The break-up of the Eurozone? Implications for Australia

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14 December 2011

Hopes were high that a resolution to the European crisis could be achieved at last week’s EU summit. However, while the agreement (the fifth relating to the crisis so far) reached by European leaders contains important steps towards preventing a repeat future crisis, there are concerns that the lack of focus on resolving the immediate issues means the survival of the Eurozone in its current form is by no means guaranteed. The departure of one or more countries from the Eurozone (e.g. Greece, Portugal, Italy, Spain or Ireland) is a real possibility. Below we consider what this means for Australia.

The European crisis continues to effect financial markets geographically far-removed from Europe, and in Australia we have seen a number of European lenders retreat from the Australian loan market to repatriate funds to their home jurisdictions. An immediate impact of this retreat has been a decrease in liquidity for the Australian loan market and a potential capital gap for Australian borrowers. The crisis is also directly affecting the ability of Australian lenders to raise funds. For example, the Commonwealth Bank recently cancelled its plan for a covered bond issue due to market turmoil related to the European situation. Such consequences are expected to increase in number and severity if the crisis is not resolved soon.

The market expected an outcome from last week’s summit that would end the crisis. That outcome was not delivered, and many concerns persist. The failure to come up with a “silver bullet” could mean that the contagion effect spreads deeper into the Eurozone. While the consequences would be felt first and foremost in Europe, they will reverberate around the world, including in Australia. This will be true from both a commercial and legal perspective. On neither front will Australia be immune to the effects.

Funding and liquidity

The longer the crisis goes on, the higher the risk of a serious and extended freeze in capital markets. As ING Bank recently noted, key aspects of the break-up scenario are already being played out in the financial markets. Liquidity is drying up for Australian lenders that need to access international capital markets to fund their lending operations. A clear indication of this is the way the big four Australian banks responded to last week’s cut to the cash rate by the RBA. Credit markets in Europe are at present expensive and very difficult to access. If this continues, it is more likely that Australian lenders will pass on their increased funding costs to customers.

A prolonged credit crunch will have a significant impact on Australian companies and other borrowers. In addition to wholesale funding issues that will be encountered by Australian lenders, Australian corporates and trusts (including securitisation vehicles and REITS) may find it difficult to refinance existing debt, let alone raise debt for new projects. We have seen borrowers with significant refinancings due over the next 12-18 months come to market early to ensure that refinancing is effected well in advance of due dates. This is the prudent approach. During the GFC, too many borrowers found they had insufficient time to refinance prior to maturity dates. That lesson must be borne in mind in the context of the European crisis.

We are also likely to see a return to forward-start facilities, in order to manage refinancing risk, and an increased push by borrowers to include in loan facility documentation provisions that address the consequences of a lender becoming a defaulting lender (i.e. a lender that fails to fund or becomes insolvent). This may be of particular relevance where a lender has agreed to fund in Euro but cannot access funds.

Redenomination and other fiscal issues

If one country leaves the Eurozone, it would likely establish its own currency. This may well be accompanied by legislation that converts debts owed by that country’s nationals into the new currency at a fixed rate. A key risk here would be a rapid depreciation of that currency.

It may be thought that such a scenario would have little effect on Australian corporates. However, despite the Eurozone crisis, Australians increased their exposure to Europe in the June quarter and according to Credit Suisse, there are a number of ASX 200 companies with significant exposure to the Euro. Some of those exposures no doubt relate to countries most likely to exit the Eurozone – Greece, Portugal, Spain and Italy. Thus, any redenomination scenario could adversely impact a number of Australian companies.

To help minimise redenomination risk, Australian companies entering into contracts with counterparties in a country that may leave the Eurozone should aim to ensure that contracts are not governed by the laws of that country. From an Australian company’s perspective, it would be ideal if the governing law is the law of an Australian jurisdiction. However, commercially, this may be difficult to achieve. A viable alternative which should help mitigate the risk of redenomination may be English or NY law. Of course, advice from lawyers in those jurisdictions should be obtained.

In addition to redenomination risk, there is also the possibility of quantitative easing in respect of the Euro and, thus, appreciation of the Australian dollar against the Euro. This could have a serious impact on Australian exporters to the Eurozone.

Material adverse change (MAC) clauses in loan facilities

If a borrower is heavily reliant on Euro revenues to repay and service debt, then (depending on the facts and the terms of the clause in question) the European crisis could potentially bring MAC provisions in its facility documents into play.

The NSW Supreme Court recently upheld the absolute discretion that lenders have in relation to suitably drafted MAC clauses (i.e. where the lender has absolute discretion to determine if a MAC has occurred), as long as they do no act unconscionably or in bad faith. MAC clauses are standard events of default in facility documentation. Borrowers should seek to ensure that MAC clauses are drafted such that they are triggered on an objective basis only, and not at the absolute discretion of the lender.

Currency swaps

Many Australian borrowers have currency swaps in place in order to service their Euro borrowings (e.g. Eurobond issues). The swap providers will need to manage their exposures under such swaps to ensure they can meet delivery obligations. From a borrower’s perspective, the position of its swap providers should be closely monitored. During the GFC a number of swap providers failed, leaving borrowers exposed. If the position of one of its swap providers is deteriorating, a borrower should seriously consider replacing that swap provider with a more creditworthy financial institution.

Wider context

The above discussion is indicative of the kind of issues arising from the European crisis. There also will be many other issues, not only on financing transactions and documentation, but also on commercial transactions in general. We expect these will include concerns in relation to, among other things:

  • Insolvency – with respect to counterparties in the Eurozone and, in particular, in countries that may leave the Eurozone
  • Supply chains – suppliers located in countries that may leave the Eurozone present a number of risks
  • IT – if a country leaves the Eurozone, various IT systems of companies operating in that country would likely need to be switched from the Euro

Actions

Time will soon tell if the Eurozone can pull together and implement the steps necessary to resolve the Eurozone crisis.

European companies reportedly are planning seriously for the possibility that the crisis is not resolved and countries exit the Eurozone. It is not clear that similar work is being undertaken by Australian companies, even where they have significant Euro exposures.

Britain's bank regulator, the Financial Services Authority, has commented on the need to prepare for the risk of a country exiting the EU: "Good risk management means planning for unlikely but severe scenarios and this means that we must not ignore the prospect of a disorderly departure of some countries from the Euro". Given what could be at stake, now is the time to consider the perils and impacts of a prolonged Eurozone crisis and put in place strategies to manage these risks.




The content of this publication is for reference purposes only. It is current at the date of publication. This content does not constitute legal advice and should not be relied upon as such. Legal advice about your specific circumstances should always be obtained before taking any action based on this publication.


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