Miko Bradford: Eurozone break-up would hit credit providers as well as trade

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Kiwi firms should consider whether any material contracts could be redenominated, writes Miko Bradford.

What does the eurozone crisis mean for New Zealand businesses?

The prospect of a euro break-up or the departure of Germany or one or more of the highly indebted eurozone nations (the so-called PIIGS) is a constant cause of concern internationally.

The Reserve Bank of New Zealand noted in its November Financial Stability Report that subdued activity in advanced economies, particularly in Europe, has contributed to slowing growth in emerging markets through trade linkages. "Global economic activity is weak and this is affecting emerging market economies, including China. Conditions in the euro area remain fragile and the underlying fiscal and structural issues facing the region are substantial. Global growth could be further undermined by the prospect of material tightening in US fiscal policy. This external environment poses significant risks for the New Zealand financial system."

This follows four years after Lehman Brothers filed for Chapter 11 Bankruptcy protection and sparked the global financial crisis.

In Europe, first Greece then Portugal, Italy, Ireland and Spain sought assistance from the international community.

Austerity measures were implemented throughout Europe and, to a more limited degree, in the United States.

Quantitative easing, or money printing, was adopted in the US, UK and Japan for fiscal reasons and others, such as Switzerland, as a response.

In addition to the impact on trade and general business confidence of a euro break-up, the key impact for New Zealand would arise for lenders/counterparties, redenomination risk and increased cost of funding for New Zealand banks and financial institutions in international markets.

A key risk to those that lend or provide credit directly to a borrower based in a country that is departing the euro or a company that has a commercial contract with a company based in a departing nation, is the overnight introduction of a new national currency with a fixed exchange rate for conversion of existing euro payment obligations into the new currency and mandatory conversion of monetary obligations into that new currency.

The mandatory conversion of a currency (in this case euro) into another currency is known as redenomination.

The new currency may, depending on whether the departing nation is highly indebted, either rapidly devalue or appreciate, leaving counterparties with assets/liabilities suddenly valued dramatically differently.

Creditors of euro denominated obligations subject to automatic conversion into the new currency may suffer considerable losses.

Based on the experience of Latin American defaults, some commentators estimate the devaluation of a new drachma upon a Greek exit, for example, could be in the 50-60 per cent range.

A departing nation, especially if highly indebted, may also implement capital and exchange controls to avoid a run on banks and removal of financial assets.

This means New Zealand creditors may not be able to repatriate funds.

Other countries may seek to impose import tariffs given the redenomination of the currency is likely to result in a significant devaluation for a highly indebted departing nation and distort trade flows. Export tariffs and controls are also possible.

When Argentina broke the peso's US dollar peg in 2002 and the peso devalued sharply, Argentina introduced its own export tariffs to raise revenue and address distorted trade flows.

Can New Zealand companies reduce euro risk? How great is the redenomination risk and how to reduce it?

The worst case scenario is for all payment obligations of people and businesses based in the departing nation or subject to the laws of the departing nation to be redenominated coupled with a complete dissolution of the euro.

New Zealand creditors should consider whether any material contracts could be redenominated or affected by capital and exchange controls.

A New Zealand counterparty should consider the following factors when dealing with eurozone counterparties.

*Currency of payment. If euro is the currency of payment, expressly define this by reference to the currency of the member states of the European Union that have adopted the single currency (as opposed to either not defining it or defining it as the lawful currency of the relevant eurozone state from time to time). This may not reduce the redenomination risk in the unlikely scenario of a complete euro dissolution however.

*Check which courts decide. The contract may, and should, specify the courts which determine disputes and interpret the contract. Courts outside of the departing nation may be more willing to assist those affected by sudden changes of law in a departing nation.

*Check governing law. Courts are often less inclined to reinterpret contracts governed by foreign law. New Zealand counterparties should therefore consider adopting a governing law that is different to that of a potential departing nation.

*Consider place of payment/performance. If the contract specifies the departing nation as the place for payment or contractual performance there may be a legal presumption that payments should be made in the new currency.

*Consider location of assets. As you may need to to sue your counterparty, consider where their principal assets are located and how difficult it is to access those legally.

*Consider credit support. Credit support (guarantees or letters of credit) from an entity you are satisfied is outside the European Union and not highly exposed to the eurozone may provide protection.

In addition, New Zealand corporates required to make public disclosures should consider and constantly review whether they have any material exposure to the eurozone and how a disorderly resolution to the issues facing the region could affect their business.

One lesson learned from the Lehman collapse is the risk of the domino effect.

Overnight, banks and financial institutions all over the world found themselves in need of assistance.

In New Zealand, before the global financial crisis, the largest source of New Zealand bank funding was short-term wholesale debt issued primarily in the US commercial paper market.

That market froze overnight and the cost of rolling over short-term debt became prohibitive.

At the same time Basel III regulatory changes required banks to increase the quality and quantity of their capital, whilst reducing their leverage through the imposition of a new leverage ratio.

The Reserve Bank in its November Financial Stability Report however concluded that the New Zealand banking system is well placed to meet the new criteria set out in the Basel III capital regime.

A note of caution is however sounded: "Nevertheless, results from stress tests [undertaken in 2012 by the Reserve Bank in collaboration with the Australian Prudential Regulation Authority] suggest that these buffers could be tested in a severe economic downturn."

Standard & Poor's Rating Services adopted a cautionary tone in their November report, noting that the New Zealand banking sector has a "material reliance" on offshore wholesale funding, although the position has progressively improved since 2009.

"Although the banks are maintaining good levels of liquidity, any prolonged disruption in offshore wholesale borrowing markets is likely to escalate funding pressure on the banks and put pressure on them meeting minimum core funding ratio requirements, with the minimum set to increase to 75 per cent from January 1, 2013," it said.


Miko Bradford is a special counsel at Minter Ellison Rudd Watts in the Auckland Banking and Financial Services group.

- NZ Herald

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