what if-the-eurozone-breaks-up ? finland’s exit of its own accord

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

O C T O B E R 2 0 1 2

What if the eurozone breaks up?

jos euroalue hajoaa?

■ Introduction

1 WHAT IF THE EUROZONE BREAKS UP? │ OCTOBER 2012 NORDEA MARKETS

Introduction Alternative euro break-up scenarios The analysis explores four eurozone break-up scenarios: i) Greece leaves the euro, ii) several countries in difficul-ties leave, iii) Finland exits on its own accord, and lastly iv) the entire eurozone splits up into two or breaks up al-together. The considerations take into account the effects on both, the exiting country and the rest of the eurozone. The analysis concludes with summarizing the effects of the different scenarios on Finland's economic develop-ment, Finnish companies’ alternatives for interest rate and currency hedging, corporate loan markets, and the equity market. We take no stand on whether the eurozone will remain as it is, or will it change or break up totally. The following only describes what we think is likely to happen should changes take place in the eurozone. There is naturally a considerable degree of uncertainty associated with the scenarios. Not all alternatives are reviewed; instead, the analysis focuses on the most interesting ones. The future of the eurozone depends on politicians The eurozone remaining in its current form is not up to money, but rather politicians. So far, politicians in Eu-rope’s creditor countries have trusted that aid packages for weak partners will not hamper their success in future elections. From the point of view of debtor countries, at least for the time being, making the required economic reforms has been more pleasant than diving into a new unknown with their own currency. However, the situation may change. If the composition of the eurozone changes, it will begin with the break-up of Greece, because the country has clearly fallen short of the agreed economic reforms, the depression has turned out to be worse than initially estimated and the need for a third aid package is increasingly apparent. At the same time, the debate on the reasonability of the aid measures has intensified in the strong countries. The direct effects of Greece leaving the euro can be controlled, as many kinds of preparations have already been made for it, such as the private sector cutting down its operations in Greece. What has a bigger effect than the direct effects are growing market expectations of whether the remain-ing eurozone is sustainable and which countries would be the next to leave. Greece leaving the euro consumes Greek deposits The process of Greece leaving may lead to a series of events, the motion of which are difficult to influence once it has begun. Expectations of breakup will lead to even the last foreign investors leaving the country, while the Greek will increasingly transfer their deposits to for-eign banks. Greece will not be able to handle its debt if the flow of aid money stops, which will lead to signifi-cant losses in Greek banks. The losses will consume

Greek banks’ capital, further decrease their access to fi-nancial markets and lead to a full-scale deposit flight from Greek banks. It will not be possible to pay all of the deposits in Greek banks back. Furthermore, the purchas-ing power of Greek deposits will weaken considerably because the value of the new currency adopted by Greece will devalue. Exit of Greece may lead to a domino effect Problems in the Greek banking sector may also be re-flected in the banks of the other weak eurozone countries. Greece leaving the euro will stun the financial system, which leads to a total halt in banks’ access to financial markets in the weak countries. The banks, which are al-ready dependent on the central bank, will have to in-crease their use of central bank financing further, and banks in the problem countries will suffer from a deposit flight as speculations over their condition intensify. Credible firewalls are vital Getting the problems of the banking sectors of poor countries under control requires the capital situation of their banks to be improved. In practice, governments will have to support the banks. As financing needs in the problem countries increase while market access weakens, the role of crisis management framework will increase further. The firewall created by the European temporary and permanent stability mechanisms, the International Monetary Fund (IMF) and the European Central Bank (ECB) plays a significant role in managing the crisis. In particular, disconnecting the link between the teetering banking sector and the government is essential to calm the situation down. The need for new aid packages will increase, but the spreading crisis will decrease the num-ber of countries providing support. If the course of events cannot be stopped, or actually there is no will to stop it, the European financial system will come to a complete standstill no later than when the crisis spreads to the EU founder states Italy and France. The problem banks will not be able to pay back their debts to the central bank. The problem banks’ increasing losses due to market value changes as well as the depres-sion in the real economy will consume their capital. The problem banks will not be able to grant loans, and a cred-it crunch follows. The value of the euro will collapse. This may result in the euro being abolished similarly to the Soviet ruble or Yugoslavian Dinar, the collapse of the financial system and hyperinflation. Germany’s exit destroys the euro system In principle, the eurozone may also be changed by a creditor country leaving the system. The exit of a small country, such as Finland, might remain an individual case, but a major country like Germany leaving would collapse the entire euro area.

