Wednesday, April 25, 2012

Six-cylinder engine splutters - German economic outlook

Although still flirting with a technical recession, the German economy should remain the bright spot of the Eurozone. However, it could be time for a new reform agenda.

At the end of last year, the German economy had finally lost its immunity against the Eurozone sovereign debt crisis and joined the pack of contracting economies. German GDP dropped by 0.2% QoQ, the first contraction of the economy since the end of the recession. Despite a disappointing fourth quarter, the year 2011 was one of the best performing years in terms of GDP growth since German reunification.

The first months of the New Year gave rise to hopes that the fourth quarter was just a brief stopover. However, the February freeze spoiled the party, sending the construction sector down by almost 20% MoM. Instead of experiencing a quick rebound, the economy is still flirting with a technical recession. Any catching up of the construction sector in March and the overall rebound in industrial production would have to be impressively strong, to return the economy into recession-free territory already in the first quarter.

Looking ahead, confidence indicators still point a very optimistic picture of the economy. Most leading indicators have been on the rise since late-2011 and their overall levels still point to solid growth. However, with the increasing discrepancy between the soft and the hard data gives rise to fear that the outlook for the economy is more nuanced than during the last years. The exuberance of 2010 and 2011 will make room for more realism and lower expectations.

The good news is that Germany should remain the showcase of the Eurozone economy. The country does not suffer from internal imbalances and consequently no imminent cleaning up works. There are a couple of unique selling points of the German economy: i) the risk of a credit crunch is relatively low. Contrary to many European peers, German banks have not, yet, tightened their lending conditions. Due to restructuring during the early 2000s, German companies should be well prepared with cash or internal financing as the most likely alternatives to bank financing; ii) low inventories and still high backlog orders are an important safety net for the industry, ensuring production even if demand for German products weakens; iii) export diversification, both in terms of product specialization and export destination, enables German exporters to benefit from almost any recovery on this planet. In 2011, three out of the five most German important trading partners were actually countries outside the Eurozone; and iv) the often mentioned solid economic fundamentals, recent wage increases and house price increases should support domestic demand.

At the same time and as in real life, however, unique selling points are no guarantee for success. In fact, there are clear limits to positive surprises. As even main trading partners from the Eurozone core are starting to engage in austerity measures (France and the Netherlands), the sovereign debt crisis is coming closer to the German borders. Moreover, with high energy prices, a cooling of the Chinese economy and a still rather anaemic US recovery, the growth impulse from non-Eurozone demand could disappoint. On the domestic side, the housing market could become an important growth driver. However, hopes for more domestic consumption on the back of higher wage could easily be disappointed. As German exporters have already been squeezing their margins to secure market shares, wage increases as the 6.3% over two years for public workers are unlikely to materialise in the tradable sector. For the entire economy, wages should hardly outperform headline inflation in the next two years.

In sum, even at a slower pace, the German economy should remain one if not the only bright spot of the Eurozone. With GDP growth rates of 0.8% this year and 1.6% next year, the economic slowdown should not be a cause of concern. At least in the short run, the slowdown should simply be part of growth stabilisation at high level.

For the medium term, however, the current slowdown should be a first reminder that all good things can come to an end. The rapidly ageing population will put significant downward pressure on German trend growth in the next two decades, it will not be sufficient to simply rely on the structural reforms of the mid-2000s. In fact, a new reform agenda to transform the current growth model into a knowledge-based economy, focussing on education and innovation, consumption taxes and higher employment, could help securing the leading economic position.

With a lack of domestic imbalances and no pressing cleaning up works, the German economy remains the six-cylinder growth engine of the Eurozone. However, particularly Germans should know very well, that regular maintenance services with some reparations are always better than paying the costs of a total loss when it is too late.

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