Emma Du Haney offers a survey of the political landscape across the euro-zone and outlines both investment and operational risk-management priorities for the eventuality of a break-up

Politics is not the art of the possible, said John Kenneth Galbraith, it consists in choosing between the disastrous and the unpalatable. Politicians in the euro-zone might be inclined to agree.

Despite enduring an existential crisis that has already lasted for three years, euro-zone leaders are still faced with two significant decisions. First, they will need to agree on how to move towards greater integration and negotiate a common fiscal policy and a banking union.

Second, governments must decide on the right balance between austerity policies, allowing them to reduce debt, and initiatives to stimulate economic growth, which may require more borrowing.

There have already been considerable, albeit slow, steps made towards greater fiscal consolidation. The European Central Bank (ECB) has provided financial support to European banks by supplying low-cost debt through the Long-Term Refinancing Operation. Sovereign funding vehicles have been established in the form of the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM).

Finally, in September the ECB announced that it would buy sovereign debt to reduce a country’s borrowing costs through carefully structured deals known as outright monetary transactions (OMT). The markets have responded positively to these measures, especially the latter.

Ultimately, the future of the euro is a political rather than a macroeconomic decision, and so a survey of political parties’ policies across the euro-zone is instructive. On integration, the ruling parties in the euro-zone are all in favour of centralising more powers rather than taking them back. Opposition parties are more divided, with some in favour of pulling away from integration and a few small groups in favour of repatriating powers or even withdrawal. The majority still advocate moving closer together.

On economic policy, ruling parties across the euro-zone are taking differing approaches to spending. Germany, Finland and the Netherlands are clearly committed to pursuing austerity, while the new president of France has signalled an emphasis on growth. Political parties are now moving away from advocating pure austerity towards a more balanced approach, and this is likely to be reflected even in Germany after elections next year. Italy has already adopted a more balanced line, and while smaller parties with seats in government favour fiscal stimulus in Greece and Belgium, they are minority players.

A broad survey of political views suggests that a move towards more integration, and policies that favour austerity but including some stimulus initiatives, will remain the order of the day for at least the short term. Upcoming elections suggest few noteworthy policy changes: the Netherlands is expected to move the focus away from pursuing austerity next year, but this is the only change that is likely before 2013.

The current situation should be resolved in an orderly fashion. Insight believes that the euro-zone will remain intact, but that the current incremental approach to change may continue for a few more years. Banking regulation and some control over spending will be centralised for much of Europe, and growth and inflation will remain low. At the time of writing, credit markets are also pricing in a more positive outcome for the euro-zone, such as that outlined above. However, from a prudent risk management perspective, investors should also prepare for a negative outcome, which could carry substantial investment and operational risks.

Practical implications
There are several ways for investors to plan for the unexpected, but all are based on good risk management practices. These should be familiar to every sophisticated investor: the first is to identify and analyse the exposures in your portfolio. These will include the investment risks underlying your assets, but also exposures to counterparties and risks to broader aspects of your portfolio, such as the maintenance of investment guidelines.

In an uncertain and unfamiliar situation such as the crisis in the euro-zone, it is also important to consider a framework for making rapid and effective decisions when the unexpected occurs. We believe it remains possible, although unlikely, that one or more countries may default on their obligations and withdraw from the single currency. We would expect such a situation to develop quite suddenly, perhaps over a weekend. Local banks in the affected country would close and a plan for a new national currency would be set out within days, in time for the banking system to open the following week. Several decisions would have to be made about the conversion rate of the euro into the new currency and how to implement exchange controls.

We would expect that, in many countries, a new currency would be substantially devalued relative to the euro. However, the risk of assets being devalued is not the only factor on which investors should focus. If a country leaves the euro and establishes a national currency, the operational ramifications could be substantial. There are several potential operational risks to manage, and investors should be aware of the processes governing transactions and their own investment decisions so that they can act quickly.

They would need to work quickly to implement the following with regard to the new currency:
• Minimise exposure if the currency is deemed likely to devalue, or exhibit high volatility, outside an investor’s parameters.
• Establish new accounts for cash holdings and foreign-exchange trading.
• Implement relevant hedges, swaps and collateral arrangements.
• Decide on any changes to permitted assets for their portfolio.
• Consider changes to performance benchmarks.

Outlining clear processes in advance will help investors to deal with this situation, should it arise, and enable them to answer important questions quickly – such as exactly how to value and trade their holdings that have been redenominated in the new currency. It is important to remember that it is not just a currency that would change; if a country withdraws from the euro, the laws governing securities issued by the relevant government could change, and some securities could fall into different or unexpected jurisdictions. Investors should therefore build in contingency plans for unexpected changes to such laws.

For now, it is instructive to consider recent progress with regard to the euro-zone. There has already been an improvement in fiscal coordination and there are moves to centralise banking regulation. However, if fiscal control is to be increasingly centralised in the future, there remain significant questions over how and whether individual countries will maintain their sovereignty, and how a single legislative authority will remain democratically accountable.

As Galbraith might have predicted, many of the solutions are bound to be considered as either disastrous or unpalatable: the question for investors is how they can best prepare for both.

Emma Du Haney is senior fixed income product specialist at Insight Investment

Topics