L O K A K U U 2 0 1 2

■ Greece leaving the euro


Greece leaving the euro

• The new Greek currency will devalue considerably

• Direct effects on euro countries manageable

Recent development in Greece Capital has been flowing out of the Greek financial sys-tem for a long time. Foreign parties have repatriated their investments and domestic parties have withdrawn their deposits and transferred their investments abroad. The outbound flow of currency has been substituted by loans from the European Central Bank to Greek banks and the international support packages granted to Greece. Greek banks have been shut almost completely out of the pri-vate funding market, so they have resorted to central bank funding. Since the collateral required for central bank funding has become scarce, banks are increasingly 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 against central government guarantees. Anatomy of the exit If the emergency funding to Greek banks is stopped, the banks’ liquidity will dry up and they will be forced to re-strict cash withdrawals by depositors. The public will in-creasingly store cash under their mattresses. Greek banks’ assets in other countries will be frozen, and inter-national transactions can no longer be made through them. Greece will have to exit the euro system in nego-tiations with the euro countries, because funding will end. Greek banks’ debts to the European Central Bank will be completely rearranged or their repayment period will be extended. Theoretically speaking, the Greek central gov-ernment is liable for any losses resulting from the emer-gency funding operations. A country’s exit of the euro and/or insolvency is likely to result in losses to the cen-tral banks of the other euro countries via the European central bank system. Greek currency will devalue significantly Greece will finally make the political decision on adopt-ing its own currency, the drachma. At first, various types of tender will be used before the new paper currency is printed. Deposits will be converted into drachmas. The easiest way to implement the transition is to convert eu-ro-denominated deposits into drachmas at the rate of 1:1. The market value of the drachmas would naturally de-crease. In the initial phase, drachma-denominated bank cheques and bearer bonds might work as the paper cur-rency. Drachma will initially experience clear overshoots. The Finnish markka, for example, devalued by over 30% in the 1990s after the currency was floated, until it stabi-lised at approximately 20% below the pre-crisis level

within a few years (Figure 1). If one compares the stabil-ity of the Greek economy to Finland at the time and takes the considerable market mistrust in Greek political deci-sion-making into account, devaluation clearly exceeding the devaluation of the Finnish markka would be proba-ble. Market mistrust is evident in, for example, the mar-ket values of the new government bonds issued after the rearrangement of Greek government bonds, which have decreased to below 40% of their face values. Figure 1. Devaluations in previous economic crises

10

30

50

70

90

110

91 92 92 93 94 95 96 97 98 99 00 01 02 03

Argentina

Finland

Russia

Thailand

Pre-crisis exchange rate = 100

Source: Reuters Ecowin Over the longer term, the exchange rate is determined on the basis of the balance of the country’s economy. The higher the current account deficit and unemployment rate, the higher the devaluation pressure. The current ac-count deficit of Greece has improved in 2007–2011 be-cause the austerity measures have decreased imports while exports have increased slightly (Figure 2). At the same time, however, the unemployment rate has in-creased to approximately 20%. In recent months, the un-employment rate in Greece has already gone up to some 25%. The unemployment rate could be reduced through stimulus measures, but funding the stimulus for an al-ready heavily indebted country is difficult. Figure 2. Current account and unemployment rate, 2007–2011

-15

-10

-5

0

5

10

0 10 20 30

Current account, % of GDP

Unemployment rate, %

Germany

Finland

Ireland

Italy

Spain

Portugal

Greece

Source: OECD



Determining the currency is not straightforward The effects of the devaluation of the currency depend significantly on whether existing contracts remain euro-denominated or are converted into drachmas. For exam-ple, would a Finnish travel agency have the right to pay the agreed hotel rent in drachmas? There will be negotia-tions, demonstrations and court rulings, also between domestic parties. The employees of export companies and the tourism industry have better chances of receiving at least part of their income in euros than the employees of home market companies. Lessors and creditors will try to charge the agreed euro-denominated amount in euros while the tenants and debtors offer the corresponding amount in drachmas. Banks are required to pay small-scale depositors a minimum amount in euros. Vehement decisions will be made in the parliament. It is likely that agreements under Greek law will be converted to drach-mas, while foreign ones will remain in the euro/foreign currency. Devaluation will benefit export companies At first, disturbances in international payments and the significant uncertainty over Greece’s future will hinder exports. Who will want to travel to a chaotic Greece where ATMs do not work and credit cards are not ac-cepted? However, over time the functioning of the socie-ty will begin to recover, and the weakening of the cur-rency will benefit the export sector and tourism industry. Companies can transfer the devaluation benefit fully or partially to prices, which will decrease the euro-denominated prices, which, in turn, will support the ex-port demand for the products. Improving demand will lead to the need for hiring new employees. In addition, the improving performance will provide opportunities for new investments. From the point of view of the national economy, devaluation is more beneficial the more its ef-fects are channelled into higher employment rates and investments. The benefits of devaluation, on the other hand, decrease the more wages and other production costs increase. If the liabilities of an export company are converted into drachmas, devaluation will decrease the liabilities in eu-ros, making it easier to cover them. The repayment of li-abilities that remain euro-denominated will only be made easier through the higher profitability resulting from the devaluation. Unfortunately for Greece, the country’s ex-port sector is small. Home market parties suffer from devaluation Devaluation would initially be harmful to Greek home market companies and consumers. Wages, pensions and other types of income will decrease in real terms once converted into drachmas. Certainly, prices of domestic products and services will decrease equally, but imported goods will still carry the same euro-denominated prices. Euro-denominated prices of imported goods may even increase, with the uncertainty and disorders in payment traffic making imports more difficult. One concrete ex-ample is the price of fuel, which is likely to go up, in-

