Â© 2012 Financier Worldwide Limited.
Permission to use this reprint has been granted by the publisher.
The break-up of the eurozone is no longer a taboo topic. Whilst the news headlines at the moment indicate that Greece has accepted the latest bailout package, this does not signify that the storm is over. Indeed, write-downs imposed on investors and domestic instability triggered by additional austerity requirements may still lead to a Greek exit from the eurozone. Relatively insignificant though Greeceâs economy may be to the world economy, the pervading fear is that such an exit would prompt a fall in market confidence and trigger exits by other European periphery countries, in a similar contagion to that witnessed after the collapse of Lehman Brothers in 2008. Such a course of events would inevitably have global repercussions.
Over the last few months a number of organisations ‘ banks, law firms, corporations ‘ have started openly to prepare for the worst case scenario by proposing contingency strategies for a continuation of the eurozone crisis and even for a eurozone break-up with one or more countries exiting the euro. However the effects of the crisis on emerging markets, in particular on African markets, have not been considered in any great detail. It is the aim of this article to examine this, with a view to proposing a number of contingency planning options for relevant governments, financial institutions and corporations to consider.
Whilst the effects of eurozone recession and a break-up would be felt across the African continent, real GDP growth across the African continent is still envisaged to be significantly higher than that forecast for most developed countries. Notwithstanding this, it would be naive to presume that Europeâs financial problems are not affecting, and will not continue to affect, real GDP growth across Africa. The effects of any slowdown in Europe would obviously differ between individual African countries however, depending on their exposure to particular economies within Europe.
Under the scenario of a eurozone recession in 2012 and a possible eurozone break-up, there would be an increasing need for further recapitalisation of eurozone (and EU) banks. This itself is likely to result in significant retrenchment amongst overseas lending institutions, as can indeed already be seen in Central and Eastern Europe. In Africa, almost 70 percent of outside loans come from European banks.
One consequence of a deepening eurozone crisis could therefore be a tightening of credit to African markets and asset withdrawals by eurozone banks due to a shortage of bank liquidity and jittery markets at home. Eurozone bank financing of long-term projects in 2012 in particular might be put on hold, especially taking into account that the European banks most heavily involved in project finance, have a combined exposure of around $450bn to Portugal, Ireland, Italy, Greece and Spain.
This retrenchment could nevertheless open up opportunities for alternative sources of funding, resulting in banks, sovereign wealth funds and similar financial institutions from other emerging regions filling the void left by European lenders, and in the increasing activity of the local banking sector, which has thus far proven resilient. In addition, debt issuance by African countries was up 17 percent in 2011, perhaps indicative of the regionâs lower sensitivity to fluctuations in global markets as compared to other parts of the world â an attractive quality for investors.
However, in a scenario of significant eurozone bank withdrawal from African emerging markets, the continuing ability of local banks to replace debt capacity, the interest of banks and financial institutions from other regions, and the ability of African countries to retain an attractive sovereign rate for further bond issuances, will all depend on the ability of relevant African countries to maintain their fiscal credibility, to continue strengthening their institutions, and on their ability to ensure, inflationary constraints permitting, that domestic banking systems have sufficient liquidity. Given the fact that most African countries weathered the 2008-09 global crisis by stimulating their economies, four years later many are in a much weaker fiscal position, resulting in inflationary pressures on their central banks and a concomitant inability to ease monetary policy at their time of need.
Maintaining fiscal credibility and managing inflation is also complicated by exchange rates. A worst-case eurozone break-up would most likely result in significant dollar appreciation against the remaining euro. In addition, if one or more eurozone member states leave the eurozone and introduce a new national currency, there will be significant legal uncertainty over the impact on euro-denominated payment obligations in contracts with a connection to any exiting member state. In addition, the euro payment obligations of an exiting eurozone member state will most likely be redenominated into the new national currency resulting in a significant depreciation in its value. Depending on the extent of exposure to an exiting eurozone member state, this could further result in the dollar strengthening to such an extent against the relevant African currency that it might impinge on its central bankâs ability to ease monetary policy.
Governments and corporations across Africa are also risking a potential decrease in trade with Europe and other countries as a result of the likely drop in eurozone import demand, plus the fall in global commodity demand as a result of any eurozone recession. North Africa and the CFA zone countries in particular are very exposed and dependent on trade with the EU. CFA zone countries are also pegged to the euro, which implies that most of the CFA zone countries have their reserves in euro, which could depreciate in real terms. The depreciation of local currency could boost competitiveness but would not necessarily help solve the problem of constrained export demand and economic growth. As most CFA zone countries are importing goods from outside Africa, following a significant depreciation the CFA franc might struggle to carry any real purchasing power (in particular in relation to petroleum commodities which are most often priced in dollars). In addition, the CFA franc is ultimately operated by the French Treasury, significantly limiting the scope of any monetary policy available to local central banks. Taking into account the recent downgrade of Franceâs credit rating, its increasing public sector and banking debt, and its large exposure to periphery eurozone membersâ debt, CFA zone countries might, unsurprisingly, feel vulnerable, increasingly finding themselves at the mercy of the eurozone storm.
In view of the above, there are a number of potential contingency plans available for relevant governments, financial institutions and corporations. Governments, financial institutions and corporations should review their exposure to issuers and/or lenders incorporated in eurozone member states, and consider if any exposure could be hedged or otherwise covered. The impact of a severe devaluation of a member stateâs new currency on trade arrangements, lenders, counterparties, custodians, customers and suppliers should also be considered. In addition, the robustness of funding arrangements and liquidity facilities, both of the central banks and relevant businesses, should be ensured, as well as closer public-private cooperation on contingency planning.
In respect of future financial transactions, the relevant parties should aim to reduce risk as far as possible. A contract for example, might need to incorporate governing law and jurisdiction provisions to take contracts outside the eurozone and express specification of currency of account/payment provisions, with tailored force majeure and material adverse clauses to address relevant scenarios. Full impact assessments of sovereign and commercial debt write downs could also be considered. A review of credit limits for all banking counterparties and awareness of any credit downgrades are relatively simple acts of oversight, viewing euro risk on a country-by-country and individual counterparty basis, rather than attempting a general, economic assessment of net exposure across the entire eurozone. Most importantly, a clear definition of the euro should be incorporated in contractual agreements, in particular in project finance facility agreements. Interestingly, even the LMA documentation does not currently contain a definition of euro, so the relevant parties might consider including a specific definition of the euro in addition to provisions setting out what the currency of payment and/or potential redenomination rate might be if the euro were no longer to exist, or if a euro break-up were to take place.
More generally, against the backdrop of the eurozone crisis, African governments might also consider further diversification away from euro trade, to trade with other emerging markets and within Africa itself. The eurozone storm could therefore be used as a trigger for a much needed improvement of free trade within the African continent. Such improvement would depend however on a successful elimination of trade barriers in the continent. The rise of BRIC and other emerging economies should also provide African countries with the opportunity to maximise such diversification, and so far, the presence of BRIC countries in the continent, especially of China and India, continues to rise. It is hoped therefore, that some of the proposed contingency strategies and the proposed diversifications might help shelter African emerging markets from the anticipated eurozone storm.
Ana-Katarina Hajduka is an associate at Trinity International LLP.
She can be contacted on +44 (0)207 997 7051 or by email: firstname.lastname@example.org