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Analysis

Germany Economic Outlook, Q4 2009

By Katharina Jungen

Executive Summary

  • Despite the pronounced uptick in growth in H2 2009, the German economic recovery will prove anemic with below-trend growth beyond 2010;
  • Unemployment will pick up significantly in fall 2009 suppressing consumption;
  • Rising loan losses are further threatening the already weak, reform-needy banking sector.

Growth

A surprise expansion of Germany’s quarterly GDP required an upward revision of the economic outlook from RGE’s July forecast. While the German economy grew 0.3% q/q in Q2 2009 on the back of strong public and private consumption and investment in construction and net exports, GDP in Q2 was still down 5.9% y/y. As a result of the unexpected economic expansion following four quarters of negative growth, RGE’s 2009 annual GDP growth forecast for Germany in July was raised to

-5.1% from the previous -6.3%. For Q3 2009, RGE expects a further expansion of German GDP, with data pointing at a quarterly increase of 0.8% q/q.

Registering 54.0, the German Composite PMI crossed the key 50-mark which separates growth from contraction for the first time in August 2009. Investor confidence has improved significantly reaching a three-year high of 57.7 in September 2009; its long-term average is 26.5. Similarly the Ifo business climate index reached 91.3 in September, its highest level in 12 months. RGE expects positive quarterly growth for the two remaining quarters in 2009 due to a combination of favorable, albeit temporary, factors. Germany’s economy is one of the most volatile in the European Union due to its excessive reliance on exports.  As a result, the German economy has proven especially vulnerable to the slump in global demand. For the same reason, Germany is currently well-positioned to benefit disproportionately from a rebound in global economic activity. Following an excessive run down of inventories in H1 2009, a restocking rally is expected to take place in the second half of the year.  A favorable carry-over effect from Q2 will have a positive influence on growth in Q3, since industrial production only started to expand in May/June. In addition, due to its “back-loaded” nature, the German stimulus will exert a much more noticeable effect on the economy starting in Q3 2009. Despite the favorable combination of strong household consumption and rising industrial production, a swift return to trend-growth is highly unlikely. The short-term economic-growth spurt triggered mostly by expansive monetary and fiscal policy as well as technical reasons will come to an end in the first half of 2010. The expiration of stimulus programs around the globe, accelerating inflation, rising unemployment, the deleveraging of the U.S. consumer and a weakening of the restocking effect will weigh heavy on the economy, setting the stage for an anemic-shaped recovery with growth rates below-trend for some years to come.  RGE’s 2010 annual GDP growth forecast of 1.2% comes with the major upside risk of a V-shaped recovery for the German economy, which requires strong, sustainable demand for German exports. In RGE’s view, this precondition will not be met within the next year.

Exports, Investment and Industrial Production

While German industrial production has recovered from its low-point in the first quarter of 2009, on an annual level the indicator was still down 17% in July 2009. In the second quarter of 2009, production only fell by 0.8% q/q following a decline of 12% q/q in the previous quarter. RGE expects industrial production to rise in the second half of 2009 on the strength of the recent rebound in orders. Still, subdued demand for capital and intermediate goods rules out robust growth in industrial production in the short-term.  Exports which make up about 50% of German gross domestic product gained 2.3% in July 2009, following an even stronger increase of 7% m/m in June.  Compared to July 2008, exports are still down 18.7% y/y. Exports are set to post their first substantial quarterly gain for six quarters in Q3 2009 in light of a rebound in global economic activity following a contraction of 1.2% in Q2 2009. Net exports contributed positively to growth in the second quarter due to the fact that imports fell at the faster rate of 5.1% q/q. Demand for German exports will determine the degree and the speed of the recovery in Germany, a factor that is likely to reinforce the authority of Germany’s export-led growth model for the remainder of 2009. Looking forward, manufacturing orders rose for the fifth consecutive month in July gaining 3.5% m/m on the back of domestic capital goods orders, indicating a recovery in the manufacturing sector.  Compared to July 2008, orders are still 20% y/y lower despite a 16% increase since February 2009. In contrast to previous months in July, the bulk of the increase stemmed from domestic demand, which gained 10.3% m/m as a result of high spending levels from the defense ministry. Ongoing inventory depletion shaved almost 2% off growth in the second quarter of 2009. Inventories are currently below their long-term averages, and a massive restocking rally is expected to start in the third quarter of 2009.Investment in construction was the only component of investment to contribute positively to German GDP in the second quarter of 2009. Construction activity is set to expand further, especially in the second half of 2009, as work on large infrastructure projects foreseen in the German stimulus plan finally begin.  Investment in machinery and equipment shrank in Q2 2009 compared with the previous quarter due to significant under-utilization of capacity, a trend which is expected to continue through 2009.