creasing the costs of companies and households. Inflation will accelerate and the unemployment rate increase, caus-ing social problems. The revenues of home-market companies will be drach-ma-denominated. Yet the companies will still have euro-denominated expenses, for example, for raw materials. Costs will increase as the result of devaluation and com-panies’ profitability will decrease. To the extent that loans are converted into drachmas, the direct effect on debt servicing ability will remain minor. On the other hand, loans that remain euro-denominated would be in-creasingly difficult to repay. The domestic market will not benefit from the devaluation until export companies increase their personnel and investments. Greek government debt will be rearranged The public sector has both domestic and foreign debt. In Greece, government bonds are mainly held by domestic banks that have purchased them with ECB funding. For-eign debt is mainly to the other euro countries via two aid packages, the IMF and ECB. The devaluation of the new currency will increase the debt burden of the Greek pub-lic sector should the debt remain in euros and public rev-enues mainly be in drachmas. Prior to the rearrangement of the loans of the Greek private sector in spring 2012, government debt was primarily in compliance with Greek law, but the new bonds issued in the arrangement follow UK legislation, making it more difficult to convert the loans to drachmas. Figure 3. Consequences of Greek exit

Disorder, strikes

Uncertainty over the

future increases

Difficulties in

international

payments

Prices of imported

goods higher in the

new currency

Unwilligness to

accept the new

currency 1:1

Accelerating inflationForeign trade comes

to a standstill

Decreasing real

income (wages,

pensions) Domestic demand

collapses

The economy

collapses

Inability to service

euro-denominated

debt

Source: Nordea Markets Greece will announce that it cannot service its debts be-cause Greece will no longer receive the current support packages after the euro exit. However, attempts will be made to negotiate on the timetables of debt servicing or at least partial repayment, because exports picked up as the result of the devaluation increase tax revenues. Debt-ors will demand their claims in courts. It is in Greece’s interest to pay the debt partially back in order to retain its EU membership. Partial repayment also contributes to the return to the international financial markets. The tax revenues of the Greek public economy have not been sufficient to cover expenses, let alone debt interest, for a long time. Devaluation will help over time, with



exports picking up, increasing the tax revenues. If ex-penses can also be kept under control, the public econo-my will begin to show a surplus. There will then be mon-ey also for the expenses of servicing the rearranged loans. A summary of the consequences of Greek exit is shown in Figure 3. Direct losses from Greek exit are minor The direct effects of Greece leaving the euro are limited for Finland and also for the rest of the eurozone. Greece is a small country, others have already prepared for its exit, and most of the government debt held by private in-vestors has already been rearranged. Finland’s trade with Greece is slim, and the private sector's receivables are in-significant. The public sector’s claims from Greece amount to approximately EUR 6 billion (Table 1). The effects of the Greek exit will be higher in the rest of Europe than in Finland due to the closer trade relation-ships and higher level of direct exposure. A Greek euro exit would hit France and Portugal the hardest, as these countries have the highest claims from Greece compared to the size of the economy. European banks will suffer losses due to approximately EUR 60 billion of Greek ex-posure. However, in practice, most of the Greek govern-ment bonds are most likely already recognized at market value. Furthermore, several banks have been reducing their Greece exposure in recent months, so the direct losses will remain considerably lower than the nominal value presented herein. Table 1. Claims from Greece, EUR billion, 03/2012

Spain Ireland Italy Greece Cyprus Portugal Total

Finland 1 0.4 0.4 0.0 0.0 0.2 2

Germany 110 74 105 5 6 21 322

Belgium 10 17 9 0.2 0.2 1 38

France 91 19 263 31 2 16 423

Netherlands 53 11 28 2 1 4 100

Austria 3 1 14 1 2 1 22

Sweden 2 1 1 0.2 1 0.2 5

Switzerland 15 10 17 2 1 2 46

UK 67 108 45 7 1 15 243

Total 353 243 482 48 15 60 1202 Source: CEPS

The European central bank system has claims of slightly under EUR 150 billion from Greece. Slightly over two thirds are from banks, the rest from the central govern-ment. If Greece was to leave the eurozone, the extent to which the country would be able and willing to repay its debts to the euro system would be unclear. According to the narrow definition, the capital of the European central bank system is only EUR 86 billion, so theoretically speaking, the losses caused by a Greek euro exit might consume the capital in full. However, the balance sheet of the central banking system includes approximately EUR 450 billion in revaluation accounts due to the in-crease in the value of the gold reserve, among others. This increase in value has not been recognised as revenue and therefore not as capital, either. These value changes could be used to cover the losses, so instead of the nar-row capital alone, it makes more sense to also examine the revaluation accounts when evaluating the balance sheet of the central bank system. In addition to utilisation of the revaluation accounts, the euro countries can inject capital into the central bank system. In addition to trade relationships and direct claims, Greece leaving the euro would increase the general un-certainty, which will impair economic activity through-out Europe. Also, the development of the euro following Greece’s exit will have an essential impact on exports. In practice, reassuring the market after one country leaves that Greece will remain an isolated case will be crucial and difficult, and it will require significant support measures by the stability mechanisms and the ECB. The first reaction will be the weakening of the euro compared to other main currencies due to the uncertainty. The de-valuation will support Finland’s and other euro countries’ exports to outside the eurozone, but increasing uncertain-ty will impair exports more than this as a whole. After a weak country has left, the euro will become stronger in the longer term, which will make adjustments in the weakest countries remaining in the eurozone increasingly difficult, with exports suffering from the strong currency.

