Germany: Pulling a Slow Train

A new growth locomotive amidst cyclical headwinds

Germany could well be on the way to becoming the new growth locomotive in Europe. The phase of underperformance in terms of GDP growth, which has plagued Europe’s largest economy for years, is clearly over. We forecast the German economy expanding on par with the euro area next year. In both cases, we forecast a noticeable slowdown in growth to around 1.5% on the back of slower global growth, a stronger currency, and tighter credit markets. But, contrary to previous downturns, the German economy will likely master the coming dip better than many of its neighbours. More generally, Europe could see a fundamental shift in its economic landscape in the coming 12 months. Yet the German growth locomotive might be pulling a slow train given the global headwinds that are gathering momentum.

End of easy credit to shift European growth pattern

A fundamental shift in the pattern of growth across Europe could be brought about if the current credit market crisis results in an outright credit crunch. As the credit super cycle goes into reverse, countries that have benefited from a major balance-sheet extension of their private sectors on a combination of rising asset values, lower interest rates, and higher debt levels will find it tougher to grow their economies. Thanks to record corporate profits, an elevated savings rate, and improving government finances, the reliance of domestic demand growth in Germany on credit has been limited in recent years. While this has made for a challenging environment for the domestic banking industry, it turns out to be a blessing going forward.

Germany does not rely on credit to grow

We estimate that more than 90% of investment spending in Germany is financed internally by corporate earnings or depreciation allowances. In other words, hardly any investment spending relies on external financing. In the euro area, by contrast, only 74% of investment spending has been financed internally. In Italy and France, about 60% of investment spending has been covered by internal funds; in Spain, less than 50%. In addition, German household debt hasn’t budged in the last decade, though it remains elevated by euro area standards. By contrast, in the euro area as whole, the share of household debt in GDP rose by 18 percentage points over the last 10 years. Because of Germany’s strong internal corporate financing and stable household debt, bank lending growth had almost come to a standstill, thus falling short significantly of the double-digit growth rates recorded in the euro area as a whole.

Competitive position remains strong

In addition, the heavy corporate restructuring and cost-cutting of the last few years puts German companies in a better position than many of their European competitors and makes it somewhat easier to absorb the pressures of a stronger euro. Germany is the only industrial country that hasn’t lost market share in global goods markets to new competitors in emerging markets. According to the WTO, Germany was again the largest exporter of goods globally in 2007. We feel that most of the pressure from the appreciation of the euro in the course of this year will likely end up in profit margins rather than result in weaker overseas demand directly. Together with concerns about tighter credit conditions, this is why corporate investment spending on machinery, equipment, and structures is likely to take a hit. In Germany, the tighter depreciation rules introduced by the corporate tax reform that will become effective at the beginning of the year will temporarily add to the downside pressures on investment spending.

Wage developments are a risk

In the face of slower growth and a cyclical deceleration in labour productivity growth the coming wage round constitutes a risk for corporate profitability and employment creation in Germany. After many years of wage moderation, trade unions are starting to make more substantial wage demands. To some extent, this started last year. But this year, there won’t a big reduction in non-wage labour costs to offset part of the pay rise from a labour cost point of view. In the course of the last year, we saw the negative wage drift, caused by effective wage increases falling short of negotiated pay rises, disappear. This, in my mind, is a clear sign of the shift in wage bargaining positions in Germany. The employment dynamics have remained favourable and, at least so far, companies haven’t started to scale back significantly on hiring intentions.

Labour market reforms reverse gears

Dark clouds are emerging on horizon of the labour market, though. On several counts, hard-won labour market reforms are partially being reversed. For starters, the period over which unemployment benefits can be drawn will be extended for older employees. In addition, minimum wages, which are about to be introduced in the postal sector, are likely to spread to more sectors in the new year. Finally, the notion of a national minimum wage seems to be gaining support amongst policy makers. The introduction of minimum wages, which so far did not exist, marks the end of political innocence in German labour relations. The German constitution stipulates that the government leave wage negotiations to workers and employers represented by trade unions and employer federations. In exchange, political strike action against structural reforms, common in other European countries, is outlawed. Going forward, we expect wages to become a topic of political debate, and trade union protests against government politics a regular occurrence.

Finally, a look back

A year ago, many forecasters were fretting that a three-point VAT hike and the accompanying fiscal tightening would derail the nascent recovery in Germany. I took the contrarian view, that the economy should be able to withstand the headwinds. My relatively optimistic forecast turned out to be too pessimistic. Like the euro area as a whole, the deceleration in headline GDP growth from 2.9% to 2.6%, was ever so slight. But as yet another splendid year for the German economy draws to a close, I find myself being more worried about the medium- to long-term outlook than I was a year ago. And it is not because of the potential repercussions of the US recession, the stronger euro, or the credit crunch on the near-term cyclical outlook. It’s because, in my view, the reform pendulum has started to swing to back.

By Elga Bartsch London
Morgan Stanley
December 16, 2007