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Analysis

Germany Economic Outlook, Q3 2009

By Katharina Jungen

Executive Summary

  • RGE forecasts an economic contraction of 6.3% for 2009 and a further decline of 0.1% for 2010.
  • The banking sector is still in a desolate state, jeopardizing economic recovery.
  • Germany runs the risk of falling into a W-shaped recovery.

Growth

Further deterioration of exports and investment activity in Germany required a downward revision of the economic outlook from RGE’s April forecast. The German GDP contracted by 3.8% q/q during the first quarter of 2009, a decline of 9.9% y/y with only private consumption and government spending showing positive contributions. This fourth consecutive decline in quarterly GDP has been the steepest since 1970 and turned out to be much stronger than RGE’s anticipated 2.2% q/q contraction. As a result, RGE‘s 2009 annual GDP growth forecast for Germany in April was further lowered to -6.3% from the previous -5.1%.  The downward revision can be justified by the manufacturing sector which performed more poorly than expected. For the second quarter of 2009, RGE expects a mild slowdown in the economic contraction with data pointing at a quarterly decline of 0.8%. The German Manufacturing PMI registered 40.9 in June 2009, the highest reading since October 2008. The indicator is still well below the 50 mark, which separates growth from contraction, and the rate of its recovery is slowing. Investor confidence improved significantly in June, marking a three-year high of 44.8 and signaling expectations of a recovery by year-end. Similarly, the business climate index reached its highest level since November 2008, at 85.9. Despite the “green shoots,” RGE sees no swift return to growth potential until the end of 2011. Levels of investment and exports have fallen so dramatically that the current signs of stabilization are taking place at a very low level. RGE is not anticipating any positive growth until the first quarter of 2010 because of a steep expected increase in unemployment starting with the second half of 2009. Due to weak domestic demand, an improvement in Germany’s economic situation will depend heavily on demand from abroad.

Exports and Industrial Production

German industrial production surged by 3.7% m/m in May, the biggest increase in 16 years. The initial market consensus expectation had been 0.5% m/m. In annualized terms, industrial production was still down by 18.1% y/y in May. The exceptionally strong cutback in production can be attributed to a slump in world trade and the resulting decline in global demand for industrial products. Exports which make up about 50% of German gross domestic product gained 0.3% m/m in May after a sharp decrease of 4.8% m/m in April. Compared to May 2008, exports are still down 24.5% y/y. RGE expects exports to further increase by the second half of 2009, as the cyclical position of the world economy improves. Looking forward, manufacturing orders in May increased by an unexpected 4.4% m/m. Compared with May 2008, orders have contracted by 28.8% y/y. The recent improvements in industrial production, exports and manufacturing orders are in line with improvements in economic sentiment surveys. While the German economy seems to be stabilizing, it does so at a very low level with overcapacity still very much present.  In line with this evidence, RGE expects industrial production to decline by 17%, accompanied by an even steeper decline in exports of 20%. This contraction is larger than the fall in global trade due to Germany’s product specialization consisting by-and-large of cyclically sensitive capital goods such as cars. Companies continue to cut inventory and disinvest, accounting for this large decline.

Consumption

Private consumption declined during three quarters in 2008 to finally turn positive in the first quarter of 2009. The increase in consumption of 0.5% q/q and the relatively small decrease of 0.1% y/y came largely from two sources. One policy stabilizing private consumption has been short-work schemes. About 1.2 million workers were registered as short-time workers in May 2009, meaning that their employers cut working hours and adjust pay accordingly. Participating workers receive income support from the government.  As economic recovery is not expected before 2010, companies will start to let go of costly short-work employees which will lead to a spike in unemployment in fall 2009 when many of these contracts end. The other positive effect on consumption stems from the “cash for clunkers” program. Since the end of January, €2500 has been paid out to buyers of new fuel-efficient cars if they agreed to scrap their old ones. Most of the program’s effects have already made their impact on consumption in May by increasing auto sales in that month to their highest level in ten years, hence lifting private consumption. The government has set aside EUR 5 billion for the program and it is expected to prop up consumption until the end of the year. After that, RGE expects to see a turnaround of this effect in 2010. The end of the “cash of clunkers” program and the rising risk of unemployment will reverse the positive effect starting in the second half of 2009 with consumption turning negative.

Unemployment

The labor market’s response to the crisis has been moderate so far in comparison to other European economies, especially given the large expected drop in German GDP. Unemployment during the first quarter of 2009 stood at 8.1%, which is up from 7.7% from the first quarter of 2008. Due to the unexpectedly large fall in GDP, the unemployment forecast from RGE’s April economic outlook has been revised upward.  RGE now expects the unemployment rate to reach 8.7% in 2009 and more than 10.5% in 2010. By June 2009 the unemployment rate already increased to 8.3%.The delay in labor-market adjustment can be explained by short-work schemes in Germany and measures to limit factory layoffs, many of which will expire in the fall. Short-work schemes are expensive for employers since they increase hourly wage costs. The indicator rose by 8.4% y/y in the first quarter of 2009. In line with the assumption that growth will not pick up significantly enough by fall 2009, companies will let go of excess labor instead of just continuing to reduce work hours. Foreign sales, accounting for one-in-every-three jobs, have been hurt substantially, explaining the large drop in employment. RGE expects the peak of unemployment to be in the first quarter of 2011 after which the first improvement in the indicator will be visible.

