Euroweek Germany report: How and why Germany is the economic engine of Europe

Euroweek Germany capital markets report, April 2013

Nobody would suggest Germany is enjoying its best economic performance right now, but it remains both the outperformer of the Eurozone and its vital engine room.

As discussed in the macroeconomic chapter, Germany suffered a weak fourth quarter, with a contraction of 0.6% over the previous quarter. But economists expect better performance in the year ahead, and certainly in 2014.

They vary on just how much they expect, and the numbers are never impressive, but they are at least universally positive. At the bottom end, Deutsche Bank expects 0.3% growth in 2013 (economist Barbara Boettcher says that, given demographic pressures, “anything around 1.5% GDP growth implies Germany is almost exhausting its growth potential”); Stefan Bielmeier, chief economist at DZ Bank, expects 0.5%, before an improvement in the second half of the year that will be visible in GDP growth numbers in 2014; Reinhard Cluse, chief economist for Europe and Emerging EMEA at UBS Investment Bank, says 0.8%; Gernot Griebling at LBBW expects 1% growth, provided emerging economies hold up well; and Ralph Solveen at Commerzbank expects 1% growth this year and 2.5% in 2014. He calls for “a significant positive reading in the first quarter, in contrast to many countries in the euro area, especially the peripherals.” And he is not alone. “Sentiment indicators are suggesting that German GDP should turn positive in the first quarter,” says Janet Henry, chief European economist at HSBC. “It’s hard to be confident of that anywhere else in the Eurozone.”

So: not great, but comparatively impressive. What’s clear, though, is the symbiotic relationship between Germany and the rest of the Eurozone. Peripheral countries need a strong Germany as the engine to keep the broader EU moving; Germany needs stronger neighbours because its economy is heavily tied to exports.

Henry notes that the Bundesbank “isn’t particularly gung ho” on its estimates for long-term potential growth, expecting just over 1%, “which is quite a downbeat forecast,” she says. “There are years when Germany grows at a significantly stronger rate than that – 2011 was over 3%. In years when the world trade cycle is growing very rapidly, you will see Germany growing much faster, but it also means it is very vulnerable to any weakness in global demand.

“It’s still a cyclical economy; domestic demand and, in particular, consumer spending, do remarkably little,” she adds.

And this is why the rest of Europe matters so much. “If the economic situation in Europe outside Germany is a lot weaker than we expected, it will have an impact on Germany too,” says Cluse at UBS. “Germany will remain an outperformer but will suffer with a weaker external environment.” And that is exactly what was happening in 2012. “The German export sector is suffering from the euro crisis,” says Bielmeier at DZ Bank. “Most European countries are in recession so demand for German products has declined. As a result, exports are pretty weak.”

The corollary is that, in this slightly brighter start to the year for the Eurozone, any positive news about the euro is also positive for Germany confidence and, hence, investment and the economy. “If you picked up the German newspapers one year ago, every day you would have found articles about the euro breaking up,” says Solveen. “You will hardly find anything like that in the papers now. The uncertainty has been reduced and you will see a pickup of investment again, which was the weak part of the German economy last year – it fell for five consecutive quarters.”

Just how reliant on exports to the Eurozone is Germany? Gernot Griebling at LBBW puts the Eurozone member states at 37% of total German exports in 2012. That’s certainly significant – viewed as a single economic bloc, it’s the most important – but it’s not as high as it once was: the Eurozone used to account for 50% of German exports at the time the euro began. “This portion is shrinking, and I am sure this is likely to continue,” says Griebling. “Germany was successful in offsetting the negative impact of the euro crisis, especially for exporters, as German corporations are extremely successful in the emerging economies.” He says that, elsewhere in the developed world, exports to the US grew by 17% year on year in 2012.

Others agree. “If you take the euro area as one market, it’s the most important for Germany, but the share has shrunk significantly and others have increased,” says Ralph Solveen at Commerzbank. “If you look at the peripheral countries, the share is around 10% of German exports. That means many other markets are much more important for Germany: Eastern Europe and Asia, for example, both have a higher proportion than the peripheral countries. The influence of the weak peripheral countries on the German economy is rather limited.”

