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
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