■ Several problem countries leaving the euro


Several problem countries leaving the euro

• Greece leaving may trigger a domino effect

• Significant losses to the private and public sectors

Greek exit may result in problem countries leaving A Greek euro exit will increase uncertainty in the other problem countries in the eurozone (such as Portugal, Ita-ly, Ireland, Spain, Cyprus and Slovenia). It may exacer-bate the distress of the financial systems of the problem countries and accelerate deposit flight from problem banks. The problem countries’ need for support will in-crease, and if there is no readiness to give support, the countries would leave the eurozone. The course of events would be similar to that in Greece, although the conse-quences of several countries leaving would be signifi-cantly higher due to the financial interconnectedness both in the countries leaving and those remaining in the euro-zone. In the resulting smaller eurozone, investments and con-sumption will crash after the collapse of general confi-dence and the entire euro system having been called into question. Devaluation decreases the purchasing power of the countries exiting the euro, which will slow down the exports of countries remaining in the euro. Uncertainty will paralyse the economy of the eurozone, but the weak-ening of the euro compared to main currencies will help the export sectors. Tension in the international financial market is increasing. Enormous credit losses will destabi-lize in particular the weakest financial institutions in the eurozone, and even the ECB will be technically bankrupt. The ECB will support banks by offering them an unlim-ited amount of liquidity. The bank system is kept run-ning, but credit losses will consume the banks' capital and credit taps will remain dry. Figure 4. Claims from problem countries

0

200

400

600

800

1000

1200

1400

Subsidiespaid

Subsidiespromised

ECB (GIIPSand CYP)*

IMF

EFSF

EFSM

ESM

Portugal

Ireland

Greece IMF

Greece EU

ECB purchases

Central bankreceivables

EUR billion

Source: Ifo *) GIIPS=Greece, Ireland, Italy, Portugal, Spain, CYP=Cyprus Fate of public claims uncertain It is probable that the debts of all countries leaving the eurozone will have to be rearranged, which will result in losses to the public and private sectors of the eurozone

countries. Not all aid and claims will be lost; repayment depends on the severity of the economic problems and debt negotiations. The public support paid by the EU and IMF in summer 2012 to problem countries amounted to approximately EUR 400 billion (Figure 4). Of this, Fin-land accounted for some EUR 7.6 billion. Finland also has liabilities via the ECB. In practice, the ECB's claims have emerged since 2007, when interbank lending dried up. Investors have withdrawn from funding the banks of the problem countries and transferred their assets to safer countries. The banks of the problem coun-tries have been forced to resort to the ECB via their own central banks in order to be able to repay depositors and investors who are repatriating their assets. Correspond-ingly, banks in countries deemed safer have made depos-its in the ECB via their respective central banks. This way, the central banks of the problem countries have ac-cumulated imputed debt in the payment system and safe countries’ central banks imputed receivables that roughly correspond to the (net) receivables and debts of the coun-tries’ financial systems to the European central bank sys-tem (Figure 5). Figure 5. Receivables in the central bank system

-600

-400

-200

0

200

400

600

800

99 01 03 05 07 09 11

Germany

Netherlands

Finland

Slovenia

France

Belgium

Austria

Portugal

Greece

Ireland

Italy

Spain

EUR billion

Source: Ifo, central banks The entire euro system shoulders the credit risk related to bank financing and is liable for the repayment of deposits in the ECB. The national central banks act as the media-tors. If banks want to withdraw their deposits, the assets will be raised from the public funds of the euro system. If, say, a loan granted to a Spanish bank results in credit losses, the central banks of the system will carry the loss in line with their ownership. Any credit losses to the ECB will probably be divided among the remaining shareholders in accordance with their ownership. Fin-land’s liabilities currently correspond to its holding of slightly under 2% in the ECB. The more countries exit the euro, the higher Finland’s ownership and liabilities will increase. The claims of the euro system from the problem coun-tries are over EUR 950 billion, of which Finland’s share is approximately EUR 20 billion. These figures reflect

■ Several problem countries leaving the euro


the current situation. If the crisis comes to a head, claims from the problem countries' financial systems will multi-ply before the credit taps are turned off. In addition to the problem countries, the European Central Bank has claims from other countries' financial institutions whose solven-cy would falter should the problem countries exit the eu-ro. How the ECB’s credit losses are managed? The ECB’s credit losses can be managed in two ways. The first alternative is that the countries remaining in the eurozone will inject more capital into the ECB in order to strengthen its balance sheet. Obtaining capital from the market in one go is not sensible, and the ECB would probably accept government bonds as a payment. Alternatively, the ECB could be allowed to continue to operate with negative capital or keep the capital positive through bookkeeping means. The central bank can well operate even if the liabilities recognised on the balance sheet exceed the assets, since the liabilities mainly con-sist of euro-denominated paper currency and banks’ de-posits in the central bank. However, keeping inflation at bay would be challenging for a central bank system oper-ating with negative capital. The central bank is a net debtor to the bank system, so interest payments to banks will have to be financed by creating new money. This is no problem with zero interest rates, but the losses of the central bank system will increase if interest rates are in-creased in order to curb inflation. The ECB can change the situation by increasing banks' reserve requirements considerably and stopping the payment of interest on re-serves. In this case, the central bank system will be capi-talised by, in practice, taxing banks. Reserves currently amount to only EUR 100 billion, so this would require multiplying the reserve requirements. Amount of paper currency will be reduced 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.

