Europe: A Tail Risk No More

 |  Includes: ERO, EU, EZU, FXE, IEV
by: Shiv Kapoor

What is a tail risk? Put simply, it is a future risk event that has a low likelihood of occurrence in the absence of sheer stupidity. In Europe, we have seen sheer stupidity flow forth from Germany. And that leads me to believe that Europe is no longer a tail risk; it is a very real risk.

This past week we saw Germany scoff at the immediate need to provide funding to IMF; we also heard that none might be provided if the rest of the world does not chip in. We also saw Troika not closing on the Greek debt deal. We also saw Monti pushing back.

Now Papademos and Monti are both technocrats. And given that what Germany demands makes no sense, it is likely that it the long term it will conclude that it would be better to leave the eurozone, gain control over its own currency, restructure its debt and move on. The alternative imposed by Germany is far worse as it has a deeper depth to suffering and a longer duration too.

Germany is proud of the way it dug itself out of a fiscal deep hole. It did this by gaining global competitiveness and generating large trade surpluses. What it forgot is that it did not really have to go through the pain required to gain competitiveness. The EU provided access to markets. The Deutsch mark was a strong currency; the coming of the weaker euro added to Germany's competitiveness. At the same time, the euro was stronger than domestic currencies of what is now troubled Europe - their relative competitiveness was harmed by the euro. And low borrowing costs caused by misunderstanding sovereign risk made it even worse. The improved competitiveness effectively allowed Germany to export its deficits to other markets by feeding the importing markets with cheap debt. So in some ways, Germany's success has led in part to the pain in the rest of the eurozone.

To resolve this, the euro must weaken to improve competitiveness of troubled Europe in markets outside the eurozone. Expanding money supply is needed. Keeping cost of debt contained by action in secondary debt markets by ECB intervention is also needed. But most of all, Germany and other trade surplus economies need to stimulate domestic markets to create demand for goods and services produced in troubled Europe - the trade surplus countries need to give back some of what they took. One must remember that troubled Europe, except perhaps Greece, is troubled not because they borrowed too much, but because their economies contracted sharply, which led to falling tax revenues and rising social entitlements/commitments. No doubt reducing social entitlements/commitments will help in the long term, but in the short term it will not help. Besides, austerity cannot cause an economic expansion, and without an expansion there is no way out.

And now that the bill is now due, Germany is unwilling to pay or play. And as a result what was a tail risk is now becoming a very real risk. In all likelihood, Italy, Greece and some other economies may have no option other than to leave euro and restructure their debt; most likely in the second half of 2012 or early 2013 latest. The outcome would be a sharp strengthening of the euro, a loss of German competitiveness globally and a shrinking trade surplus. Ultimately, events which require more balanced global trade accounts, and perhaps even more balanced capital accounts, will occur either through the operation of market forces or voluntarily. Allowing voluntary occurrence allows the process to be managed; otherwise there will be disruptions. The risk that containable problems being exported to the engines of global growth in emerging markets is very real. If that occurs, look for weak commodities, weak EM currencies, equities and everything else, with perhaps the exception of US$ and gold. Though expect some support on commodity prices as China mobilizes its massive financial resources to support its domestic economy - this will help commodity producers, specially in Africa and Latin America.

Of course there is still hope that better sense prevails, but as of now, what was once a tail risk, is now a real risk; albeit one with hopefully a small probability of occurrence. Personally, in the absence of elected European political leadership (by this I mean political leadership for Europe not a European Nation), I'd feel far happier if the EU technocrats gained influence in managing the problem instead of Germany. Germany sees the pain, but I suspect it needs to feel the pain for a positive outcome.

In the EU only Britain spoke for itself. Others in the eurozone need to stand up and be counted; France, Italy, Spain and other large eurozone economies need to speak out loud and clear, instead of being too fearful of Germany to speak at all! France in particular disappoints with its meek leadership; the small man does not have a brave heart. It would appear that the British are once again defending France; yet again she has been occupied having failed to fight her own wars!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.