devaluation is more beneficial the more its ef- Foreign trade comes Accelerating inflation Disorder, strikes fects are channelled into higher employment rates and to a standstill investments. The benefits of devaluation, on the other hand, decrease the more wages and other production Decreasing real costs increase. income (wages, The economy pensions) collapses Domestic demand collapses If the liabilities of an export company are converted into Uncertainty over the Inability to service drachmas, devaluation will decrease the liabilities in eu- future increases euro-denominated debt ros, making it easier to cover them. The repayment of li- abilities that remain euro-denominated will only be made Source: Nordea Markets easier through the higher profitability resulting from the devaluation. Unfortunately for Greece, the country’s ex- Greece will announce that it cannot service its debts be- port sector is small. cause Greece will no longer receive the current support packages after the euro exit. However, attempts will be Home market parties suffer from devaluation made to negotiate on the timetables of debt servicing or Devaluation would initially be harmful to Greek home at least partial repayment, because exports picked up as market companies and consumers. Wages, pensions and the result of the devaluation increase tax revenues. Debt- other types of income will decrease in real terms once ors will demand their claims in courts. It is in Greece’s converted into drachmas. Certainly, prices of domestic interest to pay the debt partially back in order to retain its products and services will decrease equally, but imported EU membership. Partial repayment also contributes to goods will still carry the same euro-denominated prices. the return to the international financial markets. Euro-denominated prices of imported goods may even increase, with the uncertainty and disorders in payment The tax revenues of the Greek public economy have not traffic making imports more difficult. One concrete ex- been sufficient to cover expenses, let alone debt interest, ample is the price of fuel, which is likely to go up, in- for a long time. Devaluation will help over time, with 3 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012 NORDEA MARKETS
  • 5. ■ Greece leaving the euro exports picking up, increasing the tax revenues. If ex- The European central bank system has claims of slightly penses can also be kept under control, the public econo- under EUR 150 billion from Greece. Slightly over two my will begin to show a surplus. There will then be mon- thirds are from banks, the rest from the central govern- ey also for the expenses of servicing the rearranged ment. If Greece was to leave the eurozone, the extent to loans. A summary of the consequences of Greek exit is which the country would be able and willing to repay its shown in Figure 3. debts to the euro system would be unclear. According to the narrow definition, the capital of the European central Direct losses from Greek exit are minor bank system is only EUR 86 billion, so theoretically The direct effects of Greece leaving the euro are limited speaking, the losses caused by a Greek euro exit might for Finland and also for the rest of the eurozone. Greece consume the capital in full. However, the balance sheet is a small country, others have already prepared for its of the central banking system includes approximately exit, and most of the government debt held by private in- EUR 450 billion in revaluation accounts due to the in- vestors has already been rearranged. Finland’s trade with crease in the value of the gold reserve, among others. Greece is slim, and the private sector's receivables are in- This increase in value has not been recognised as revenue significant. The public sector’s claims from Greece and therefore not as capital, either. These value changes amount to approximately EUR 6 billion (Table 1). could be used to cover the losses, so instead of the nar- row capital alone, it makes more sense to also examine The effects of the Greek exit will be higher in the rest of the revaluation accounts when evaluating the balance Europe than in Finland due to the closer trade relation- sheet of the central bank system. In addition to utilisation ships and higher level of direct exposure. A Greek euro of the revaluation accounts, the euro countries can inject exit would hit France and Portugal the hardest, as these capital into the central bank system. countries have the highest claims from Greece compared to the size of the economy. European banks will suffer In addition to trade relationships and direct claims, losses due to approximately EUR 60 billion of Greek ex- Greece leaving the euro would increase the general un- posure. However, in practice, most of the Greek govern- certainty, which will impair economic activity through- ment bonds are most likely already recognized at market out Europe. Also, the development of the euro following value. Furthermore, several banks have been reducing Greece’s exit will have an essential impact on exports. In their Greece exposure in recent months, so the direct practice, reassuring the market after one country leaves losses will remain considerably lower than the nominal that Greece will remain an isolated case will be crucial value presented herein. and difficult, and it will require significant support measures by the stability mechanisms and the ECB. The Table 1. Claims from Greece, EUR billion, 03/2012 first reaction will be the weakening of the euro compared