Losses of the private sector The private sector will also suffer credit losses from its exposure. Finnish banks had slightly under EUR 2 billion of claims from the problem countries in March 2012. The highest exposure is to Spanish banks. Should the problem countries leave, their debt will be re-arranged and their bank systems will suffer. Companies’ opportunities for servicing euro-denominated loans are poor, and the number of bankruptcies will surge. The re-maining eurozone will carry considerable losses from these claims. However, the exposure is not only unidirec-tional. The problem countries’ companies and citizens have deposits in the banks of the remaining eurozone, and these deposits and cash moved to safe havens will begin to be repatriated after the adoption of their own currency. This may result in a situation in which the indebted sec-tors of the problem countries firstly fail to service their debts to the core countries, and surplus companies and households subsequently aim to repatriate their assets held safe as deposits in the core countries. Table 2. Bank exposure to the problem countries, EUR billion

Public,

EFSF/ECB

Private

(BIS)Total % of GDP

France 67 35 101 5.1%

Germany 89 11 99 3.9%

Italy 58 2 60 3.8%

Spain 39 1 40 3.7%

Netherlands 19 3 21 3.6%

Belgium 11 1 12 3.2%

Portugal 5 6 12 6.8%

Austria 9 2 11 3.6%

Finland 6 0 6 3.1%

Ireland 3 0 4 2.1%

Total 306 59 365 Source: BIS

■ Finland’s exit of its own accord


Finland’s exit of its own accord

• Finland can have two currencies in the beginning

• The development of the markka is not self-evident

Uncertainty over economic policy and currency A strong country may also leave the eurozone if the lia-bilities related to the support packages need to be in-creased further. Finland’s exit of its own accord would differ from a Greek exit, because a balanced national economy may, theoretically speaking, have two curren-cies even for a long transition period, and peg the new markka to the euro at a rate of 1:1 during the transition period. In the best case scenario, the uncertainty would be temporary and impacts on Finnish economic devel-opment remain limited. In practice, however, the impacts depend on investors’ moods and the general economic development, so the transition period may be problemat-ic. Initially, both currencies could be legal tender. Euros are not automatically converted into markka. Instead, all de-posits, debt and other agreements remain in euros until deposits are transferred to markka-denominated accounts and parties amend their contracts. During the transition period, the Bank of Finland exchanges euros and mark-kas at a rate of 1:1 both ways. Eagerness to exchange will depend on people's expectations of the development of the value of the markka after the transition period. The financial markets may have doubts as to the consistency of Finnish economic policy, since Finland was known for its devaluation cycles prior to joining the EU. Therefore, an immediate liquidity crisis may emerge as early as in the transition period if eurozone investors withdraw their assets for fear that euros will not be safe in Finland. Risk-averse eurozone investors who currently have in-vested in Finland to be safe might not be willing to carry the exchange rate risk. In addition, the European Central Bank might not be willing to secure liquidity by lending to a country that is about to leave the eurozone. Currency risk related to euro-denominated funding Following the transition period, the markka will be al-lowed to float against the euro and the markka will be made the only legal tender. Existing commitments may remain euro-denominated, because their unilateral amendment would collapse Finland’s credit rating, and the balance of the Finnish national economy in any case supports the rate of the markka against the euro remain-ing close to 1:1. Finnish banks have more loans granted to the public than deposits, and some of the loans have been financed by borrowing from the euro market. This results in an ex-change rate risk to the banks. The Bank of Finland may 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

whole, Finland’s foreign liabilities and receivables are fairly balanced, so the need for exchanging euros to markkas and vice versa would neutralize each other, and the central bank’s need for action to stabilise the ex-change rate of the markka against the euro remains small. The development of the markka is not self-evident Right after the currency peg ends, the exchange rate of the markka may fluctuate even to a considerable extent, depending on whether Finland is seen as a safe haven in the euro crisis or whether investors will withdraw their assets from the small illiquid marginal market. In the longer term, the development of the markka will depend in particular on the growth outlook, inflation-related ex-pectations and investors’ attitude towards the exchange rate risk of a small currency. In any case, the value of the markka will fluctuate more than that of the euro. A minor strengthening caused by the relatively good bal-ance of the Finnish economy may lead to a mass move-ment of investors, which strengthens the currency strong-er than warranted by the situation of the real economy. Such a positive cycle keeps interest rates low and sup-ports indebtedness and domestic demand. The recent weakening of the balance of current accounts intensifies, making the Finnish national economy increasingly de-pendent on the moods of foreign investors. Corporate and government funding more expensive? On the other hand, the value of the markka may decrease considerably because a small currency is not needed for balancing investment portfolios in the same way as the euro, a major currency. A significant proportion of the money invested in Finland during the euro era columns from investors who have been looking for safe euro-denominated investments and are not willing to carry the exchange rate risk associated with a small fringe curren-cy. If foreign investors leave the small Finnish market, the liquidity of Finnish markka-denominated listed equity and bond markets decreases, risk premiums increase and high fluctuations in prices become more frequent. Funding of banks, companies and the central government becomes more difficult and expensive. Increasing finan-cial costs decrease consumer spending and willingness to invest. General confidence weakens, and it will be diffi-cult to restore it. Credit taps are tightened, the economy enters a recession, and the debt servicing capacity of the public sector weakens. The credit rating of Finland will be placed under credit watch due to the exit-related un-certainty, and the risk of the credit rating being lowered will increase. Leaving the euro without exit from the EU is not simple.

