Germany 2005 - Can the elephant gallop?
Germany, still the Eurozone’s giant, has experienced the dismal trio of contracting growth with sluggish domestic consumption and rising unemployment. Coupled with elevated oil prices and a strengthening euro, this augurs ill for the future. But with recent consumer surveys upbeat and reforms underway, can the mild recovery regain momentum? Zaki Kada reports.
The year 2004 started positively for the German economy, with healthy growth mainly driven by robust contribution from net exports (+1.2% in 1Q04, see table 2), while domestic demand remained the Achilles heel of the economy. As the year progressed, however, and global demand waned, net exports became a drag in the second half, hampering growth significantly in 3Q 04 (–1.6%). With domestic demand failing to offset the shortfall in external demand, the German economy was back in the doldrums in the second half of last year.
This year global demand may remain supportive as China continues to grow while the US is expected to do well. But in terms of external demand, as short-term interest rates rise across the globe and China applies the breaks on its overheating economy, external demand may not prove to be as buoyant as in 2004.
Despite lacklustre domestic consumption and high unemployment, German competitiveness remains favourable relative to its European neighbours, thanks to previous aggressive cost-cutting measures that boosted corporate profitability.
As the threat of outsourcing has mounted, previous taboos have been broken and Germany’s trade unions have become more flexible. There have been deals by internationally focused corporates to increase working hours at no extra cost that have enhanced profitability, and there has been improved competitiveness though at the expense of the domestic consumer.
The restructuring efforts that led to lower labour costs have given the German economy more of a competitive edge. This has translated into a higher export market share that should support the net trade balance this year. In addition, lower expected inflation within Germany, supported by declining unit labour costs, should continue to keep the country’s competitiveness on a sound footing.
Private consumption will be highly dependent on the savings ratio, which in turn is linked to the labour market. With concerns over job security and pension problems stemming from the aging population, precautionary savings could resume their upward trajectory. However, as corporates start to increase their investments and labour reforms start to bear fruit, we could see a further improvement in sentiment and more willingness to spend.
But downside risks stem from the continuation of restructuring efforts by firms keen to dampen high German labour costs by negotiating cheaper contracts. This would lead to real wage moderation and a deflationary income spiral could develop, thereby damaging future consumption prospects.
Public consumption slumped in the last quarter of last year as the government attempted to meet the Growth and Stability Pact rule before the year-end close. With international pressure from the EU, the government could rein in spending, though the decentralised structure of German authorities makes central power over the budget more difficult and with it spending retrenchment. In 2006, and as the election approaches, fiscal policy could be more relaxed.
Robust external demand failed to feed through into higher investment in 1H 04, but in 2H04 there were some tentative signs of a recovery. In the early part of last year, German corporates focused on squeezing existing resources and were deterred from adding to their cost base in the face of rising energy costs and intense international competition exacerbated by the appreciation of the euro.
Now, as corporates restore their margins and utilise cash flows accumulated from last year's restructuring and cost cutting, investment could rise gradually and with it employment levels. There is already some evidence of an improvement in employment as vacancies are on the rise despite the weakening unemployment trend, and as this materialises, it will bode well for consumption and hence domestic demand.
Oil and the euro
Aside from global demand, there are other external factors that could influence future German growth. In the second half of last year, higher oil prices and the strength of the euro were blamed for the frail growth. So it is worth taking a close look at their significance and potential impact on future prospects.
After rocketing in October last year, oil prices seemed to have moderated at the end of 2004, but as of mid March they were back on the rise. This year, oil prices are not expected to recede significantly given tight spare capacity and continuously robust demand from China. Cold winter weather has already pushed prices briefly above US$55, and OPEC has signalled that it is content with a price range between US$40 and US$50 this year.
The ECB had already pencilled in a price of US$44.70 when it estimated growth for this year, and high oil prices should certainly impinge on German growth this year and next. The biggest fear is that this resource is finite, and as non-OPEC production starts to decline while demand is set to continue to grow as China develops, one can safely argue that cheap oil prices are a thing of the past.
On the currency side, as the world becomes more globalised in terms of trade, international competition will intensify, and the value of the currency will play a bigger role in determining competitiveness. Since the euro’s period of weakness in 2000, the currency has gradually firmed and now stands at a record high against the US dollar. Inevitably this will hurt German exports, though the impact may not be as marked as in Italy due to the fact that German exports are of higher quality and are less price sensitive.
Nonetheless, as global demand abates, exports will become more price-elastic and the strength of the currency will be of greater significance. As the US dollar is not expected to rebound strongly, given its massive unsustainable twin deficits and increasing foreign currency reserve diversification, the euro may well remain firm against the dollar. The ECB has already pencilled in a rate of €/US$1.3 in its forecast for this year. The combination of a strong euro and softer global demand could inevitably undermine the buoyancy of growth from net exports.
Overall, then, the combination of continued high oil prices and a strong euro augurs ill for growth. Chart 1 shows that the relationship between GDP and the euro is inversely correlated, as is clear in 2H01, and from 2003 onwards. In other words, a higher euro correlates with lower growth.
But if high oil prices and a strong euro have dampened domestic demand in Germany, why has private consumption fared well in France and Spain?
We know that high unemployment in Germany depressed consumer spending as consumers worried about their jobs and increased precautionary savings. But Spain and France also suffer from high unemployment. The aging population problem is also widespread across Europe, so why has France decreased its saving ratio steadily since 2001 while Germany's saving ratio has gradually risen?
One clear difference between Germany and these other countries is the progress of the housing market. While house prices continued to trend up sharply in France and Spain, German house prices remained stagnant or even fell in real terms. Evidence shows that there is a clear correlation between consumer spending and house prices (as well as savings) – see chart 2. As house prices climb, “wealth effects” are generated, and as consumers feel wealthier on paper, their savings fall and consumption grows. The best evidence of this is the UK, where a robust housing market lent support to consumption while relatively anaemic housing growth in Italy led to a frail domestic consumption.
Another factor that is more specific to Germany is the post-unification burden that the country had to endure. Since unification in 1990, it is estimated that €950bn of subsidies have been injected by Germany into its former communist Eastern states. That burden naturally weighed on public finances and acted as a drag to growth as the subsidies were not as effective as expected. Despite the subsidies, growth stalled in the East from 1996 to 2003, and unemployment continued to deteriorate, from 10.2% in 1991 to 20.1% in 2004.
Note of caution
As a final point, 2005 growth in Germany should get some uplift from investment, as corporates start to spend some of their accumulated cash piles, but the filtering to the broader economy will be slow, hampered by external factors and fragile domestic environment. Then as external demand wanes, the recovery should be more broad based.
Estimates from independent bodies suggest no acceleration from 2004’s 1.6% growth (see table 3), and in fact, the odds looked stacked for a slowdown. Poor visibility has led to a wide range of estimates, but if reforms start to bear fruit earlier than expected and oil prices and the euro retreat, then the picture could differ.
Nonetheless, German structural problems would remain and limit any upside, with the overburdened welfare, pension and healthcare systems and frankly astronomical unemployment levels providing significant headwind for the economy.
In a final conclusion, with external demand losing some steam, and private consumption not looking to rebound strongly, downside risks seem to outweigh upside risks, and a slowdown is on the cards. Continuation of the fragile recovery will hinge on investment and the effectiveness of the reforms.