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How To Play This European Giant’s Double Economic Downside

|Includes: iShares MSCI Germany ETF (EWG)

by Martin Denholm, Managing Editor, Smart Profits Report

Grab a Weizenbock… this could get ugly.

Having already hit the skids, Europe’s top economy may soon be about to barrel headlong into the crash barrier.

Beyond the nasty headline figure that showed a 2.5% first quarter GDP contraction for the Eurozone economy was a more stomach-churning number.

Germany, the world’s fourth-largest economy (having recently been overtaken by China) was in serious backpedal mode, recording a 3.8% GDP drop. As I reported here last week, it was the country’s worst quarterly performance since 1970 and meant that over the past three quarters alone, it has wiped out all the gains made since 2005.

But anyone thinking that this has signaled a bottom for the German economy could be in for a surprise. The country is actually in the midst of a poisonous economic “double-whammy&a... that could send it - and the broader Eurozone - into an even bigger mess.

Germany Follows Japan Down The Rocky Export Road

For many years, Germany has held the honor of being one of the world’s biggest exporters.

In fact, exports make up about one-third of its GDP growth and are thus a critical part of the country’s economic fortunes. Perhaps too critical.

While you won’t find Germany’s main political parties calling for a change to the country’s business model, others have argued that the nation has become too reliant on exports.

For example, ETF Trends reports that net exports accounted for a massive 60% of growth between 2004 and 2007. However, with the German government projecting a drop of almost 20% in its export market this year, it says this will consequently send overall GDP down by 6% this year (although the European Commission forecasts a tamer 5.4% fall).

This is a road already well-trodden by Japan - as I covered last week - and fellow export-heavy “Big 5″ country China would do well to take note of such perils, too.

It will also see Germany’s budget vault from a balanced level in 2008 into a deficit equivalent to 6% of GDP in 2010.

In an attempt to haul Germany out of its worst postwar recession, German Chancellor Angela Merkel has proposed a $112 billion economic stimulus package.

But what throws this already severe macroeconomic situation from “bad” to “worse” is the dire state of the country’s banks…

Germany’s Twist On The “Bad Bank”/Toxic Asset Sideshow

In addition to its $112 billion worth of economic relief, the German government is on the hook for billions more to bail out its ailing banks.

Under a recent government plan, banks will be able to offload any assets that they can’t sell into a separate account, supported by another fat chunk of German government money - 200 billions euros ($280 billion), to be exact.

But German politicians are just as crafty with their wording as others. A distinction made in the proposal notes that this is not a version of buying so-called “toxic assets.” No, sir… banks themselves and weary shareholders are still on the hook for those.

Nor is Germany setting up a central “bad bank” to deal with the mess.

I couldn’t actually find a handy phrase to sum up Germany’s plan. So I guess we’ll just have to go with boring old “state funding.”

What the plan does call for, however, is the forced nationalization of any bank whose mess threatens the entire financial system - a so-called “expropriation&a... law.

Either way, it could all be about to blow up in Germany’s face…

Set To Blow “Like A Grenade”

Being the disciplined nation that it is, Germany is more wary of pumping in stimulus money at the rate the U.S. and U.K. have done. But it’s a strategy that it may have to re-think, given a harrowing prediction from the country’s financial regulator.

The Daily Telegraph reports today that BaFin projections call for bank write-offs may hit 816 billion euros ($1.1 trillion). That’s double the total reserves of the entire country’s financial institutions.

Makes that 200-billion euro “safety net” fund seem kind of weak, doesn’t it?

Nevertheless, BaFin advises banks to take advantage of the relief program, otherwise the country faces its toxic debts blowing up “like a grenade” if credit rating agencies issue damaging downgrades that would pressure an already fragile system.

Stating that, “We are pretty sure that within a month or two, our banks will feel the full force of the sharpest recession ever on their credit portfolios,” BaFin says market forces will “kill” endangered banks that attempt to survive without the government protection.

The International Monetary Fund has also weighed in, stating that with European institutions having written off less than 20% of an estimated $900 billion worth of losses by 2010, an American-style “stress test” is needed for Europe’s banks.

And as we all know, a bank stress test cures everything!

Either way, this is a politically sensitive issue, as well as an economic one, with German elections coming up in September. Some have accused the government of trying to slap Band-Aids over the cracks, rather than letting market forces get rid of the dead wood that is dragging the economy down.

And this situation, coupled with the similar drag that Germany’s beleaguered export market is having on GDP growth, could continue to stifle the country for some time.

You can play German downside in a quick and easy way, using the ETF that represents the price and yield performance of German stocks - the iShares MSCI Germany Index (NYSE: EWG). In addition to shorting EWG through the regular stock, you could also buy put options on it.

Best regards,

Martin Denholm

Disclosure: No positions