■ Split or breakup of the euro


Split or breakup of the euro

• Germany’s exit leads to the breakup of the eurozone

• An imputed euro and euribor will be created

Northern euro strengthens against the southern one If the eurozone splits up into northern and southern euro-zones, the northern euro will retain the current euro and institutions because the head office of the ECB is in Germany. The problem countries adopting the southern euro will have to be able to establish a central bank sys-tem and paper currency of their own. Splitting the central bank system of the old eurozone in two and clarifying the claims will be a painstaking process. The northern euro will weaken against the other main currencies with significant uncertainty shaking all of Eu-rope. However, the northern euro will strengthen against the southern euro as capital flows to a safe haven in the markets of the relatively stronger countries. Northern eu-ro countries seem more stable compared to the southern ones, and they will not suffer from the outflow of capital to the same extent. The northern economies will suffer considerable losses due to their receivables from the southern eurozone. The northern financial system will require significant support, which will increase the countries' national debts. Fur-thermore, the northern economies’ exports to the south will suffer due to the strengthening currency and fall in demand in the southern eurozone. The economy will en-ter a recession, but it will benefit slightly from low inter-est rates and the weakening of the currency against other major currencies. The euro of the southern eurozone would devalue The value of the southern euro made up of the weaker countries will decrease. Foreign capital will flee the southern eurozone, frightened by devaluation pressures, and the bank system will suffer with deposits fleeing to safety, stuffed into mattresses or moved abroad. The economy of the southern eurozone will fall all the way into a depression, as the debt rearrangements of the cen-tral governments and the increasing number of bankrupt-cies will consume banks' capital and accelerate the credit depression. Gradually, the weak currency will support the exports of the southern economies. If the debt of the southern eurozone countries is convert-ed into southern euros, their value in northern euros will decrease. This will make it easier to repay the debt of the southern area, but the devaluation of the currency will re-sult in increasing losses to the north in the southern euro-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.

Domino effect or German exit may collapse the euro A chain reaction starting with the exit of weak countries may lead to the entire eurozone breaking up. When ex-pectations of the exit of weak countries increase, capital flight to safe countries will accelerate, and the central banks of the weak countries will have to support their fi-nancial systems by printing more euros. There is the risk of a total collapse in the value of the currency with the central banks printing euros without limits. The eurozone may also break up due to the exit of Ger-many, a large and strong financing country. If Germany decides to leave, the other strong countries will follow in its footsteps. The entire eurozone will break up because the remaining countries in crisis will not have the com-mon political will to build the required institutions. Germany leaving the eurozone will plunge the country’s own financial system to a chaos, even though the country as a whole is at a surplus. Germany will suffer losses when the private and public problem country exposures have to be rearranged. The German economy will suffer from the tightening credit taps of the banking sector, weakening demand in the export demand in the former eurozone and the strengthening currency. German banks have received safe-haven deposits from the southern eurozone, which will begin to be repatriated when the situation clears up. There will be disputes over whether deposits moved from southern Europe to Ger-many can be converted to D-Marks. Their conversion to the new domestic currency would lead to a decrease in the value of the deposits because the new domestic cur-rency will devalue. Germany, on the other hand, wants only domestic deposits to be converted to the new, strong D-Mark. In this case, the amount of money in Germany will not increase exponentially, which will restrict the in-flation pressure. Breaking up of the eurozone will be chaotic If the entire eurozone breaks up, the European Central Bank will be closed down and its tasks will be trans-ferred back to the national central banks. The European financial system will collapse and Europe will end up in a credit depression, from which it will not recover for a long time. The central banks of all former member states will provide their banks with unlimited liquidity. The banks will need new capital. The complete breakup of the eurozone will plunge the entire global financial system into full-scale chaos. The entire eurozone will enter a de-pression, which will have long-lasting effects in all coun-tries.

■ Split or breakup of the euro


An enormous extent of negotiations on the currency to be used in agreements will follow. One option is to adopt an imputed euro exchange rate, determined as the weighted average of the new currencies of the euro countries. Such a currency already existed before the euro in the form of the ”ECU basket currency,” which was exchanged into euros at a rate of 1:1. The exchange rates of the strong 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.

Euribor is the most common reference rate in the eur-zone, and the quoting of euribor interest rates would end in case of a complete breakup of the eurozone. In this case, a substitute should be found for the euribor rates. In practice, the substitute could be formed out of the new national interbank interest rates as an imputed interest rate.

