A Country Default: What Does It Mean?

Eyes have been on Greece and its debt crisis for a long time. The downward spiral of the Greek economy began some 35 years ago with fiscal policies that expanded the country’s debt-to-GDP ratio four-fold over the ensuing decade and into the early 1990s. After stabilizing its economy and holding the debt-to-GDP ratio relatively constant until the advent of the Great Recession, Greece has experienced a 50 percent increase in the ratio to its present unsustainable level. Structural weaknesses in the economy, the recent default on debt obligations, and lost confidence among lenders regarding Greece’s ability to take responsibility for its fiscal issues have led to the present crossroads.

After the initial 2010 bailout and subsequent bailout extensions, coupled with extensive debt restructuring involving principle reductions, extended maturities and lower rates, the present crisis has been marked by weeks of debate and posturing between Greece and the eurozone in which the country requested additional debt relief and the eurozone demanded concrete proposals that will lead to progress toward achieving the long-term debt-to-GDP ratio targets set by previously established bailout terms. On July 5, a strong majority of Greek citizens voted to reject the current bailout terms, causing global capital markets to tumble amid the uncertainty over what will happen next.

In the aftermath of the Greek vote, the country’s finance minister was replaced and negotiations with the eurozone have continued. As it stands today, the eurozone has demanded new proposals from Greece to secure a deal with creditors in time for evaluation by the eurozone finance ministers prior to a full summit of the European Union (EU) scheduled for Sunday, July 12.

So it’s all coming to a head. Either there will be a deal or Greece and its banks will be on their own starting next week.

So Why Should We Care?

As the 45th largest economy in the world in terms of GDP in 2014, Greece’s economy is smaller than that of the Seattle, Washington metropolitan area in the United States. It’s slightly greater than one percent of EU GDP. Since no one is arguing that Greece is too big to fail, why do we care what happens in the crisis?

Perhaps the primary reason is the uncertainty of not knowing what we don’t know. Could a so-called Grexit from the euro and reintroduction of the drachma destabilize the eurozone and would a permanent default by Greece on its debt throw global markets into distress mode? No one wants to start a fire they can’t put out.

What about the effect on Greece itself following a Grexit? It is reasonable to expect the new drachma to devalue significantly relative to the euro once the currency is pegged to another currency (perhaps to the euro). In addition, we can expect higher inflation, exorbitant interest rates and lost purchasing power for Greek citizens. Add rising unemployment and out-of-reach prices for imported goods, a possible run on the banks (which may have already begun), a drop in per capita income, and rising income inequality, and you’ve got a not-so-pretty picture of declining living standards and a budding humanitarian crisis in the making.

Close observers of the situation in Greece have seen the present impasse coming for a long time. Hopefully, companies with operations or other interests in Greece have been able to make adjustments over time to prepare. But the real question is this: What other countries are exposed to bankruptcy due to economic, structural and/or political issues, do we operate there, and if so, are our operations exposed? In addition to Greece, examples of such countries include Venezuela, Argentina, Egypt, Pakistan, Ukraine, Jamaica and Cuba. And there are other countries that may be on the brink or headed in the wrong direction.

Managing Country Risk

Companies invest in other countries to enter new markets, lower costs and, above all, earn a satisfactory return on investment. The less stable a country, the greater the exposure to either investment impairments or reductions in investment returns. These may arise from:

  • Confiscatory actions by a sovereign (g., nationalization of the business or expropriation of assets);
  • Discriminatory actions by a sovereign directed to the company, a targeted industry (say banking) or companies from certain countries (e.g., additional taxation, price or production controls, exchange controls, currency manipulation or performance requirements); or
  • As we witnessed in the Arab spring, destructive/disruptive acts by others (e.g., violence, terrorism, war, strikes, infrastructure deficiencies, kidnappings or physical phenomena).

The primary objective of managing country risk is to protect company investments and sustain investment returns. To that end, if multinationals believe that destabilizing situations in certain countries exposes them to confiscation, discrimination or destructive/disruptive acts, they can face these changes with confidence by:

  • Managing down investment: Repatriate cash to the extent exchange controls and currency conditions allow, manage the operation as though it’s a “cash cow” until conditions stabilize, avoid any additional capital investments, cease replenishing inventory from abroad, and/or look for ways to finance payroll, maintenance and other operational functions through local cash flow.
  • Moving assets to higher ground: Move tangible and non-tangible (e.g., data files, intellectual property) assets out of harm’s way, if feasible. For example, if the company has physical assets close to known “hot spots” where the masses are likely to converge, it may be best to move them to other locations away from the action and potential violence.
  • Sharing the risk: Enter into joint ventures with local/foreign partners to reduce exposure to confiscation risk since the presence of nationals can take a multinational under the radar. If cost-effective, political risk insurance is another option covering the risks of confiscation, political violence, insurrection, civil unrest and discrimination.
  • Listening to local management: Make sure local management is on top of things and empower them to do what they have to do to take any and all necessary steps to protect the safety of employees and safeguard company assets.
  • Initiating an exit strategy: Divesting assets in the cool of the day (before violence breaks out) may be a viable option, if there is a willing buyer. Obviously, it is not likely to be viable when people take to the streets.
  • Paying attention to the warning signs: Assess exposure to instability and take proactive steps to manage that exposure. Don’t wait until it’s too late and options are limited. Watch countries with runaway food price inflation such as those with a low GDP per capita and a very high percentage of food relative to total household consumption. People have to eat.
  • When stuff happens, conducting a post-mortem: When an adverse event happens, review the assumptions your company had previously from an economic, political and structural standpoint. Did management see the event coming? If not, why not? If management saw it coming, did the organization take steps to prepare? Could the company have done anything different?

A Grexit would pose new uncertainties – for Greece and its people, for the EU and eurozone, for global markets and for companies with operations affected by the fallout. It’s just another illustration that the world is a dynamic place and escalating cost structures are impossible to sustain without growth. It’s also a reminder that multinationals can expect continued challenges when countries in which they operate become unstable.

Jim

One thought on “A Country Default: What Does It Mean?

  1. Pingback: 7 Must Reads for Every CAE - CAE Leadership Forum -

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