And Barbara Boettcher at Deutsche Bank notes how “export orientation is focusing on faster growing emerging markets. The product portfolio in Germany exactly fits the needs of those markets: investment products to back the catching-up process. These products entail high technology and are not very price sensitive which makes German exports more resilient to the depreciation of the euro.”

The suggestion is, then, that although Germany’s economic fortunes are clearly intrinsicly linked to the health of the rest of the Eurozone, there has at least been some success in achieving export diversification.

[Subhead]Europe’s safe haven

While a weak Eurozone hampers exports, it does cement Germany’s standing as a safe haven, something which grew stronger still after the UK followed the US and France in losing its AAA rating. Other top-rated countries do exist in Europe – Finland is one – but none has Germany’s depth and liquidity.

This has certain advantages, most obviously that the cost of borrowing has become absurdly low: 10-year yields were at 150 basis points at the time of writing, reinforcing Germany’s position as Europe’s economic engine since it has ready access to cheap funding whenever it needs it. If Germany ever reaches a time when it can’t borrow, then nobody else in the world is likely to be able to either.

While marvelous for the state treasury, it hasn’t been so great for investors. “The impact on capital inflows was that two year Germany bond yields became, in nominal terms, negative by the summer of 2012,” says Griebling. “When you go to university or look in a book you are told this is impossible, but German bund yields for two years were minus 0.1 or 0.2% by last summer. Nominal yields are the lowest since the era of Bismarck, 140 years ago.”

It’s an imbalance with the rest of Europe, and one that became particularly acute last year, but there is little one can do about it: investors are highly astute at analysing the health of an economic balance sheet and Germany’s looks better than any. “Germany obviously is a safe haven economy, that’s why its interest rates are so incredibly low,” says Henry at HSBC. “The ECB, with its commitment to OMT [Outright Monetary Transactions, the purchases of secondary sovereign bonds], has tried to ease fragmentation in the Eurozone but both the price and availability of credit are still major problems in the periphery. Germany is one of the few economies in the Euro area not facing any kind of credit crunch.”

There seems little threat to Germany’s AAA status. “The rating of Germany is in my view rather stable, driven by the business model of the German economy which still depends mainly on the industrial sector,” says Bielmeier at DZ Bank. “The fiscal position has improved significantly in the last two years because of a very strong performance in tax income. It’s visible in borrowing costs and in the performance of the bond markets overall here in Germany.”

The relative strength can’t last forever, but despite recent flows into peripheral countries, there is still a lot of appetite for safety. “Germany’s safe haven status will continue, although international investors can’t put all their money into Germany,” says Henry. “Further down the road, as the Eurozone makes further progress on integration, you would expect German rates to be higher as peripheral rates fall, but that’s not going to be a major theme in 2013.”

Bielmeier adds: “Definitely if the euro crisis comes to an end, then the safe haven status might lose a bit of its attraction, but overall the bond market in Germany should continue to benefit from the very high structural performance of the country.”

In fact, funds have been coming out of Germany and into peripheral markets, as risk appetite has begun to return in 2013, and Spain in particular has begun to look like it might survive the crisis in reasonable shape – while still offering attractive yields. But what’s interesting is, German yields haven’t budged a bit despite the movement of capital. Germany doesn’t necessarily suffer just because money goes into peripheral states, because the fact that it does so implies greater health in the Eurozone, which only strengthens Germany’s economy.

So where next? “From the bond market perspective, this is a safe haven, and has the credibility to remain one,” says Cluse. “Investors have to ask two questions: what happens when the world recovers and global allocation spins back to equity and risk assets? Then there might be room for bond yields to rise, including Germany. And the other is if European integration continues and more of the burden is put on Germany’s shoulders, there might be elements of mutualisation of debt that could hurt the bund market.”

Mutualisation of debt, should it occur, might really test Germany’s relationship with the reminder of the Eurozone. The theory is that by pooling government debt, the weakest countries in the European Union are shielded from the panicked flight of capital that we have seen in the darker moments since 2009. The argument against it is that it brings moral hazard, higher costs for creditor countries, and arguably doesn’t solve the problem anyway. Mutualisation warrants a whole other article, and in any case, few in Germany believe it is on the near horizon; as Cluse says, “Proper mutualisation isn’t coming any time soon.”