Spain Ireland Italy Greece Cyprus Portugal Total to other main currencies due to the uncertainty. The de- Finland 1 0.4 0.4 0.0 0.0 0.2 2 Germany 110 74 105 5 6 21 322 valuation will support Finland’s and other euro countries’ Belgium 10 17 9 0.2 0.2 1 38 exports to outside the eurozone, but increasing uncertain- France 91 19 263 31 2 16 423 Netherlands 53 11 28 2 1 4 100 ty will impair exports more than this as a whole. After a Austria 3 1 14 1 2 1 22 weak country has left, the euro will become stronger in Sweden 2 1 1 0.2 1 0.2 5 Switzerland 15 10 17 2 1 2 46 the longer term, which will make adjustments in the UK 67 108 45 7 1 15 243 weakest countries remaining in the eurozone increasingly Total 353 243 482 48 15 60 1202 difficult, with exports suffering from the strong currency. Source: CEPS 4 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012 NORDEA MARKETS
  • 6. ■ Several problem countries leaving the euro Several problem countries leaving the euro • Greece leaving may trigger a domino effect countries. Not all aid and claims will be lost; repayment depends on the severity of the economic problems and • Significant losses to the private and public sectors debt negotiations. The public support paid by the EU and IMF in summer 2012 to problem countries amounted to Greek exit may result in problem countries leaving approximately EUR 400 billion (Figure 4). Of this, Fin- A Greek euro exit will increase uncertainty in the other land accounted for some EUR 7.6 billion. problem countries in the eurozone (such as Portugal, Ita- ly, Ireland, Spain, Cyprus and Slovenia). It may exacer- Finland also has liabilities via the ECB. In practice, the bate the distress of the financial systems of the problem ECB's claims have emerged since 2007, when interbank countries and accelerate deposit flight from problem lending dried up. Investors have withdrawn from funding banks. The problem countries’ need for support will in- the banks of the problem countries and transferred their crease, and if there is no readiness to give support, the assets to safer countries. The banks of the problem coun- countries would leave the eurozone. The course of events tries have been forced to resort to the ECB via their own would be similar to that in Greece, although the conse- central banks in order to be able to repay depositors and quences of several countries leaving would be signifi- investors who are repatriating their assets. Correspond- cantly higher due to the financial interconnectedness both ingly, banks in countries deemed safer have made depos- in the countries leaving and those remaining in the euro- its in the ECB via their respective central banks. This zone. way, the central banks of the problem countries have ac- cumulated imputed debt in the payment system and safe In the resulting smaller eurozone, investments and con- countries’ central banks imputed receivables that roughly sumption will crash after the collapse of general confi- correspond to the (net) receivables and debts of the coun- dence and the entire euro system having been called into tries’ financial systems to the European central bank sys- question. Devaluation decreases the purchasing power of tem (Figure 5). the countries exiting the euro, which will slow down the exports of countries remaining in the euro. Uncertainty Figure 5. Receivables in the central bank system will paralyse the economy of the eurozone, but the weak- 800 Germany ening of the euro compared to main currencies will help EUR billion 600 Netherlands the export sectors. Tension in the international financial Finland market is increasing. Enormous credit losses will destabi- 400 Slovenia lize in particular the weakest financial institutions in the 200 France eurozone, and even the ECB will be technically bankrupt. Belgium The ECB will support banks by offering them an unlim- 0 Austria ited amount of liquidity. The bank system is kept run- -200 Portugal ning, but credit losses will consume the banks' capital Greece -400 and credit taps will remain dry. Ireland -600 Italy Figure 4. Claims from problem countries 99 01 03 05 07 09 11 Spain IMF Source: Ifo, central banks 1400 EUR billion EFSF 1200 The entire euro system shoulders the credit risk related to EFSM bank financing and is liable for the repayment of deposits 1000 ESM in the ECB. The national central banks act as the media- 800 tors. If banks want to withdraw their deposits, the assets Portugal 600 will be raised from the public funds of the euro system. Ireland If, say, a loan granted to a Spanish bank results in credit 400 Greece IMF losses, the central banks of the system will carry the loss 200 in line with their ownership. Any credit losses to the Greece EU ECB will probably be divided among the remaining 0 ECB purchases shareholders in accordance with their ownership. Fin- Subsidies Subsidies ECB (GIIPS paid promised and CYP)* Central bank land’s liabilities currently correspond to its holding of receivables slightly under 2% in the ECB. The more countries exit Source: Ifo *) GIIPS=Greece, Ireland, Italy, Portugal, Spain, CYP=Cyprus the euro, the higher Finland’s ownership and liabilities Fate of public claims uncertain will increase. It is probable that the debts of all countries leaving the eurozone will have to be rearranged, which will result in The claims of the euro system from the problem coun- losses to the public and private sectors of the eurozone tries are over EUR 950 billion, of which Finland’s share is approximately EUR 20 billion. These figures reflect 5 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012 NORDEA MARKETS
