Be prepared Four in-depth scenarios for the eurozone and for Switzerland

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1 Be prepared Four in-depth scenarios for the eurozone and for

2 Introduction The Swiss economy is cooling down and we are currently experiencing unprecedented levels of uncertainty in the eurozone. The potential political and economic outcomes that will emerge from the eurozone crisis in 2012 are not clear, although all share a similar theme. A harsh adjustment to a new fiscal reality will be unavoidable, regardless of the path politicians finally decide to follow. But what are the impacts on? How it came to this The roots of the crisis go back to the euro s inception in 1999, and two underlying problems that have gone unchecked. 1. There has been a build-up of government and private sector debt without any sanctions from the Stability and Growth Pact. Now, most of the European countries are heavily indebted and will show a deficit in 2011 (see figure 1). 2. The eurozone countries have developed large differentials in their competitiveness (see figure 2). Fig. 1: European and Swiss government debt and deficit 2011 High debt High deficit Ireland 100 Belgium UK France Government 80 deficit Austria Spain (% of GDP) Cyprus Netherlands Moderate debt High deficit Greece Portugal Italy Gov t debt (% of GDP) Source: IMF, axes refer to Maastricht limits High debt Moderate deficit Moderate debt Moderate deficit In addition, before 2009 countries could lend money at similar rates to Germany irrespective of a country s debt level and ability to pay. As a result, many countries borrowed too much, which they are now struggling to repay. Fig. 2: Competiveness ranking, 2011 World Ranking Source: IMD, World Competitive Ranking France Germany Greece Italy Portugal Spain The question remains as to how this crisis will end. Will the eurozone survive? And if it does, in what form, and at what economic cost? PwC has developed four potential scenarios to help address these questions and we will show what implications we see for the Swiss economy. Scenario 1: Monetary expansion The European Central Bank is given the go ahead to inject significant liquidity into vulnerable economies and banks. Recession is avoided, interest rates are kept low in the short term, but inflation rises well above the 2% target, while the euro depreciates. Scenario 2: Orderly defaults A programme of voluntary defaults is agreed for the most indebted countries, which triggers a contractionary debt spiral and a prolonged recession, lasting between 2 and 3 years, resulting in a cumulative loss in GDP of around 5%. Scenario 3: Greek exit Greece is compelled to leave the eurozone, and then suffers a sharp deterioration in its economy, a rapid depreciation of its new currency and an inflation spike. The eurozone seeks to protect its currency through tough fiscal discipline and other measures to increase investor confidence, but still suffers a recession that lasts for up to 2 years. Scenario 4: New currency bloc A Franco-German acknowledgement that the existing eurozone is unsustainable paves the way for a new, smaller and more tightly regulated currency bloc. We expect the new euro to appreciate dramatically and for the new bloc to benefit from a boom in domestic demand. Economies that are excluded suffer a sharp currency depreciation and a severe economic slump.

3 Scenario 1: Monetary expansion What is the impact on the Swiss economy? Strong monetary expansion of the European Central Bank (ECB) would have the toughest impact on the Swiss economy. In this scenario eurozone leaders agree to pursue an expansionary monetary policy in response to the escalating crisis. We assume that there is a political commitment to save the euro and recognition that a mix of quantitative easing and structural adjustment would be necessary. The monetary stimulus would come as a shock to investors and they would sell euro assets causing the euro to depreciate. We estimate that this depreciation could be around 20% against the Swiss franc. An exchange rate close to parity would lead to shrinking margins for the Swiss export industry and potential mid-term growth rate would tend to be below zero and cause a strong recession for the next years. This would all happen if the Swiss National Bank (SNB) did not intervene. Fig. 3: Projected inflation after monetary easing CPI Inflation (%) Eurozone Source: Eurostat, PwC projections Policy actions of SNB In September 2011 the Swiss National Bank undertook to maintain the exchange rate at a lower limit of 1.20 EUR/ CHF. We assume this commitment to weakening the Swiss franc will be maintained at any cost. The package of intervention would consist of two key elements, although only one is still available: The SNB has reduced the target range for 3-month libor from to , so there is no additional space to lower the short-term interest rates. The SNB could boost additional liquidity in the Swiss franc money market over the next few months. Economic outcomes The costs for the Swiss National Bank to defend the exchange rate target would be immense and the additional liquidity in the market could lead up to double-digit inflation. But we suggest in relation to a historic observation that the impact would be not that strong and inflation would remain between 5% and 6% so it could be more or less under control (see figure 3), however, only under the assumption that the euro will be stabilised, the US will start to reduce its debts and commodity prices will return to normal levels. Exports will slow down within the next few years and only marginally recover. The Swiss austerity measures would mean that even against an inflationary backdrop exports would struggle to grow in the coming years. The SNB would need to restore its credibility and slow down the anticipated inflation in the medium term. This would only be achieved through a prolonged period of increased interest rates and a correspondingly lower potential growth rate than in the 2000s. We view this as a relatively harsh intervention by the SNB to defend the Swiss franc and it could come at the expense of lower medium-term growth prospects. Table 1: Outcomes for Scenario 1 (% change) GDP growth Inflation Source: PwC projection

