Tuesday, December 20, 2011

Faltering but not falling

German Economic Quarterly 1Q12

The debt crisis has finally reached the German economy. Strong fundamentals, however, should prevent the economy from falling off the cliff.

The German economy was one of the last strongholds of the Eurozone in the third quarter. The economy grew by 0.5% QoQ, from 0.3% QoQ in 2Q. Compared with 3Q 2010, the economy grew by 2.6%. Interestingly, growth was much more balanced than expected, with private consumption being the main growth driver. Remarkably, often despised private consumption has actually grown in six out of the last seven quarters. Even if the growth performance is still dwarfed by the impressive export sector, private consumption has almost unnoticed become an important growth driver of the German economy.

With the latest stage of the Eurozone debt crisis and fiscal problems in France and Italy, two important German trading partners, concerns about the strength of the German economy have increased. The strong third quarter defied these concerns for the time being but the continued drop of confidence indicators has not been boding well for the future. Again, looking ahead, the one-million-dollar question is whether the last stronghold of the Eurozone will also give in, eventually pushing the entire Eurozone into a recession?

Without any doubt, the German economy is cooling off. And indeed, there are at least three major risks for the German economy in the coming months. Obviously, the Eurozone debt crisis comes in at top of potential risks. With bigger trading partners having to engage in austerity measures, external demand looks set to weaken. Don?t forget that France is Germany?s single most important trading partner, accounting for roughly 10% of all German exports. Second, a further drop in sentiment, particularly by just recently awakened consumers, could lead to a significant loss of momentum. With external demand weakening, stable domestic demand will be crucial. Finally, bank recapitalisations and restructurings could lead to a credit crunch in the coming months. According to the last bank stress tests, the two biggest German banks, Deutsche Bank and Commerzbank, have to raise more capital than previously estimated. In total, German banks will have to raise 13bn euro, instead of 5bn euro to raise their Tier1 capital ratios to the required 9% by next year.

However, even at the risk of sounding like a lay preacher, repeating the same old story over and over again, the fundamentals of the German economy are still sound and while there are three major risks, there are at least six arguments in favour of strong fundamentals: i) the absolute levels of most confidence indicators are still above recessionary levels and some indicators even rebounded recently; ii) a further stabilization of the US economy could at least to some extent offset weakening Eurozone demand as the US, not China, was the most dynamic export destination for German manufacturers since the beginning of the year; iii) latest lending data do not confirm any credit crunch concerns, yet. In fact, credit to the private sector has actually increased over the last couple of months; iv) German companies are benefitting from low interest rates as the high dispersion of bond yields across the Eurozone is also reflected in bank interest rates; v) the strong labour market is supporting domestic demand and the lack of qualified workers should prevent unemployment from rising, even if growth was to deteriorate more than expected; vi) finally, the high backlogs of companies and low inventories put a strong safety net under the economy.

If all else fails, the German economy still has fiscal stimulus as the final trump card to cushion a worse-than-expected slowdown. At least as regards fiscal balances, the German government has become a model student of the Eurozone class. Strong economic growth of the last two years has created significant revenue windfalls, lowering the fiscal deficit to around 1.5% this year and close to 1% next year. Moreover, German public finances are also benefitting from the sovereign debt crisis. The safe-haven effect on German government bonds has provided a net profit of around 9bn euro to the German government.

Interestingly, in cyclically-adjusted terms, Germany will be close to fulfilling the new European debt-break rules in the next two years. Against this background of a favourable fiscal outlook, the German government agreed on a tax relief of around 8bn euro (0.3% of GDP) for 2013. Obviously, there would be room for more, particularly given the fact that the next federal elections will be held in late-2013.

At the end of 2011, the German economy is finally feeling the strong headwind from the Eurozone debt crisis. The German export-dependence is again showing its ugly face. It would need an unexpected consumption or production boom in the last two months of the year to prevent negative growth in the fourth quarter. In fact, the impressive growth rally with ten consecutive quarters with strong GDP growth has come to an abrupt end. At the current juncture, however, German fundamentals look too sound to fear a spreading of weak exports into other sectors of the German economy. Contrary to 2008, the economy should not fall off a cliff but rather re-emerge after a soft patch. The length of the soft patch will to a large extent be determined by the management of the debt crisis. The German economy should remain the stronghold of the Eurozone. It is faltering, but not falling.

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