  • 7. ■ Several problem countries leaving the euro the current situation. If the crisis comes to a head, claims Losses of the private sector from the problem countries' financial systems will multi- The private sector will also suffer credit losses from its ply before the credit taps are turned off. In addition to the exposure. Finnish banks had slightly under EUR 2 billion problem countries, the European Central Bank has claims of claims from the problem countries in March 2012. The from other countries' financial institutions whose solven- highest exposure is to Spanish banks. cy would falter should the problem countries exit the eu- ro. Should the problem countries leave, their debt will be re- arranged and their bank systems will suffer. Companies’ How the ECB’s credit losses are managed? opportunities for servicing euro-denominated loans are The ECB’s credit losses can be managed in two ways. poor, and the number of bankruptcies will surge. The re- The first alternative is that the countries remaining in the maining eurozone will carry considerable losses from eurozone will inject more capital into the ECB in order to these claims. However, the exposure is not only unidirec- strengthen its balance sheet. Obtaining capital from the tional. The problem countries’ companies and citizens market in one go is not sensible, and the ECB would have deposits in the banks of the remaining eurozone, probably accept government bonds as a payment. and these deposits and cash moved to safe havens will begin to be repatriated after the adoption of their own Alternatively, the ECB could be allowed to continue to currency. operate with negative capital or keep the capital positive through bookkeeping means. The central bank can well This may result in a situation in which the indebted sec- operate even if the liabilities recognised on the balance tors of the problem countries firstly fail to service their sheet exceed the assets, since the liabilities mainly con- debts to the core countries, and surplus companies and sist of euro-denominated paper currency and banks’ de- households subsequently aim to repatriate their assets posits in the central bank. However, keeping inflation at held safe as deposits in the core countries. bay would be challenging for a central bank system oper- ating with negative capital. The central bank is a net Table 2. Bank exposure to the problem countries, debtor to the bank system, so interest payments to banks EUR billion will have to be financed by creating new money. This is Public, Private Total % of GDP no problem with zero interest rates, but the losses of the EFSF/ECB (BIS) France 67 35 101 5.1% central bank system will increase if interest rates are in- Germany 89 11 99 3.9% creased in order to curb inflation. The ECB can change Italy 58 2 60 3.8% the situation by increasing banks' reserve requirements Spain 39 1 40 3.7% considerably and stopping the payment of interest on re- Netherlands 19 3 21 3.6% serves. In this case, the central bank system will be capi- Belgium 11 1 12 3.2% Portugal 5 6 12 6.8% talised by, in practice, taxing banks. Reserves currently Austria 9 2 11 3.6% amount to only EUR 100 billion, so this would require Finland 6 0 6 3.1% multiplying the reserve requirements. Ireland 3 0 4 2.1% Total 306 59 365 Amount of paper currency will be reduced Source: BIS In addition to credit losses, the amount of paper currency will be a problem for the ECB. The amount of issued pa- per currency must be reduced as the eurozone gets small- er to match the needs of a smaller economic area. Infla- tion will accelerate if the cash in circulation in the exit countries enters circulation in the remaining eurozone countries. The Italians alone are estimated to have EUR 150 billion in cash, which accounts for almost one sixth of the amount of cash in the entire eurozone. However, this sum is only three per cent of the total sum of cash and demand deposits. 6 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012 NORDEA MARKETS
  • 8. ■ Finland’s exit of its own accord Finland’s exit of its own accord • Finland can have two currencies in the beginning whole, Finland’s foreign liabilities and receivables are fairly balanced, so the need for exchanging euros to • The development of the markka is not self-evident markkas and vice versa would neutralize each other, and the central bank’s need for action to stabilise the ex- Uncertainty over economic policy and currency change rate of the markka against the euro remains small. A strong country may also leave the eurozone if the lia- bilities related to the support packages need to be in- The development of the markka is not self-evident creased further. Finland’s exit of its own accord would Right after the currency peg ends, the exchange rate of differ from a Greek exit, because a balanced national the markka may fluctuate even to a considerable extent, economy may, theoretically speaking, have two curren- depending on whether Finland is seen as a safe haven in cies even for a long transition period, and peg the new the euro crisis or whether investors will withdraw their markka to the euro at a rate of 1:1 during the transition assets from the small illiquid marginal market. In the period. In the best case scenario, the uncertainty would longer term, the development of the markka will depend be temporary and impacts on Finnish economic devel- in particular on the growth outlook, inflation-related