4 Scenario 2: Orderly defaults In this scenario eurozone leaders negotiate a one-off debt restructuring for countries with very high debt defined in this scenario as debt to GDP ratios greater than 100%. We assume that there would be a 50% default on Portuguese and Irish sovereign debt and a 25% default on Italian sovereign debt, in addition to the 50% default already announced on Greek debt. In parallel, leaders would agree a package of measures to partially insulate the rest of the eurozone from a damaging collapse in confidence. Additionally, we assume that countries will fall into a strong recession and would be required by treaty to implement a programme of fiscal austerity to restructure their debts. The resulting economic contraction would be hardest felt in countries with banks strongly exposed to the restructured bonds: Italy, Greece, and Portugal. These economies would additionally have to implement austerity measures, exacerbating the contraction. and the Swiss banks have low exposures compared to other European countries against indebted countries. The Swiss principal trading partner is the eurozone which is the destination for around 60% of its exports. A strong recession in the eurozone as predicted in this Scenario of orderly defaults would lead to lower exports and would weigh down the Swiss growth prospects for 2012 and beyond. The scale of the crisis highly depends on how severe the subsequent credit crunch in is. The exposure of the Swiss banks to Greece, Portugal and Ireland is comparatively small and default would have a small impact. Moreover the Swiss banks have one of the highest Tier 1 capital ratios within the European countries and are definitely sufficient capitalised. Table 2: Swiss bank losses assuming defaults on Portuguese, Irish, Italian, Greek and Spain debt (m USD) Greece Ireland Italy Portugal Spain Total Banks 1,124 4,474 9, ,862 26,642 Public institutions , ,477 8,561 Source: Communication of SBVg about debt crisis of the eurozone, November 2011 Fig. 4: Swiss export statistics % 20.6% 6.2% 58.6% 25.2% 5.3% 10.1% 13.1% 32.9% 13.4% However, exposure to Italy and Spain is much greater and bank losses could lead to a severe restriction of credit within. Therefore, it depends highly which countries default and to what extent. If the credit crunch would flood over into the SNB will have to take measures to recapitalise the Swiss banking system in the same way as it did during the financial crisis. We do not expect much capital flight but possible spill-over effects are difficult to predict. This scenario could lead to a depreciation of the euro in the low percentages. After the orderly defaults we assume the eurozone and the Swiss economy would recover. Total EU (27) Asia USA Rest of the World Source: Germany Italy France UK Spain Rest of the EU (27) Table 3: Outcomes for Scenario 2 (% change) GDP growth Inflation Source: PwC projection

