Country Report Germany
Economic growth slowed down in 2012. Going forward, activity is expected to pick up only slowly in 2013. Long-run growth prospects remain weak, caused by the aging population and subdued labour productivity growth in the services sector. In light of the upcoming elections, no major reforms are expected until September 2013. After the elections, a minimum wage is likely to be introduced by the new government, which would be a welcome development. The fiscal position of Germany is strong but some contingent liabilities stemming from the European sovereign debt crisis and the exposure of the banking sector to Southern Europe could pose a risk. House price appreciation is not a risk to the banking sector yet, but the current environment of low interest rates could cause overshooting of real estate prices and risks a sudden slowdown once monetary conditions normalize.
In 2012, the economy grew by 0.7% y-o-y after having grown by 3.1% in 2011. The slowdown intensified towards the end of the year, with the fourth quarter recording a 0.6% q-o-q contraction. This was caused by a weakening of external demand, mainly stemming from weaker economic conditions for its European trading partners. Germany’s main source of growth was exports towards emerging markets and in particular China. For 2013, we expect Germany to continue to recover, but the growth figure is expected to be 0.5% y-o-y. On the back of its strong competitive position, the Germany economy should be able to benefit from demand recovery within Europe and the rest of the world. Also domestic demand is expected to increase since the labour market is strong, which is leading to robust real wage growth. Moreover, the private sector investment outlook amid favourable financing conditions is expected to gradually improve through 2013.
Germany’s medium- to long-term growth, however, is not bright. The IMF estimates potential growth to be around 1¼%. The shrinking labour force as a result of an aging population together with subdued labour productivity growth in the services sector are the main reasons behind the low potential GDP growth rate. Structural reforms that improve total factor productivity growth are needed to improve the long-term outlook. Introducing such growth enhancing policies is not a central topic for the upcoming elections.
The current biggest party, the Christian Democratic Union (Germany excluding Bavaria) and Christian Social Union (Bavaria) (CDU/CSU) is expected to remain in power and so chancellor Merkel will probably remain in office after the elections. It is more interesting which party will be the second one in the coalition. The current coalition partner, the pro-business Free Democratic Party (FDP) stands to take a loss and may even fail to meet the 5% threshold, which is needed to remain in the parliament (Bundestag). A grand coalition, with the Social Democratic Party (SPD) now seems the most likely outcome. A coalition with the Greens (Grüne) is also a possibility. No major changes in policies towards Europe are expected, but domestically some policies may change. This includes the introduction of a statutory minimum wage of EUR 8.50, a change for which both the SPD and the Greens are in favour. This can be problematic for small employers but it will be beneficial for domestic demand, especially since the labour market reforms of 2003 (Agenda 2010) led to a major increase in low paid and temporary jobs. An introduction of minimum wage is supported by a big majority of the public and so has a high likelihood of being implemented by the new government, especially since the CDU indicated to be in favour of a ‘wage floor’, although one set through collective bargaining instead of by bureaucrats. The introduction of such a minimum wage will be a welcome development, since it could lead to increased domestic demand. This, in turn, will help Germany’s rebalancing process towards a more domestic driven growth model.
Following the outbreak of the global financial crisis and the support given to the banking system, German public debt-to-GDP ratio increased markedly to 81% in 2010 and has been stable thereafter. During the last couple of years, the government reduced its budget deficit and in 2012 even ran a small surplus (0.2% of GDP). This was due to higher than expected tax revenues and lower interest payments, which is owing to the country’s ‘safe-haven’ status. Since the government added a ‘debt brake’ rule to its constitution –setting the maximum structural budget deficit to 0.35% of GDP– the fiscal outlook remains positive on the longer run. This projection is, however, prone to downside risks stemming from large contingent liabilities. The sovereign exposure resulting from the provided rescue loans to crisis-hit countries is about 7% of GDP (excluding implicit exposure through the Target2 claims). Should the sovereign debt crisis escalate, Germany’s public finances can weaken further and, in the worst-case scenario, the country could even lose its safe-haven status.
Another source of risk for Germany’s fiscal position is its banking sector. After the global financial crisis, the system was considerably strengthened by substantial government efforts, like bank recapitalisation, liquidity provision and the implementation of a bank restructuring act. According to the Bundesbank, the major German banks increased their tier 1 capital ratio from 8.3% to 13.6% of their risk weighted assets between March 2008 and September 2012. Also the leverage ratios of these banks (i.e. total assets divided by total capital) decreased by about 25% in the same period. German banks, however, remain highly exposed to Southern Europe, in particular to Spain and Italy. The sum of exposure to these two countries amounts to approximately 7% of GDP or 77% of total bank equity. Worsening economic conditions in Spain and Italy could therefore potentially lead to substantial losses in the German banking sector.
The low interest rate environment and high amount of liquidity is also having its impact on the banking sector. Competition between banks became fiercer, while insurers and pension funds have problems to achieve the required returns. If such an environment persists, it can lead to a shift away from relatively safe, low yield assets towards more risky assets. The current rate of house price appreciation in urban areas could be an example of this ‘search for yield’. Whether this can cause problems for the banking system is questionable, since mortgage lending standards remain conservative and were even tightened during 2012 according to the latest ECB Bank Lending Survey. Mortgage loans form 48% of the domestic loan book, which makes banks vulnerable to swings in housing prices. That said, such risks are mitigated by the low average loan-to-value ratio (70%), which is lower than the EU average (79%).