ex- opment remain limited. In practice, however, the impacts pectations and investors’ attitude towards the exchange depend on investors’ moods and the general economic rate risk of a small currency. In any case, the value of the development, so the transition period may be problemat- markka will fluctuate more than that of the euro. ic. A minor strengthening caused by the relatively good bal- Initially, both currencies could be legal tender. Euros are ance of the Finnish economy may lead to a mass move- not automatically converted into markka. Instead, all de- ment of investors, which strengthens the currency strong- posits, debt and other agreements remain in euros until er than warranted by the situation of the real economy. deposits are transferred to markka-denominated accounts Such a positive cycle keeps interest rates low and sup- and parties amend their contracts. During the transition ports indebtedness and domestic demand. The recent period, the Bank of Finland exchanges euros and mark- weakening of the balance of current accounts intensifies, kas at a rate of 1:1 both ways. Eagerness to exchange will making the Finnish national economy increasingly de- depend on people's expectations of the development of pendent on the moods of foreign investors. the value of the markka after the transition period. The financial markets may have doubts as to the consistency Corporate and government funding more expensive? of Finnish economic policy, since Finland was known for On the other hand, the value of the markka may decrease its devaluation cycles prior to joining the EU. Therefore, considerably because a small currency is not needed for an immediate liquidity crisis may emerge as early as in balancing investment portfolios in the same way as the the transition period if eurozone investors withdraw their euro, a major currency. A significant proportion of the assets for fear that euros will not be safe in Finland. money invested in Finland during the euro era columns Risk-averse eurozone investors who currently have in- from investors who have been looking for safe euro- vested in Finland to be safe might not be willing to carry denominated investments and are not willing to carry the the exchange rate risk. In addition, the European Central exchange rate risk associated with a small fringe curren- Bank might not be willing to secure liquidity by lending cy. to a country that is about to leave the eurozone. If foreign investors leave the small Finnish market, the Currency risk related to euro-denominated funding liquidity of Finnish markka-denominated listed equity Following the transition period, the markka will be al- and bond markets decreases, risk premiums increase and lowed to float against the euro and the markka will be high fluctuations in prices become more frequent. made the only legal tender. Existing commitments may Funding of banks, companies and the central government remain euro-denominated, because their unilateral becomes more difficult and expensive. Increasing finan- amendment would collapse Finland’s credit rating, and cial costs decrease consumer spending and willingness to the balance of the Finnish national economy in any case invest. General confidence weakens, and it will be diffi- supports the rate of the markka against the euro remain- cult to restore it. Credit taps are tightened, the economy ing close to 1:1. enters a recession, and the debt servicing capacity of the public sector weakens. The credit rating of Finland will Finnish banks have more loans granted to the public than be placed under credit watch due to the exit-related un- deposits, and some of the loans have been financed by certainty, and the risk of the credit rating being lowered borrowing from the euro market. This results in an ex- will increase. Leaving the euro without exit from the EU change rate risk to the banks. The Bank of Finland may is not simple. carry part of the currency risk by making long-term for- ward contracts with the banks, i.e. committing to ex- change the markka at a fixed rate in the future. On the 7 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012 NORDEA MARKETS
  • 9. ■ Split or breakup of the euro Split or breakup of the euro • Germany’s exit leads to the breakup of the eurozone Domino effect or German exit may collapse the euro A chain reaction starting with the exit of weak countries • An imputed euro and euribor will be created may lead to the entire eurozone breaking up. When ex- pectations of the exit of weak countries increase, capital Northern euro strengthens against the southern one flight to safe countries will accelerate, and the central If the eurozone splits up into northern and southern euro- banks of the weak countries will have to support their fi- zones, the northern euro will retain the current euro and nancial systems by printing more euros. There is the risk institutions because the head office of the ECB is in of a total collapse in the value of the currency with the Germany. The problem countries adopting the southern central banks printing euros without limits. euro will have to be able to establish a central bank sys- tem and paper currency of their own. Splitting the central The eurozone may also break up due to the exit of Ger- bank system of the old eurozone in two and clarifying the many, a large and strong financing country. If Germany claims will be a painstaking process. decides to leave, the other strong countries will follow in its footsteps. The entire eurozone will break up because The