Germany: In Uncertain Times
Elga Bartsch (London)
German economy to approach important crossroads
Both the economic recovery and the reform process in Germany will likely reach important crossroads in the coming months. In terms of cyclical outlook, it remains to be seen whether domestic demand, both consumer and corporate spending, will strengthen sufficiently to offset the coming slowdown in external demand. In terms of the political outlook, the key question is whether the government will be tempted to water down its reform agenda in response to the massive voter backlash experienced in a string of recent regional elections. Admittedly, the evidence on both counts is mixed at the moment, and skepticism is on the rise. On balance, however, we continue to expect the conditions for a domestic demand recovery to fall into place going forward and the government to, by and large, stick to its reform agenda.
Future recovery hinges on domestic demand
The continuation of the German economic recovery remains uncertain at this stage. In the first half of this year, German GDP growth was entirely driven by dynamic export demand. Meanwhile, domestic demand, notably corporate investment, weighed on economic performance. In fact, our own forecast for a broadly unchanged GDP growth rate of 1.7% next year, after a projected 1.8% this year, is unlikely to be met if consumer spending and investment spending don’t recover noticeably in the coming quarters. So far, there are few signs of such a revival. Contrary to earlier recoveries, German corporates seem to be reluctant to step up inventories. In addition, investment in machinery and equipment has been disappointing in the first six months of this year. The pronounced weakness in capital spending in Q2 is at odds with strong turnover and industrial production in the capital goods sector during the period. Only domestic capital goods orders, which corrected slightly between April and June, but which have a much looser correlation with capex than turnover or production, would partially support the preliminary Q2 GDP numbers. Furthermore, capacity utilization rates have started to rebound, underlining that the repair and replacement cycle should slowly be getting into motion.
Especially, investment and consumer spending
In addition, we feel that the German construction bubble still has to be corrected further, especially in residential housing investment (see “Why Can’t We Be More Optimistic for Construction?” September 22, 2004). However, after the sharp drop seen between January and June, we foresee a gradual stabilization in overall construction investment the coming quarters — partly a reflection of an improved outlook for commercial construction activity. Accounting for almost 60% of overall demand, consumer spending is critical for a sustained recovery. Having disappointed substantially in the past, retail sales offered a glimmer of hope by registering a marked rise over June/July. In the meantime, however, statisticians have revised down significantly the July data from +1.5%M to -0.4%M (August data are out later this week), thereby wiping out all potential upside risks to our Q3 consumer spending estimate of 0.3%Q. On a more positive note, consumer confidence rose in September as German households became a little more optimistic about the economic outlook and also their personal financial situation. Going forward, improving job prospects, additional income tax cuts in January 2005, and a gradual reduction in health-care contribution rates, resulting from the Health Care Reform implemented this January, should support disposable income growth. A rapidly rising household savings rate over the last three years underlines, though, that it is more a lack of confidence amongst the German population than the lack of income that has been holding back spending.
Offshoring isn’t a major threat to the recovery
The lacking revival in domestic demand has sparked a lively debate in Germany over whether offshoring is the reason for the lack of investment and job creation. Some observers argue that because of a rising share of intermediate goods imported from abroad, Germany is turning into a ‘bazaar’ economy that only re-packages and then re-exports cheap imports from Central and Eastern Europe and Southeast Asia. However, in our view, the evidence on the ‘bazaar’ economy is not conclusive (see “On Offshoring, Restructuring, and Reforms, August 9, 2004).
First, the gap between output and value-added in the industrial sector has not widened further in the last few years, suggesting that aggressive offshoring has run its course. This hypothesis would be in line with marked improvements seen in German price-competitiveness since the late 1990s. As a result of this improved cost-competitiveness, German exporters are gaining market share again and have remained relatively resilient in the face of the EUR appreciation in the Spring.
Second, the weaker value-added growth in the industrial sector might also reflect outsourcing within the country rather than offshoring. If, for instance, service support functions of manufacturing companies are outsourced, the newly established company will now be classified as a service-sector company. This shift could potentially distort growth rates in the industrial sector to the downside.
Third, the balance of payment data show that foreign direct investment flows to Central and Eastern Europe have dropped markedly in the last few years. Compared to a total of 3.2 million jobs lost in the German manufacturing sector alone since 1991, an estimated 300,000 jobs pushed across the eastern border are relatively small. In addition, we have found a positive correlation of around 85% between domestic job growth in Germany and employment dynamics at German foreign affiliates in Central and Eastern Europe over the last five years, arguing against a massive shift of jobs to the East.