Consumption

Private consumption registered its second consecutive rise in Q2 2009. Consumption increased 0.7% q/q which represents an increase of 0.5% y/y in comparison to the same quarter in 2008. Retail sales gained 0.7% m/m in August 2009. The resilience of German household consumption, which is traditionally rather weak, helped stabilize the economy in the second quarter of 2009 despite the depth of the recession. In contrast to the U.S. consumer, German households did not rely excessively on credit or rising home prices. In addition, in recent months, consumer spending has been propped up by low inflation, summer sales and discounts, and significant fiscal stimulus measures aimed directly at the German consumer. While minor tax relief and pension hikes in July 2009 contributed positively to consumption, the cash-for-clunkers program and short-work measures have had the greatest impact on household spending.   More than 1.4 million workers were registered for short-time work in September 2009, a scheme in which employers cut working hours and the government compensates workers for the loss in salary. The short-work program helped avert massive lay-offs, thereby avoiding a collapse in private consumption. The first short-work contracts are set to expire in fall 2009 which will lead to a spike in unemployment as employers will make permanent adjustments to their workforce. The cash-for-clunkers program has been judged a big success in Germany, lifting expenditure on transport and communication, which also covers private purchases of cars by 6.0% y/y, in Q2 of 2009. The €5 billion subsidy program, which paid car owners €2500 starting in January 2009 if they agreed to scrap cars made in 2000 or earlier when buying a new one, expired at the beginning of September once two million applications had been received. Still, the positive effect on consumption is expected to last well into the first quarter of 2010 as only about a quarter of the applications have been processed so far. The German Federal Statistical Office estimates that while consumption increased 0.1% y/y in the first half of 2009, it would have declined 1% y/y without the cash-for-clunkers program. In October 2009, the Gfk’s consumer confidence index rose to 4.3, its highest level since June 2008. While consumption is likely to contribute positively to growth for the remainder of 2009, the trend is set to reverse at the beginning of 2010 due to fading stimulus measures and rising unemployment.

Unemployment

The labor market’s response to the crisis has been moderate so far when compared to other European economies, especially in light of the large expected contraction of the German economy. The seasonally-adjusted unemployment rate in July 2009 stood at 8.3%, up from 7.7% a year earlier, and is unchanged since June 2009, despite an expected 2009 annual GDP contraction of 5%. Employment was only 0.2% lower in June 2009 compared to a year earlier. Short-work schemes, without which an additional 300,000-400,000 Germans would find themselves out of work, helped delaying the labor market adjustments. Short-work schemes are expensive for employers: Unit hourly wage costs rose by 6% y/y in the second quarter of 2009, and productivity fell by 7.1% y/y. The ongoing substantial under-utilization of capacity will start to translate into wider job losses once the first short-work contracts expire in fall 2009. The level of demand will be incapable of supporting the current level of employment. Furthermore, German firms were rumored to postpone big job cuts until after the general elections, which took place on September 27, 2009, in order to ensure the election of a center-right coalition. RGE expects the unemployment rate to rise to 8.6% in 2009 and to peak at 10.2% in 2010, which represents a slight downward revision from the July forecast.

Inflation

In August 2009, the Harmonized Index of Consumer Prices (HICP) decreased 0.1% y/y, registering its second consecutive negative reading following a decline of 0.7% y/y in July. Compared with July 2009, prices rose by 0.3% m/m in August. The fall in the annual price level is due to base effects stemming from high energy prices during the summer of 2008 when inflation peaked at 3.5% y/y. The favorable energy price effect is starting to reverse and the threat of deflation has diminished, despite weak core inflation as a result of under-utilization of capacity and rising unemployment. RGE reconfirms its 2009 inflation forecast of 0.2% from July’s outlook. In 2010, inflation is expected to accelerate and reach 0.9%.