northern euro will weaken against the other main the remaining countries in crisis will not have the com- currencies with significant uncertainty shaking all of Eu- mon political will to build the required institutions. rope. However, the northern euro will strengthen against the southern euro as capital flows to a safe haven in the Germany leaving the eurozone will plunge the country’s markets of the relatively stronger countries. Northern eu- own financial system to a chaos, even though the country ro countries seem more stable compared to the southern as a whole is at a surplus. Germany will suffer losses ones, and they will not suffer from the outflow of capital when the private and public problem country exposures to the same extent. have to be rearranged. The German economy will suffer from the tightening credit taps of the banking sector, The northern economies will suffer considerable losses weakening demand in the export demand in the former due to their receivables from the southern eurozone. The eurozone and the strengthening currency. northern financial system will require significant support, which will increase the countries' national debts. Fur- German banks have received safe-haven deposits from thermore, the northern economies’ exports to the south the southern eurozone, which will begin to be repatriated will suffer due to the strengthening currency and fall in when the situation clears up. There will be disputes over demand in the southern eurozone. The economy will en- whether deposits moved from southern Europe to Ger- ter a recession, but it will benefit slightly from low inter- many can be converted to D-Marks. Their conversion to est rates and the weakening of the currency against other the new domestic currency would lead to a decrease in major currencies. the value of the deposits because the new domestic cur- rency will devalue. Germany, on the other hand, wants The euro of the southern eurozone would devalue only domestic deposits to be converted to the new, strong The value of the southern euro made up of the weaker D-Mark. In this case, the amount of money in Germany countries will decrease. Foreign capital will flee the will not increase exponentially, which will restrict the in- southern eurozone, frightened by devaluation pressures, flation pressure. and the bank system will suffer with deposits fleeing to safety, stuffed into mattresses or moved abroad. The Breaking up of the eurozone will be chaotic economy of the southern eurozone will fall all the way If the entire eurozone breaks up, the European Central into a depression, as the debt rearrangements of the cen- Bank will be closed down and its tasks will be trans- tral governments and the increasing number of bankrupt- ferred back to the national central banks. The European cies will consume banks' capital and accelerate the credit financial system will collapse and Europe will end up in depression. Gradually, the weak currency will support a credit depression, from which it will not recover for a the exports of the southern economies. long time. The central banks of all former member states will provide their banks with unlimited liquidity. The If the debt of the southern eurozone countries is convert- banks will need new capital. The complete breakup of the ed into southern euros, their value in northern euros will eurozone will plunge the entire global financial system decrease. This will make it easier to repay the debt of the into full-scale chaos. The entire eurozone will enter a de- southern area, but the devaluation of the currency will re- pression, which will have long-lasting effects in all coun- sult in increasing losses to the north in the southern euro- tries. zone. On the other hand, if the debt remains in northern euros, the debt burden of the southern eurozone will in- crease, which will increase the probability of debt rear- rangements. 8 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012 NORDEA MARKETS
  • 10. ■ Split or breakup of the euro An enormous extent of negotiations on the currency to be Euribor is the most common reference rate in the eur- used in agreements will follow. One option is to adopt an zone, and the quoting of euribor interest rates would end imputed euro exchange rate, determined as the weighted in case of a complete breakup of the eurozone. In this average of the new currencies of the euro countries. Such case, a substitute should be found for the euribor rates. In a currency already existed before the euro in the form of practice, the substitute could be formed out of the new the ”ECU basket currency,” which was exchanged into national interbank interest rates as an imputed interest euros at a rate of 1:1. The exchange rates of the strong rate. surplus countries will strengthen in proportion to the oth- er former eurozone countries. If the debt is in imputed euros, the strengthening of the new currency would de- crease the euro-denominated debt. The debt of weak def- icit countries would have the same fate as Greece’s debt in case of a Greek exit. 9 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012 NORDEA MARKETS
