Looking ahead and as I have written previously, I expect trend growth for the upcoming decade to fall significantly in the US, the UK but also in the periphery of the Eurozone. However, I am more optimistic with respect to Germany and Switzerland. In light of the new government's plans for the upcoming legislative period and the prospects for a net fiscal easing at the start of 2010 and again in 2011, I see myself confirmed in my view of a relative outperformance of Germany within the developed economies' universe.
Below I try to put the situation of the German economy in a much broader historical perspective, tackling as well on some political and socio-economic issues. It is mainly qualitative but can be backed-up with much more data.
Following the burst of the reunification inspired housing bubble in Germany in the mid-90s, the domestic economy essentially went into a downturn. German corporates, instead of restructuring, tried to profit from the building TMT bubble and went on a debt-financed buying spree (largely to buy foreign companies as well as finance UMTS licences). At the turn of the millennium, German corporates were over-indebted and had a massive financial deficit. This financial deficit of the corporate sector amounted to 8% of GDP in early 2000, far outweighing the Eurozone average (including Germany) as well as the US', both at around 3%. Furthermore, the hope for a bright TMT future in conjunction with a significantly weaker trade-weighted Euro (see chart below) took off the pressure for German corporates to restructure.
Trade-weighted Euro: Strong tailwind into the TMT bubble reversed early this decade
Source: BloombergAdditionally, with the birth of the Euro in 1999, exchange rates within the Eurozone were fixed at an overvalued level for Germany which was only overshadowed temporarily by the TMT bubble and the ongoing fall of the external value of the Euro. So at the time when the TMT bubble burst and the Euro reversed its fortune, the shortcomings of the German corporate sector (uncompetitive within the Eurozone, high costs basis, overindebted, too high financial deficit) were unveiled. Additionally, the German economy at the beginning of this decade suffered from a high price level, especially vs. the other Eurozone members. Besides the negative impact on competitiveness, this led to a lower inflation rate than the Eurozone average and therefore to higher real yields. This is one of the problems in the Eurozone, the country with the cyclically weakest economy and therefore relatively low inflation gets the highest real yields. Furthermore, labour markets were very rigid and finally, the government suffered from a significant structural budget deficit which was only temporarily overshadowed by the huge UMTS-licence receipts in 2000. Moreover, the cyclical global economic downturn also unveiled the structural shortcomings of the German banking sector. First, the re-unification construction boom and subsequent bust meant that German banks' balance sheets were significantly burdened by non-performing assets. Second, the German banking market was extremely fragmented, rendering it difficult to generate profits for the private banks from their home market.
Germany saddled by relatively high real interest rates early this decade - but not anymore
The chart below tries to highlight the real yield problematic for the German economy. It shows the difference between the Eurozone core inflation rate and the German core inflation (in blue). Furthermore, it shows 10y Bund real yields defined as 10y Bund yields minus realised core inflation and 10y swap real yields (as a proxy for the Eurozone average) defined as 10y swap rates minus realised Eurozone core inflation. Into the cyclical downswing, German core inflation fell by more than the Eurozone average, therefore, limiting the fall in German real yields. Whereas at the turn of the millennium 10y swap and 10y Bund real yields were the same, in early 2003, 10y Eurozone real yields had fallen by some 300bp to roughly 2% whereas 10y Bund real yields were around 3.35%.
In turn, it what this horrible macro-economic environment with no ability for an effective accommodative monetary or fiscal policy which led corporates to restructure (i.e. move from a financial deficit into a surplus to pay down debt, cut costs via downsizing & offshoring) and forced the government into structural reforms where amongst others labour market flexibility was increased (via for example the so-called Hartz reforms) and social benefits were partially reduced (via for example a raise in the statutory retirement age which means that one has to either work longer or take a significant cut in pensions).
This combination of a significant rise in unemployment (amid the corporate restructuring), a more flexible labour market and a reduction in social benefits led to some rational consequences for private households/consumers.
- a rise in the savings ratio amid lower social benefits
- downside wage pressures especially for lowly educated people amid higher unemployment and a more flexible labour market coupled with higher hurdles to be granted extended unemployment benefits
- an ongoing weak housing market amid record unemployment and high real yields
- an increasing divergence between the domestic economy and the export-led corporate sector once the global economy was recovering and corporates re-established their competitiveness
Politically and economically, a focus on structural reforms was the only promising way out (this is not to say that the reforms could not have been designed much better). On the positive side, the competitiveness of the German corporate sector improved considerably and labour market flexibility increased also while tax rates have been lowered. Furthermore, the relatively healthy situation of government finances at the beginning of the current crisis as well as the much lower relative price level of Germany vs. its Eurozone partners than some 10 years ago means that the ability to conduct an accommodative monetary and fiscal policy has improved considerably. This can also be seen in the chart above where 10y Bund real yields have dropped to the lowest since the existence of the Euro ( to around 2%, almost 150bp lower than in early 2003) whereas Eurozone average 10y real yields are at similar levels than in 2003. This reduction in real yields coupled with the prospects for more fiscal easing over the next two years as well as only a limited rise in the unemployment rate suggest that the prospects for a domestically generated economic upswing are relatively good. Low real yields but no further significant cuts in social security benefits should reduce the inclination to save and I expect a drop in the German savings ratio over the next 2-3 years. Coupled with tax cuts, this will go a long way to rebalance the German economy with a relatively higher share of consumption to GDP, reducing the dependency on exports.
On the negative side in economic terms, the country is still too focused on exports. However and as just mentioned I see a good probability that the economy can become more balanced. More serious is that the domestic banking market remains only lowly profitable. While some mergers have taken place in the private banking segment as well as with Landesbanken over the past year, so far it is still a very fragmented banking market.
I see the most important negative aspect of the German experience, though, in the socio-economic sphere. Downside wage pressures at the low end of the income scale persists as the 'supply' of lowly educated people is still larger than the demand. The improved situation of the corporate sector - at least up to the start of the financial crisis - on the one side and lower social benefits for longer-term unemployed/lower wages for the low-income earners on the other side has led to a deep rift in society and the political landscape. In turn, the perception is that the structural reforms were 'paid' by the low income earners/unemployed which seems to be a key reason for the poor fate of the SPD at the last election.