Eurozone troubles

No-one in the financial world can have escaped the excitement (if that is the right word) of the eurozone crisis. It seems that the markets have forced the bailout of Greece and now Ireland and will probably now head off for Portugal. What exactly is going on and more importantly what should treasurers do about it.

There were fault lines in the euro from day one. The euro was both a domestic currency (in that national banks issued notes and coins and these notes and coins are honoured everywhere in the eurozone) and a foreign currency (central banks could not print euros). The market assumed greater inter governmental support than was actually built in and markets being markets, manage to find the fault lines and expose them for profit. The same thing happens in equities, if the market senses trouble in a company, they sell.

While commentators differ on the outcome, the treasurer has to consider the issues that face his firm. Some say the euro cannot die and we will go to political unity, others say there was life with separate currencies and there can be life with them again.

One issue of particular interest in corporate finance is the issue of interest rates. The theorists of corporate finance considered their ideas with the concept of a risk-free rate. This concept runs through into WACC and the assessment of investments. This was always government securities. However life has become somewhat complicated for this simple idea. Firstly a firm with investments in two countries with differing risk free rates has to decide which of the two to use. One could use one or a blend according to the investment split. What then about the equity premium?

We move now to the euro and discover that there is not actually a risk free rate because no one country or central bank has the ability to print money (unlike e.g. the USA or UK) to repay its obligations. Many might use Germany’s interest rate (the rate on its government’s debt). However what if all operations are in Greece, or Ireland, where the intrinsic rate is much higher. An investment in Ireland must be riskier than an investment in Germany, because there is uncertainty over domestic demand if nothing else. But should we use the current bond yield?

A further issue is caused by inflation. Although the eurozone has had identical nominal rates, the real interest rates have been hugely different if inflation is taken into account. Germany, with low inflation, has probably had real rates, whereas Ireland or Portugal, for example, have had negative real rates. Regions in countries have had differing inflation rates before but have had fiscal transfers to deal with lack of local demand etc.

There is no answer to these issues, except that the tools of the treasurer must be applied carefully. Ranges of input variable should be used to produce ranges of outcomes so that management is fully informed.

http://www.lyddonconsulting.com/newsletter/herman-van-rompuy.pdf?utm_med...

By Will Spinney