But the budget deficit remains a problem
Reining in the sizable budget deficit remains a struggle for the German government. Only projected privatisation receipts of around EUR 15 billion allow the government to present a 2005 budget that meets the requirement of the German constitution. The constitution permits the (planned) budget deficit to exceed investment spending only under very special circumstances, thus imposing a stricter version of the ‘Golden Rule’ than the UK Treasury. The privatisations planned include selling the remaining shares in Deutsche Telekom and Deutsche Post to the Kreditanstalt fuer Wiederaufbau (KfW). Contrary to earlier years, when privatisation receipts were used to pay down government debt and/or to cover future pension obligations, next year they will likely be used to finance government spending. As a result, the German budget deficit might once again be above the 3% ceiling of the Stability and Growth Pact in 2005. A pledge to the other finance ministers at the Ecofin meeting last November, when both Germany and France fended off further sanctions by committing to bringing their respective deficits below 3% in 2005, will probably not be met. Note that privatisation receipts are disregarded under the Maastricht definition of the budget deficit and thus don’t help to solve the government’s ‘3% problem.’ This year, a potential further shortfall in tax revenues, likely to be revealed in the November tax estimate, will not only necessitate a supplementary 2004 budget but also could push the general government deficit through the 4% level.
Voter backlash against reform agenda…
Against the backdrop of a weak economy and rising concerns about the future of the generous German welfare state, Chancellor Schroeder’s Social Democratic Party (SPD) has seen a massive decline in voter support since the last general election in September 2002. Approval ratings plunged to historical lows of slightly above 20%. This compares to 38.5% of the votes captured in the last general election. In addition, the SPD has lost a large number of votes in all recent regional state elections. The most recent regional state elections in Brandenburg and Saxony, however, highlight that the opposition Christian Democrats (CDU/CSU) are equally hit by the voter backlash against the unpopular reforms, notably the tightening of unemployment benefits that will become effective next year.
The loss in voter support implies that Chancellor Schroeder could potentially lose further control over the legislative process as early as next summer. If his SPD loses the upcoming regional elections in Schleswig-Holstein (February) and North-Rhine Westphalia (June), where it currently governs together with the Greens, the Christian Democrats would command a 2/3 majority in the Upper House, the Bundesrat. This would effectively allow the CDU/CSU to block most legislation in the Lower House, the Bundestag, and to also put forward and push through some of their own initiatives. However, there are some tentative signs that the SPD’s approval rates have bottomed now. In addition, the next general election doesn’t take place before the fall of 2006, and the CDU/CSU remains deeply divided in its views on key policy areas, too. Hence, the opposition leader, Angela Merkel, might find it difficult to enforce discipline on the state premiers in the Upper House, especially while the issue of choosing the CDU/CSU’s Chancellor candidate isn’t resolved yet.
… hasn’t derailed the government’s course so far
But despite his party’s dramatic loss of votes in the recent elections, Chancellor Schroeder continues to stand by his Agenda 2010, and so far has defied calls for a reversal of some of the recent unpopular decisions. However, left-wingers within his own party are calling for a reversal of some of the income tax cuts at the top end of the income scale. In addition, trade unions and some of the SPD’s rank and file have started to push for an introduction of minimum wages in Germany. So far, minimum wages have been absent in Germany, because they are seen as an interference in the independent wage negotiations between the trade unions and employer federations. But with the role of these bilateral industry-wide wage negotiations diminishing rapidly and company-specific wage contracts mushrooming, the trade unions now seem to be ready to turn to the legislature for help. If minimum-wage legislation were to be implemented and if the wage level were to be binding, this would be a major blow to creating a more dynamic segment at the low-skilled end of the labour market, where unemployment is high and persistent. In the past, a generous welfare system, rigid employment protection legislation, and a lack of wage differentiation have constituted major impediments. With the just-passed labour market reforms removing some of these impediments, it would be a pity if the obstacles to a low-wage segment of the labour market were re-introduced through the back door.
Micro-restructuring is an additional key factor
All in all, the progress on structural reforms remains painfully slow, and the government is unlikely to push through additional major reform projects before the 2006 general election. As a result, the much needed but highly controversial overhaul of the health-care system will only be tackled in the next parliament. However, to the extent that the appetite for more reforms seems to be waning at the political level, structural reforms have started to migrate from the macro to the micro level. Companies are starting to push for further labour market flexibility, through company- or even plant-specific measures negotiated directly with their employees and their trade union representatives. A number of recent agreements reached on a company-by-company level provide for greater flexibility on the number of hours worked, for instance. Working longer hours at an unchanged monthly pay underlines that German industrial relations still have considerable scope of improving cost-competitiveness and thus retaining jobs onshore. Decades of reducing working hours have caused a 15% gap versus the US, for instance, in the average number of hours worked per year. Together with the above-EMU average unemployment rate, this underlines the growth potential hiding in the labour market.
A Personal Postscriptum: The coming months will likely be decisive in determining the future direction of the German economy. I am therefore delighted to have the opportunity to spend the next few months on an assignment to the German government. During this period, I will completely disengage from financial markets, which have been my intellectual home for the last seven years. In my absence, my colleagues on the European economics team, notably Joachim Fels and Annemarieke Christian, will stand ready to answer all your questions. But I already look forward to continuing the long-standing dialogue with so many of you upon my return in early 2005. |