Government Spending

In order to counteract the effects of the severe economic recession, the German government has adopted two fiscal stimulus packages worth a total of €81 billion, with a total stimulus effect equivalent to 3.5% for 2009-10. Germany is among only four countries of the G20 with a “back-loaded” stimulus plan, e.g. one that plans to expend at least the same amount of stimulus in 2010 as it does to 2009. This feature is due to the timing of tax cuts in Germany (July 2009) as well as the plan’s reliance on infrastructure projects which tend to have longer lead times and are subject to bureaucratic delays, which in Germany can be excessive.  The German stimulus will therefore be felt even more substantially in 2010. Stimulus measures and automatic stabilizers will increase government spending significantly while tax receipts—in particular those from income-related taxes—are declining sharply. As a result, the fiscal balance is set to deteriorate from near-balance of -0.1% in 2008 to a deficit of 6.2% in 2010. During the first six months of 2009, government spending increased 3.5% y/y while tax revenues fell 1.1% y/y. With €86 billion of new debt foreseen in the 2010 budget, the largest in the post-war era, the public debt burden is expected to rise from 66% of GDP in 2008 to 79% of GDP in 2010. The deteriorating deficit and the decline in nominal GDP and financial-sector support measures are the main drivers behind this development. As described in more detail in RGE’s July outlook, Germany introduced an amendment to its constitution in June 2009 that will prohibit the federal government from running a structural deficit greater than 0.35% of GDP starting in 2016. After 2020, regional state deficits will be abolished. In order to comply with the stipulations of the new balanced-budget law, the German government will have to cut spending and/or increase taxes visibly starting in 2011 at the latest. 

Banking Sector

The German banking sector has proven to be one of the worst affected by the financial crisis due to its exposure to U.S.-originated toxic assets. The German “bad bank” scheme has proven unsuccessful in dealing with the toxic assets, which are estimated at €800 billion, as discussed in RGE’s July outlook.  The weakness of the banking sector is particularly worrisome in light of rising non-performing loans. Standard and Poor’s base case scenario expects domestic loan losses to reach €80 billion by 2011—3.5% of total lending. Since German banks have one of the lowest Tier 1 ratios in Europe, they will have to increase their capital ratios and/or decrease risk. Inadequate attempts to strengthen the banking sector should be seen in the context of the presidential election held on September 27, 2009, which has delayed sweeping reforms. The newly elected Christian Democratic Union (CDU)/Free Democratic Party (FDP) coalition is likely to modify the current “bad bank” scheme so that it is more in line with the approaches of the U.S. and UK.  In addition, the CDU proposed to modify the insolvency law so that insolvent banks can be forced into public administration, avoiding outright nationalization. Furthermore, the German Federal Financial Supervisory Authority (Bafin) will be vested with the right to replace managers and reorganize systemically-important banks without shareholder approval.  In lieu of these reform measures, RGE expects that the German banking sector will be lagging behind for years, thereby suppressing economic growth through tighter financing conditions.

German 2009 National Elections

On September 27, 2009, national election results showed a thin majority for a center-right coalition. German chancellor Angela Merkel will remain in office for a second term, this time around in a coalition with the business-friendly Free Democrats. While the CDU remains the strongest party in the German parliament, it posted its second-worst election result in the post-war era.  Only the significant increase in FDP supporters averted a continuation of the uncomfortable “grand coalition” between the CDU and the Social Democrats (SPD).  Many traditional CDU voters were upset with the party for adopting centrist positions, and voted for the FDP in the elections, strengthening the FDP’s position in an alliance with the CDU. In past coalitions, it was not unusual for the CDU to have four times as many seats as FDP, if not more. The newly-elected coalition is a much more balanced alliance, and the FDP is set to have significantly more influence on policy decisions.  A center-right coalition gives Merkel the chance to rediscover her radical free-reform ideas. Whereas prior to the financial crisis, reforms were aimed more at the business sector, Merkel is likely to now focus on taxpayers. CDU and FDP are promising a simplification of the tax system as well as a reduction in income taxes. Due to their strong agreement on the matter, swift implementation can be expected. A CDU/FDP coalition is in a position to push through though reforms since it holds the majority of seats in the Bundestag, the lower chamber, as well as in the Bundesrat, the upper legislative chamber, giving the party a lot of room for maneuver at least until next year, when regional state elections will take place in North Rhine Westphalia. So far it is not clear how the tax cuts will be financed, but a sizable reduction in spending on entitlement programs is likely in order to avoid jeopardizing the ongoing process of fiscal consolidation. Following a period of stagnation, reform pace is set to accelerate substantially under a center-right coalition in Germany, raising the prospect that the ailing German banking sector could finally be addressed.

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