Inflation

In June, Germany’s consumer prices remained constant with the Harmonized Index of Consumer Prices (HICP) displaying 0% y/y growth. The steep fall in the price level during recent months is the mirror image of the scenario in the summer of 2008, when high inflation rates reached a peak of 3.5% y/y due to a rise in prices for food and oil. In coming months, RGE expects a steady decline in the core inflation rate due to the larger-than-expected output gap. For the year 2009, RGE expects an average inflation of 0.2%.

Government Consumption

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.  The main components are infrastructure spending, cuts in income tax and social security contributions, tax cuts for companies, subsidies for new “green” car purchases, and one-off transfers for families. Together with other measures, the total stimulus effect is estimated at 3.5% of GDP over 2009-2010, 1% of which will take effect in 2009. Considering the additional impact of automatic stabilizers, these measures imply a fiscal balance deterioration of 0.1% of GDP in 2008 to about -4.4% in 2009 and to -6.2% in 2010. Moreover, revenue from profit-related taxes will fall steeply in the next months. The public debt burden is expected to increase from 66% of GDP in 2008 to 79% of GDP in 2010, according to the European Commission. Expected deficits are largely responsible for this, but measures to support the banking sector also played a role. Both the deficit and debt ratios violate the Maastricht Criteria as laid out in the Stability and Growth Pact. As a result, the European Commission is expected to open an excessive deficit procedure against Germany within the coming months. On June 12, the German government introduced a budget-balancing law in the constitution. As a result, the Federal government will not be allowed to run structural deficits that exceed 0.35% of GDP over the economic cycle after 2016. In order to keep up with this plan, the government will have to cut spending or increase taxes visibly starting in 2011 at the latest. This policy puts Germany in stark contrast with countries such as France and the UK which are planning on prolonging and extending fiscal stimulus programs.

Banking Sector

Since RGE’s Q1 outlook, it is has become painfully obvious that Germany’s banking sector is among the worst affected by the financial crisis due to its heavy investment in U.S. mortgage securities. Already the federal and regional governments have recapitalized a number of commercial banks and regional state-owned banks, the Landesbanken. In addition, the government adopted a “bad bank” plan to deal with the toxic assets estimated at €800 billion that the Landesbanken own.  Participation in the “bad bank” schemes—there are separate versions for commercial banks and Landesbanken—is on a voluntary basis only. For example, commercial banks can transfer their illiquid assets to their affiliated “bad bank” special purpose vehicle for a period of up to 20 years in exchange for government-backed bonds. Potential losses have to be carried by the owners of the banks and will be paid out of profits or dividends. Days before the bill was adopted, the valuation date for eligible positions was moved back from March 31, 2009 to the pre-Lehman date of June 30, 2008 to encourage banks’ participation. Banks have to write-down a 10% loss on the book value of the assets they move to the “bad bank,” as long as this action does not push their core capital below 7%. In addition, an annual compensation has to be paid to the “bad bank” out of the funds earmarked for distribution to shareholders. Participating banks have to agree to certain conditions such as limiting annual executive pay to €500,000 and participating in non-public “stress tests.” In a slightly extended scheme, state-owned regional banks are allowed to create their own banks to offload their toxic assets and whole non-strategic business operations in exchange for the state’s promise to focus on development in their regions. The state-owned banks avoided consolidation and restructuring threats due to last minute changes to the bill. Hopes remain that pressure from the European Commission will effect change in the nearer future in the Landesbanken sector. While the “bad bank” scheme keeps banks responsible for future losses from toxic assets, commentators see the scheme as not much more than an accounting trick, and do not believe that it meets the banks’ need for fresh capital. Moreover, high uncertainty about potential losses will remain for 20 years, paralyzing the banking sector.  Coupled with the voluntary nature of the “bad bank” scheme and the avoidance of public stress tests, RGE expects that the German banking sector will lag for years, suppressing economic growth through tighter financing conditions.

W-Shaped Recovery Risk

The greatest risk that RGE sees with regard to Germany’s economic future is that of a W-shaped recovery. While the economic contraction has slowed down during the second quarter, the possibility remains that fiscal policy mistakes and/or a rise in oil and commodity prices could jeopardize the recovery. Even though oil and commodity prices have fallen significantly since the start of the recession, they managed recover some losses in Q2 2009. Such unfavorable growth conditions will slow down the recovery and possibly lead to a further contraction in economic activity. With regards to fiscal policy, Germany is running the risk of suffocating the recovery with its strict deficit cap. The defecit cap will require cuts in spending or an increase in taxes by 2011 in order to comply with its conditions. Such an action during an early stage of recovery could possibly take the steam out of the upswing. Especially in light of decreasing consumption due to rising unemployment in the second half of 2009, the economy will need more support and stimulus instead of exaggerated fiscal discipline.

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