5 Scenario 3: Greek exit A combination of domestic pressure and a loss of patience by other eurozone members precipitates Greece s exit from the eurozone. The short-term impact on Greece would be a sharp deterioration in its economy led by rapid depreciation of its new currency and a spike in inflation. The long term benefits to Greece would depend on its ability to sustain a competitive advantage and build credibility in its institutions. The direct impact on the eurozone from Greece s exit would be small. However, the eurozone would need to act decisively to prevent contagion spreading to other vulnerable economies and restore investor confidence in the euro. A Greek exit, as explained in this scenario, would have a marginal impact on the Swiss economy and banks which have just a minimal exposure to Greek bonds compared to other countries. Fig. 5: Claims of foreign banks in Greece (in million US dollars) A Greek exit could have, in the long run, a positive effect on the eurozone as the continuing burden of bailing out Greece would be removed. This could strengthen confidence in the euro, although this is not guaranteed. An exit could also arise fear of further exits from the eurozone. The immediate effect of a Greek exit would include bank losses and some capital flight as investor confidence would be shaken. would not be immune to the impact of a Greece exit and a subsequent slowdown. But we estimate that these impacts would be relatively short lived and the euro would appreciate, resulting in a weaker Swiss franc strengthening Swiss exports. Table 4: Outcomes for Scenario 3 (% change) GDP growth Inflation Source: PwC projections 27.2% 8.0% 6.4% 2.1% 2.5% 21.3% 32.5% Germany France Italy Portugal UK Rest Source: BIS Quarterly Review, December 2011

6 Scenario 4: New currency bloc A Franco-German acknowledgement that the existing eurozone is unsustainable paves the way for a new, smaller and more tightly regulated currency bloc. The new bloc benefits from an inflow of capital and a boom in domestic demand but loses competitiveness. Economies that are excluded suffer an economic contraction in the short-term and an uncertain future. Fig. 6: Possible members of the new currency bloc The last scenario, in which a new euro bloc is formed, would lead to a depreciation of the Swiss franc against the new euro as it adjusts to reflect the economic strength of the strong northern eurozone countries. We expect that the new euro exchange rate would be permanently higher than today (between 15%-30%) with key trading partners. This would boost Swiss exports and the economy, helping it reach a growth rate of around 2.5% next year (table 5). However strong depreciation could cause inflation. Countries that exited the eurozone and are not part of the new bloc would face difficult challenges for the coming years. The currency of these countries would swiftly depreciate. They would then face the long, hard challenge of individually reconstructing credible fiscal and monetary institutions and establishing credible new currencies. The success or failure of each country would depend on the choices that their leaders and citizens make. All would suffer in the short term as they adjust to a weaker currency, higher interest rates and fiscal contractions. In the long term some countries would thrive in a low cost exporting environment unconstrained by a strong currency, while others would not do so well. Table 5: Outcomes for Scenario 4 (% change) GDP growth Inflation Source: PwC projections

7 Conclusion Expect surprises this year. There is a high probability that the eurozone will undergo fundamental changes and the future path is likely to be volatile. The impacts of these changes will be felt well beyond the eurozone. In the short term we will experience them as a result of lack of confidence, but they will also be transmitted through trade and finance. Further, it is not sure if the emerging economies will still grow at such a pace. And the economical development of the United States is another important but uncertain component. In this report, we gave you insights from a range of distinctive scenarios which we recommend our clients to use in order to prepare for potential outcomes. However, reality will most likely be somewhat a mixture of the four scenarios. Certain parts of those scenarios have already become reality, others might take place in near future but we cannot predict at which intensity they will happen. The European Central Bank (ECB) already buys bonds of indebted countries continuously and at moderate level to stabilise the system. The European finance ministers agreed to a second Greek bail-out package of 130bn. This package depends highly on the final negotiations between the Greek Government and private investors, which have to accept the default of 53.5 percent of their invested money. This will not save Greece, it will only delay a bail-out. In the long run we see an exit scenario of Greece as the most likely because the structural deficit, a high unemployment rate and a weak competitive position cannot be changed overnight. We believe that other countries would also profit from one off debt restructuring. However, this can lead to different spillover effects. As a result, a new eurozone would need to be established only including countries with similar structures and similar competitive positions. Therefore for we foresee only moderate growth over the next years. The pressure on margins due to the strong Swiss franc will continue while the demand of the eurozone will weaken. If the overall situation continues to be stable there will be a low inflation risk during the next few years and inflation should be around zero percent. We would be happy to talk to you in detail about these scenarios, how they could impact your business and what measures you can take to prepare yourself. Contact Dominik Tiedt Head of Research Tel Reto Brunner Head of Business Restructuring Tel PwC. All rights reserved. PwC refers to PricewaterhouseCoopers AG, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity.

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