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In this audio presentation, Bain partner João Soares recaps the root causes of the Eurozone crisis and highlights the practical options now available to those involved.
Stakeholders can successfully navigate the turmoil by developing a playbook that identifies growth opportunities while shielding them from potential risks.
Presentation transcript: Navigating Europe's financial crisis
Slide 1: Navigating Europe’s financial crisis
Welcome to this brief update on our perspectives on the European crisis. My name is João Soares.
Slide 2: How did we get here?
A reminder on how we got here. Since 2008, a bailout counter started just after the fall of Lehman with countries like Hungary, Iceland and Latvia asking for bailouts, but also the British banks, the Belgian banks, a number of German banks.
Then Greece was the first Eurozone country to be bailed out, then Ireland. Portugal was the third country of the Eurozone to be bailed out. Then you saw Dexia for a second time. Greece for a second time. And then a major acceleration—so the Cypriot banks; Bankia surprising the markets by saying that it required an additional €19 billion in rescue; four banks in Greece receiving a recapitalization of €18 billion; banks from Slovenia; in Austria; the Spanish banking system as a whole requesting an additional €80 billion; Cyprus entering a bailout program as a country; Spain entering as a fifth country in the bailout program; and now, the first Italian bank requesting aid.
Slide 3: Conditions have deteriorated for many countries since 2008
In 2008, the number of European countries that were outside of what we call the “safe zone,” both in terms of public debt as a percentage of GDP and private debt as a percentage of GDP, which is the debt of individuals and companies that resides on the balance sheet of the banks. So countries like Greece were over-extended on the public side, countries like Ireland were over-extended on the private side, and Portugal was over-extended on both, although to a lesser extent.
What we saw in terms of evolution to 2011 was not that the countries retrenched to a safer zone, but we witnessed the deterioration in the case of Greece; Italy entering into the red zone; the same with Spain; Portugal not solving its issue; and even Ireland, that started the deleveraging process but didn’t get far enough, and so still there’s a long way to come.
Slide 4: GIIPS market banks have increased their exposure to their sovereigns since LTRO was introduced
The breaking of the crisis will require actions on liquidity, on debt and on growth. For the liquidity front, the European central bank has intervened with €1 trillion of liquidity through what they call the LTRO injections, both in December and in February. And what happened was the banks in many of these countries used those funds to acquire additional sovereign debt. So that was the case in Italy, where the exposure of the banks increased by 70%; Spain, at 38%; Portugal by 62%; and Ireland by 25%. That was the movement since the last EBA test in September 2011 data to February 2012. And so the increased linkage between the banks and the sovereigns has now taken place.
It’s not only a linkage that is an issue in terms of the volume, but also in terms of price as the default-swap spreads have increased for each of these countries and, as such, created an issue on both volume and price that will have to be measured and taken into account on further tests.
Slide 5: Total deleveraging of €1-€2T assets expected over two to three years
So where are we now? Did we start the deleveraging process that needs to be done? Well, the US has. It’s now at around 80%. But Europe and the UK still have a long way to go. If we compare to previous crises, that long way to go is even more visible. So you see the US following the curve of Southeast Asian countries in the crisis of the ‘90s, which was an aggressive reaction to restore growth, whereas Europe is more closely following the curve of Japan, which has been dubbed to be the “lost decades” in which it took a very sluggish path to resolution, which impaired growth and kept unemployment at very high levels.
In order to accelerate, the regulators can prompt for deleveraging, which will bring a significant amount of assets to the market, between €1 trillion and €2 trillion coming in from the large economies and prompting the banks of Germany, France, the UK and Italy to offer tremendous volume of transactions.
Still, we are currently more on a path of “lost decades” than in a painful course adjustment.
Slide 6: Each bank needs a playbook tailored to its position
So what does this mean for each of the banks facing these circumstances? Well, some banks have a weak balance sheet. If they have little exposure to sovereign debt, they’re what you call a “stop the rot” quadrant. They will need to redefine their activity around their future core; act decisively on bad loans; create investment headroom and reposition themselves for growth; divesting noncore assets; upgrading risk management; and retaining top talent.