And Windels argues that a rating is not the whole point anymore. “The role of the rating is not so important today as it was two or three years ago,” he says. “The first move, from triple A to double A plus for the US, caused no market reaction. It’s not so important to have triple A in France: it’s better to have it, but if you have no-one with a triple A, or a very small segment, the benchmark just becomes AA+.

“Today investors are used to looking for different arguments for the bonds they want to buy: [in France, for example:] what is the plan for higher productivity levels, to reduce public employed staff, to have a more diversified company sector, to strengthen the export base.” That may be true, but nevertheless, Germany’s rating sets it apart for a reason: it is the strongest economy and the rating agencies are correct to differentiate between it and its large peers.

[Subhead]The Surplus

Any economic analysis of Germany swiftly turns to the country’s strong current account surplus; any discussion of it in a European context notes that it would be helpful if there was rather more balance in Germany’s trade relationships with the rest of the continent. “It would certainly make it easier for the rest of the Eurozone to grow their exports a bit more quickly if Germany was growing more rapidly,” says Henry.

However, addressing the surplus is easier said than done. The theory is fine; the practice is different. “As a macroeconomist, if you look at the imbalances in foreign trade, it’s hard to see that there will be more stability in the next year,” says Windels. “You would have to look for balanced foreign trade, more consumption and more imports. I have no idea how to persuade German consumers to spend more.”

Or as Cluse puts it: “I read Martin Wolf in the FT writing that Germany needs to consume more. As an economist, I get it: it would be very helpful if you want to adjust current account balances across Europe. But it’s also an issue of mentality, and in practice it will be very difficult to get the Germans spending to generate a massive increase in demand that would help other Eurozone countries.

“On the public sector side the government is brutal about tight fiscal policy; on the private sector side, spending aggressively is just not in people’s mindsets.”

Perhaps there is not much to be gained from trying to fix the surplus issue anyway. “In an ageing country, it is to a certain extent natural that you have a surplus,” says Boettcher. “And it is rather difficult to change the surplus if you see the demand for German goods: you can’t ask other countries to stop demanding German products.”

It is perhaps better to look at it from the other direction: peripheral countries improving their own accounts with Germany. In this respect, progress is being made. “Peripheral countries such as Spain have substantially reduced their deficit with Germany in their latest current account,” says Boettcher. “Things are changing slowly, but you will never have a Germany that will experience a severe current account deficit for a longer period of time, due to our economic structure and export orientation.”

Also, some improvement in German consumption is expected, which will help those Eurozone countries that export to Germany. “You have to reckon on German wage growth, which has accelerated recently, and which is the reason for improving consumption,” says Bielmeier. “There are more than 41 million people employed here in Germany.” On top of that, he says, wage growth in Germany has been welcomed by euro area peers because it has dented Germany’s competitiveness.

Immigration is relevant here, and shows once again how the German economy is married to that of broader Europe. Economists agree that the nature of immigration has changed recently. “We have had a small rise in immigration by really educated people driven by the euro crisis,” says Bielmeier. “People from Spain and Greece have been driven to come to Germany. That’s definitely a positive development for Germany; for the other countries, it’s not such a positive. Their high-potential employees have left the country.”

Windels expects more of this, and argues that there is actually a positive impact for other countries. “We will have significant inflows from people abroad: Greece, Italy, Spain, Portugal, France,” he says. “If you have a low possibility of having more engineers in your country, you have to pay more money for them, and this will increase the wage dynamic in 2013-14: it will have a negative impact on the German companies sector, and will give more leeway for France or Southern European companies sector, and I hope a more balanced position in Europe.”

Looking at Germany’s economy within the context of Europe helps to explain why the country has committed so much to protected the euro: it is so clearly in the country’s interest that it survives.

“The big problem for politicians is that nobody knows what would happen if the euro broke apart,” says Solveen. “They have no experience for something like that. Maybe the consequences would not be as harsh as many people fear, but it would harm the German economy significantly.” Fortunately, the mood today suggests that danger has passed, and that Germany and the Eurozone can continue their mutually beneficial relationship as Europe slowly emerges from crisis.