  • 11. ■ Effects of the scenarios on the Finnish economy and market Effects of the scenarios on the Finnish economy and markets Table 3. Impacts on the Finnish economy Nordea’s base line Greece leaves Problem countries Only Finland leaves The entire eurozone leave breaks up Economic growth Effects on Finland The direct effects on Effects on the Direct effects on will accelerate are minor, because Finland are higher development of the Finland are gradually from this direct Finnish trade than in the previous Finnish economy are extremely high year’s below 1% to with and Greek scenario, because the minor in the best almost 3% in 2014 exposure are small problem countries case scenario The European account for a large financial system will Unemployment will The indirect effects proportion of the Finland’s exit will collapse remain at will also be minor to eurozone and 30% of escalate the crisis of approximately 8% Finland because Finland’s exports are the eurozone and the Credit depression until 2014 Greece is a small to the eurozone outlook for country and many economic growth After a very deep Inflation will remain preparations have Eurozone will enter will become plunge, the economy at slightly over 2%, already been made a financial crisis and gloomier will begin to recover but will not exceed for a potential Greek depression that will around the third year 3% even in 2014 exit be more severe and The currency may following the longer than the 2009 fluctuate greatly breakup Current account Finland's export crisis after the transition deficit will remain demand will begin to period Risk of increasing moderate recover from the Finland’s losses inflation slump caused by the from the Once the temporary exit within as little as rearrangement of uncertainty clears a year bailout packages, up, Finland begins to euro system and recover from the private sector claims euro exit within a will be significant year The remaining eurozone and Finland will begin to recover from the breakup of the euro around the third year after the exit 10 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012 NORDEA MARKETS
  • 12. ■ Effects of the scenarios on the Finnish economy and market Table 4. Effects of the breakup of the eurozone on the interest rates and interest rate derivatives Greek exit Problem countries Only Finland leaves The entire eurozone leave breaks up If the Greek exit is The capitalisation need If Finland’s euro- The euro will be replaced controlled and based on a of banks is considerably denominated bonds are with an accounting mutual decision in the higher than in the converted into markka- currency similar to its eurozone, it is likely that preceding scenario. The denominated bonds, predecessor, the ECU, the capitalisation of the problem countries will being marginal which is calculated by banks of each eurozone adopt their own investment, they will be weighing the national country will be secured if currencies, and with the subject to selling currencies. capitalisation is devaluation, covering the pressures, and Finland’s The ECU interest rate perceived necessary. In existing euro- interest rates will calculated on the basis of this scenario of a denominated debt will increase. the national currencies controlled Greek exit, the become impossible. If will be higher than the economic outlook will the debts of the problem The same phenomenon Euribor rate. This will improve. The interest countries are converted will apply to the issuance result in upside pressure rates will normalise and into their own currencies, of new markka- to fixed interest rates. long-term interest rates this will result in losses denominated bonds, even will increase more than to the bearers of the if the old debt remains The consequences of the short-term rates. bonds due to the euro-denominated. entire eurozone breaking weakening of the up will be of such a scale If Greece exits in an currency. The risk of devaluation that the market reactions uncontrolled way, the of the markka and will be considerable and market will begin to Increasing risks for the accelerating inflation. significant uncertainty is price the possible exit of banking sector will Receive Finnish associated with other problem countries. create upside pressure on inflation. predicting them. Interest rates will remain Euribor interest rates, low, and the European increasing the difference Pay long-term fixed stability mechanisms and with the overnight Eonia interest. Receive Finnish the ECB will secure the interest rates. inflation. financing needs of the problem countries. This Receive expanding will subsequently Euribor-Eonia interest increase the inflation rate differential. Receive pressure. inflation (eurozone or Finland). Pay long-term fixed interest. Receive inflation (eurozone or Finland). 11 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012 NORDEA MARKETS
  • 13. ■ Effects of the scenarios on the Finnish economy and market Table 5a. Effects on a Finnish company’s foreign exchange hedging: company exports Greek exit Problem countries Only Finland leaves The entire eurozone leave breaks up There is the risk of euro- If all of the problem The markka will be The markka will be denominated receivables countries exit, the adopted as the expense adopted as the expense from Greece being situation has a rather currency, and the currency, and the converted to the new similar logic to that of a strengthening of the strengthening of the Greek currency, which Greek exit. The new markka is a risk. It is not markka is a risk. It is not will devalue currencies of these currently possible to currently possible to considerably against the countries would probably hedge against hedge against the new euro. devalue against the euro fluctuations in the value currencies. Hedging (of the remaining strong of the markka. using derivatives Demand will fall countries). correlating with credit considerably due to both Hedging