If the resistance to sovereign debt is actually low, if there is an issue of sovereign debt coupled with the fragility of the balance sheet, the banks are in what we call the “highest concern.” They will likely have government intervention; their future business model will have to be significantly restructured and be significantly different.
On the other hand, if the balance sheet is robust, we have two alternatives: Either the sovereign debt exposure is low, then they are “carpe diem.” They play their hands well, they can build scale to gain competitive position.
Or they have a robust balance sheet but they need to tackle with decisions made around sovereign debt. It’s what we call the “brace for survival” quadrant. Dispose of asset portfolios; raise capital; and manage costs down.
But for all of them, there are shared top priorities around liquidity; around long-term funding; the selling of assets; the revenue reenergizing—so what is the equity story?—and lastly, cost efficiencies.
Slide 7: Asset investors also need tailored priorities
Asset investors also need tailored priorities, with private equity funds, hedge funds or just overall investors looking into these markets.
So for the “stop the rot” quadrant, there are opportunities to buy subsidiaries or portfolios at a discount.
For the “highest concern” quadrant, there is an elevated element of risk brought in by the fact that it’s a three-way negotiation with the government.
For the “carpe diem” quadrant, they have no pressure to sell, but they are divesting assets with an opportunity to take in significant assets for your portfolio.
For the “brace for survival,” the opportunity is to buy both parents or subsidiaries at discount, with or without control.
Slide 8: Tactics for operating companies depend on exposure
For operating companies, tactics depend on exposure—on whether the company is exposed to the Eurozone crisis, both in terms of industry or geography, and whether it has a strong or weak market position. It can be a critical action or a secondary priority, depending on the company.
The first level is to protect against the European crisis risks around securing long-term funding; reviewing bank selection for deposits, and to double down on receivables management.
The second tactic to be solved is adjusting the BAU to your evolving market environment. So resizing your budgets (consumption has gone down driven by austerity); refresh your customer segmentation (the profit pools have shifted); and align your go-to-market strategy with market opportunities.
And lastly, transform your cost base, both on reduction of complexity and centralization of operations currently being fragmented across markets, and transforming your cost structure—optimizing the footprint that you may have.
Slide 9: Operating company strategy depends on exposure
On a more strategic level, what you can do is invest selectively in the core business, both by clarifying the “where to play” and the “how to win” and making a differential organic investments and rebalancing the portfolio based on market risks and opportunities—both by targeting and tailoring your assets to the risk profile you wish and also scanning the market for opportunities and acquisitions.
Slide 10: Let’s take a step back: We are clearly at a juncture…
Let’s take a step back: We continue to be at a juncture. On the one hand, we can face a total meltdown in which there is a devolution—the banks collapse massively across countries, and there’s a contagion effect onto the US and Asia.
On the other extreme, we’ll see a stronger center—a permanent fund, a banking union, and what we’ll see as well are the austerity measures creating decades of impaired growth in the periphery countries, but the stronger center emerging as a driver of greater convergence and harmonization.
There are intermediate scenarios. The current course continues to be, three years into this crisis, a limp-along status quo in which each new event in the crisis prompts a specific and additional bailout and no action on the root causes create an additional pressure for austerity, prompting the periphery countries into a more dire situation but also starting to erode also the core.
There’s talk about the soft break-off on the stronger core, in which a country would leave. The example that’s often mentioned in the media is the “Grexit” or the exit of Greece. In this case, it’s hard for a politician to make these decisions, as the savings or the reserves of a nation have been eroded by the crisis, if a country is to leave and devalue its currency, it will be hard to access the markets for oil or for pharmaceuticals, in the case that those countries don’t produce them.
We’re currently on the limp-along status quo. The actions are driving us toward a stronger center, but they’ve been very slow, and the resolution has been very sluggish.
Slide 11: Contact us
Thank you very much for your time. Should you have any questions, please do not hesitate to reach out to me or any of my colleagues in the Financial Services practice.
First published in agosto 2012