■ 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 leave

Only Finland leaves The entire eurozone breaks up

Economic growth will accelerate gradually from this year’s below 1% to almost 3% in 2014 Unemployment will remain at approximately 8% until 2014 Inflation will remain at slightly over 2%, but will not exceed 3% even in 2014 Current account deficit will remain moderate

Effects on Finland are minor, because direct Finnish trade with and Greek exposure are small The indirect effects will also be minor to Finland because Greece is a small country and many preparations have already been made for a potential Greek exit Finland's export demand will begin to recover from the slump caused by the exit within as little as a year

The direct effects on Finland are higher than in the previous scenario, because the problem countries account for a large proportion of the eurozone and 30% of Finland’s exports are to the eurozone Eurozone will enter a financial crisis and depression that will be more severe and longer than the 2009 crisis Finland’s losses from the rearrangement of bailout packages, euro system and private sector claims will be significant The remaining eurozone and Finland will begin to recover from the breakup of the euro around the third year after the exit

Effects on the development of the Finnish economy are minor in the best case scenario Finland’s exit will escalate the crisis of the eurozone and the outlook for economic growth will become gloomier The currency may fluctuate greatly after the transition period Once the temporary uncertainty clears up, Finland begins to recover from the euro exit within a year

Direct effects on Finland are extremely high The European financial system will collapse Credit depression After a very deep plunge, the economy will begin to recover around the third year following the breakup Risk of increasing inflation



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

Greek exit Problem countries leave

Only Finland leaves

The entire eurozone breaks up

If the Greek exit is controlled and based on a mutual decision in the eurozone, it is likely that the capitalisation of the banks of each eurozone country will be secured if capitalisation is perceived necessary. In this scenario of a controlled Greek exit, the economic outlook will improve. The interest rates will normalise and long-term interest rates will increase more than short-term rates. If Greece exits in an uncontrolled way, the market will begin to price the possible exit of other problem countries. Interest rates will remain low, and the European stability mechanisms and the ECB will secure the financing needs of the problem countries. This will subsequently increase the inflation pressure. Pay long-term fixed interest. Receive inflation (eurozone or Finland).

The capitalisation need of banks is considerably higher than in the preceding scenario. The problem countries will adopt their own currencies, and with the devaluation, covering the existing euro-denominated debt will become impossible. If the debts of the problem countries are converted into their own currencies, this will result in losses to the bearers of the bonds due to the weakening of the currency. Increasing risks for the banking sector will create upside pressure on Euribor interest rates, increasing the difference with the overnight Eonia interest rates. Receive expanding Euribor-Eonia interest rate differential. Receive inflation (eurozone or Finland).

If Finland’s euro-denominated bonds are converted into markka-denominated bonds, being marginal investment, they will be subject to selling pressures, and Finland’s interest rates will increase. The same phenomenon will apply to the issuance of new markka-denominated bonds, even if the old debt remains euro-denominated. The risk of devaluation of the markka and accelerating inflation. Receive Finnish inflation.

The euro will be replaced with an accounting currency similar to its predecessor, the ECU, which is calculated by weighing the national currencies. The ECU interest rate calculated on the basis of the national currencies will be higher than the Euribor rate. This will result in upside pressure to fixed interest rates. The consequences of the entire eurozone breaking up will be of such a scale that the market reactions will be considerable and significant uncertainty is associated with predicting them. Pay long-term fixed interest. Receive Finnish inflation.



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


Only Finland leaves


There is the risk of euro-denominated receivables from Greece being converted to the new Greek currency, which will devalue considerably against the euro. Demand will fall considerably due to both the economic situation and the weakening of the drachma. With regard to foreign exchange risks, one should consider, for example, if it could be possible to ensure the payment of the least open deals in euros through contractual arrangements. Risk of the customer’s insolvency.

If all of the problem countries exit, the situation has a rather similar logic to that of a Greek exit. The new currencies of these countries would probably devalue against the euro (of the remaining strong countries). Direct hedging against, for example, the weakening of the Italian lira is impossible. Utilising the country’s bankruptcy probability could be considered as a hedging option. The probability of Italy’s euro exit is likely to correlate with the country’s bankruptcy probability, in which case credit risk derivatives could be used for hedging against the exit.

The markka will be adopted as the expense currency, and the strengthening of the markka is a risk. It is not currently possible to hedge against fluctuations in the value of the markka. Hedging exports to outside the eurozone (e.g. USD) carries the risk of the hedging being for changes in the exchange rate of the euro but not of the markka. The most problematic scenario is that the euro will weaken significantly and hedging with a forward contract results in costs while the markka strengthens. Options are useful for this problem instead of a binding (forward, etc.) hedge. An option would hedge against the weakening of USD, for example, but would not be binding in the event of a Finnish exit.

The markka will be adopted as the expense currency, and the strengthening of the markka is a risk. It is not currently possible to hedge against the new currencies. Hedging using derivatives correlating with credit risk could be considered.

Hedging exports to outside the eurozone (e.g. USD) carries the risk of the hedging being for changes in the exchange rate of the new basket currency ECU but not of the markka. The most problematic scenario is that the new ECU basket currency will weaken significantly and hedging with a forward contract results in costs while the markka strengthens.

Options are useful for this problem instead of a binding (forward, etc.) hedge.



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


Only Finland leaves


The drachma weakens and provides an opportunity for decreasing import prices. Specific hedging against this currency scenario is probably not as necessary as for, e.g., an export company. One could, for example, as a contractual way consider how to reserve an opportunity for quickly renegotiating the purchase prices.