exports to risk could be considered. the economic situation Direct hedging against, outside the eurozone and the weakening of the for example, the (e.g. USD) carries the Hedging exports to drachma. weakening of the Italian risk of the hedging being outside the eurozone lira is impossible. for changes in the (e.g. USD) carries the With regard to foreign Utilising the country’s exchange rate of the euro risk of the hedging being exchange risks, one bankruptcy probability but not of the markka. for changes in the should consider, for could be considered as a exchange rate of the new example, if it could be hedging option. The The most problematic basket currency ECU but possible to ensure the probability of Italy’s scenario is that the euro not of the markka. payment of the least euro exit is likely to will weaken significantly open deals in euros correlate with the and hedging with a The most problematic through contractual country’s bankruptcy forward contract results scenario is that the new arrangements. Risk of probability, in which in costs while the markka ECU basket currency the customer’s case credit risk strengthens. will weaken significantly insolvency. derivatives could be used Options are useful for and hedging with a for hedging against the this problem instead of a forward contract results exit. binding (forward, etc.) in costs while the markka hedge. strengthens. An option would hedge against the weakening of Options are useful for USD, for example, but this problem instead of a would not be binding in binding (forward, etc.) the event of a Finnish hedge. exit. 12 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012 NORDEA MARKETS
  • 14. ■ Effects of the scenarios on the Finnish economy and market Table 5b. Effects on a Finnish company’s foreign exchange hedging: company imports Greek exit Problem countries Only Finland leaves The entire eurozone leave breaks up The drachma weakens The situation has a The markka will be the The markka will be the and provides an similar logic to a Greek income currency, and income currency, and opportunity for exit. there is a risk of the there is a risk of the decreasing import prices. markka weakening markka weakening Specific hedging against The supplier’s expense against the purchase against the purchase this currency scenario is currency weakens and currencies. currencies. probably not as provides an opportunity necessary as for, e.g., an for decreasing import Forward contract involve Forward contracts export company. prices. the risk of the euro and involve the risk of the the markka developing in new ECU and the One could, for example, different directions. markka developing in as a contractual way Options, for example, different directions. consider how to reserve could be considered as Options, for example, an opportunity for the solution. could be considered as quickly renegotiating the the solution. purchase prices. Hedging purchases from the current eurozone Hedging purchases from countries is not directly the current eurozone possible. countries is not directly possible. Table 5c. Effects on a Finnish company’s foreign exchange hedging: foreign subsidiary Greek exit Problem countries Only Finland leaves The entire eurozone leave breaks up Local demand will Similar risks to a Greek The group’s home The group’s home decrease. In addition, exit. The risk of the currency will be the currency will be the there is a risk of the currency weakening markka, and there is a markka, and there is a drachma weakening and decreasing the value of risk of the markka risk of the markka decreasing the value of the holding. If the strengthening against the strengthening against the assets. One should national currency currency of the holdings. currency of the assets. In prepare for strong overshoots, the impact the event of a complete fluctuation, which has a could quickly affect the The impact in the event breakup of the euro, the considerable effect on group’s equity and of a Finnish exit will effect could be rapid and the group’s equity and balance sheet covenants. probably be not as great preparations for the balance sheet covenants, as, for example, in the weakening of, e.g., for instance. Local lending can be breakup of the entire equity and balance sheet considered as a potential eurozone, but there is a covenants would be As a sort of option, one natural hedge. risk of major changes on useful. Changes in the might think about the balance sheet. value of assets in whether a euro- Germany and other denominated loan taken To the extent that the strong countries might by the subsidiary locally Finnish parent’s external partly offset this. could function as a euro-denominated loans natural hedge: would the finance subsidiaries in Local funding could be a euro-denominated loan other Eurozone natural hedge. taken in Greece be countries, it is essential converted into drachmas, that the loans remain which would compensate euro-denominated. for the decrease in the euro-denominated value of the drachma assets? 13 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012 NORDEA MARKETS