The situation has a similar logic to a Greek exit. The supplier’s expense currency weakens and provides an opportunity for decreasing import prices.

The markka will be the income currency, and there is a risk of the markka weakening against the purchase currencies. Forward contract involve the risk of the euro and the markka developing in different directions. Options, for example, could be considered as the solution. Hedging purchases from the current eurozone countries is not directly possible.

The markka will be the income currency, and there is a risk of the markka weakening against the purchase currencies. Forward contracts involve the risk of the new ECU and the markka developing in different directions. Options, for example, could be considered as the solution. Hedging purchases from the current eurozone countries is not directly possible.

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


Only Finland leaves


Local demand will decrease. In addition, there is a risk of the drachma weakening and decreasing the value of assets. One should prepare for strong fluctuation, which has a considerable effect on the group’s equity and balance sheet covenants, for instance. As a sort of option, one might think about whether a euro-denominated loan taken by the subsidiary locally could function as a natural hedge: would the euro-denominated loan taken in Greece be converted into drachmas, which would compensate for the decrease in the euro-denominated value of the drachma assets?

Similar risks to a Greek exit. The risk of the currency weakening decreasing the value of the holding. If the national currency overshoots, the impact could quickly affect the group’s equity and balance sheet covenants. Local lending can be considered as a potential natural hedge.

The group’s home currency will be the markka, and there is a risk of the markka strengthening against the currency of the holdings. The impact in the event of a Finnish exit will probably be not as great as, for example, in the breakup of the entire eurozone, but there is a risk of major changes on the balance sheet. To the extent that the Finnish parent’s external euro-denominated loans finance subsidiaries in other Eurozone countries, it is essential that the loans remain euro-denominated.

The group’s home currency will be the markka, and there is a risk of the markka strengthening against the currency of the assets. In the event of a complete breakup of the euro, the effect could be rapid and preparations for the weakening of, e.g., equity and balance sheet covenants would be useful. Changes in the value of assets in Germany and other strong countries might partly offset this. Local funding could be a natural hedge.



Table 6. Effects on corporate bonds



A majority of Greek companies will find themselves in financial difficulties and a credit event. For credit rating agencies, the conversion of the currency of the bond alone gives rise to a credit event. In the slightly longer term, export companies and subsidiaries of large international corporations would be in the best position. Sufficient liquidity plays a key role. The effects on most Nordic companies would probably remain more limited than on French companies, for example, due to the lower volume of exports and banks’ risks.

The European corporate bond market is already considerably mixed up, and the number of credit events is significant also outside the problem countries. The same principles as in the case of Greece: companies whose operations take place outside the eurozone and Europe to a significant extent are in the best position. Because the European financial market is mixed up, an extensive funding base plays a key role, which includes a good relationship with major banks and access to financial markets outside the eurozone Non-cyclical companies will fare better operationally, but taxation pressure on these companies will 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.

If Finland exits of its own accord, increasing uncertainty and possible speculation concerning the next exit decisions are the most significant indirect effect on the corporate bond market. Finnish export-driven companies would suffer from continuous uncertainty in Finland and the rest of Europe alike. In contrast with, for example, the Greek exit scenario, the transition period from the euro to the markka could be long, and existing loans could possibly remain euro-denominated. The risks of Finnish companies will increase in the form of currency risks.

The number of bankruptcies and credit events will be extremely high – applies to all euro-denominated bonds. Because refinancing is practically impossible, there will also be defaults in bonds in other currencies than euro.

In contrast with the previous scenarios, the consequences to corporate bond markets are enormous also outside the eurozone and Europe. In the longer run, the normal regularities will apply: extensive funding base, geographic distribution, cyclicality and competitive situation. Companies that are critical for public activity and safety and have operations across borders are in the best position.



Table 7. Effects on the equity market



The market is turbulent until the Greece-related liabilities of companies and financial institutions are fully known. For Finnish companies, the direct Greek exposure is small, and pressure on valuation is mainly caused by the general uncertainty. Since the possibility of an exit has already been assessed and it has been possible to prepare for it, the market turbulence may remain short-lived.

The markets will price in a considerably higher risk than in the exit of Greece alone. Risk premiums will increase significantly, and with particular regard to cyclical and indebted companies, the pressures are comparable with the development in 2008-09. The competition field will transform in sectors with competing capacity in southern Europe (e.g., paper, steel). The strong euro of the strong countries will burden the competitiveness of exports.

The short-term reactions are remarkable turbulence, high risk premium and flight of foreign capital. The longer-term consequences depend on the value (and stability) of the currency. The risk premium, however, will remain higher.

Risk premiums will increase considerably, and the pressures are comparable to the development in 2008–2009. Finland will remain underweighted in the allocation of international investments (foreign ownership decreased following the Lehman crisis and has not increased to a significant extent). Consumption and investment demand will weaken significantly. The risk premium of shares listed in Finland will increase at a steeper rate than the risk premiums of companies listed in capital markets perceived safer.

For further information: Aki Kangasharju, Director, Head of Research [email protected] +358 9 165 59952

Suvi Kosonen, Analyst [email protected] +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.

what if-the-eurozone-breaks-up ? finland’s exit of its own accord

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