  • 15. ■ Effects of the scenarios on the Finnish economy and market Table 6. Effects on corporate bonds Greek exit Problem countries Only Finland leaves The entire eurozone leave breaks up A majority of Greek The European corporate If Finland exits of its The number of companies will find bond market is already own accord, increasing bankruptcies and credit themselves in financial considerably mixed up, uncertainty and possible events will be extremely difficulties and a credit and the number of credit speculation concerning high – applies to all euro- event. events is significant also the next exit decisions denominated bonds. outside the problem are the most significant Because refinancing is For credit rating agencies, countries. indirect effect on the practically impossible, the conversion of the corporate bond market. there will also be currency of the bond The same principles as in defaults in bonds in other alone gives rise to a credit the case of Greece: Finnish export-driven currencies than euro. event. companies whose companies would suffer operations take place from continuous In contrast with the In the slightly longer outside the eurozone and uncertainty in Finland previous scenarios, the term, export companies Europe to a significant and the rest of Europe consequences to and subsidiaries of large extent are in the best alike. corporate bond markets international corporations position. are enormous also would be in the best In contrast with, for outside the eurozone and position. Sufficient Because the European example, the Greek exit Europe. liquidity plays a key role. financial market is mixed scenario, the transition up, an extensive funding period from the euro to In the longer run, the The effects on most base plays a key role, the markka could be normal regularities will Nordic companies would which includes a good long, and existing loans apply: extensive funding probably remain more relationship with major could possibly remain base, geographic limited than on French banks and access to euro-denominated. distribution, cyclicality companies, for example, financial markets outside and competitive due to the lower volume the eurozone The risks of Finnish situation. of exports and banks’ companies will increase risks. Non-cyclical companies in the form of currency Companies that are will fare better risks. critical for public activity operationally, but and safety and have taxation pressure on operations across borders these companies will are in the best position. increase hand in hand with the governments’ difficulties. Furthermore, the creditworthiness of state-linked companies will, relatively speaking, weaken the most due to no longer being supported by the government ownership. 14 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012 NORDEA MARKETS
  • 16. ■ Effects of the scenarios on the Finnish economy and market Table 7. Effects on the equity market Greek exit Problem countries Only Finland leaves The entire eurozone leave breaks up The market is turbulent The markets will price in The short-term reactions Risk premiums will until the Greece-related a considerably higher are remarkable increase considerably, liabilities of companies risk than in the exit of turbulence, high risk and the pressures are and financial institutions Greece alone. premium and flight of comparable to the are fully known. foreign capital. development in 2008– Risk premiums will 2009. For Finnish companies, increase significantly, The longer-term the direct Greek and with particular consequences depend on Finland will remain exposure is small, and regard to cyclical and the value (and stability) underweighted in the pressure on valuation is indebted companies, the of the currency. The risk allocation of mainly caused by the pressures are comparable premium, however, will international investments general uncertainty. with the development in remain higher. (foreign ownership 2008-09. decreased following the Since the possibility of Lehman crisis and has an exit has already been The competition field not increased to a assessed and it has been will transform in sectors significant extent). possible to prepare for it, with competing capacity the market turbulence in southern Europe (e.g., Consumption and may remain short-lived. paper, steel). The strong investment demand will euro of the strong weaken significantly. countries will burden the competitiveness of The risk premium of exports. shares listed in Finland will increase at a steeper rate than the risk premiums of companies listed in capital markets perceived safer. 15 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012 NORDEA MARKETS
  • 17. For further information: Aki Kangasharju, Director, Head of Research aki.kangasharju@nordea.com +358 9 165 59952 Suvi Kosonen, Analyst suvi.kosonen@nordea.com +358 9 165 59002 Nordea Markets Research Finland Aleksis Kiven katu 9, 00020 NORDEA nordeamarkets.com Tel (09) 1651 Nordea Markets is the name of the Markets departments of Nordea Bank Norge ASA, Nordea Bank AB (publ), Nordea Bank Finland Plc and Nordea Bank Danmark A/S. The information provided herein is intended for the sole use of the intended recipient. The views and other information provided herein are the current views of Nordea Markets as of the date of this document and are subject to change without notice. The views have been provided solely based on the information made available to Nordea Markets and for the purposes of presenting the services made available by Nordea Markets. This notice does not substitute the judgement of the recipient. Nordea Markets is not and does not purport to be an adviser as to legal, taxation, accounting or regulatory matters in any jurisdiction. Relevant professional advice should always be obtained before making any investment or credit decision. This document may not be reproduced, distributed or published for any purpose without the prior written consent from Nordea Markets.