Wednesday, November 3, 2010

German Wirtschaftswunder revisited

I have been arguing for a long time that the multi-year outlook for the German economy is extremely positive (see for example There is more to celebrate for Germany from Nov last year or German Wirtschaftswunder 2.0 from May this year). In the meantime, economic data out of Germany has surprised most economists and investors. While growth projections have been revised upwards, I remain convinced that the outlook for the German economy (and thus for German real and financial assets) is by far much more favorable.

There are various reasons why this is the case:
a) German corporates have become extremely competitive over the past decade. During the first years of EMU they had to largely regain competitiveness vs. the rest of the Eurozone as Germany locked in an uncompetitive exchange rate when the euro was formed and German corporates were heavily in financial deficit following the debt-financed M&A boom during the dot-com bubble. In turn, at the start of the last decade German corporates had to restructure (i.e. cut costs - especially via headcount reduction in Germany and offshoring/outsourcing) to regain cost competitiveness and reduce the financial deficit. Unfortunately, as Germany regained internal competitiveness during the last decade, the external value of the euro soared, especially vs. key competititors such as Japan. However, over the past 2 years, the euro has lost altitude - again especially vs. key competitors - and German corporates for the first time since the start of EMU are competitive on an intra-Eurozone and on an extra-Eurozone basis. Additionally, German corporates on aggregate have moved from a financial deficit into a financial surplus.

b) German households have been burdened over the past decade by the restructuring of the corporate sector and the numerous reforms by the state of amongst others the labour market, the unemployment benefits as well as the pension systems. In combination they had the effect of rising the financial risks carried by each individual (via lower job security and lower social security), temporarily increasing unemployment and reducing wage growth. All this put downward pressure on the sum of wages earned and upward pressure on the German savings ratio, in turn creating an environment of weak domestic demand. However, now the sum of wages earned is increasing (as unemployment dropped sharply and we are likely to enter an upcycle in wage growth) while no more significant structural reforms are on the agenda. In turn, the outlook for consumption growth has become favorable as well for the first time since the start of EMU.

c) The Germans state was forced to carry through numerous structural reforms as well as several rounds of fiscal tightening to reduce the structural fiscal deficit. However, at present the situation of German state finances is relatively healthy and in turn the need to carry through fiscal tightening measures is limited. The German government decided to engage on a 4-year tightening programme, but on average the tightening amounts to only approx. 0.25% of GDP per year. Furthermore, as the economy is doing better than anticipated, fiscal deficits are undershooting the projected levels by a significant margin.

d) At the start of EMU, Germany had a high price level which combined with weak economic developments resulted in below-average inflation and thus in above-average real yields, further restraining the economy. Now, however, the German economy is roaring ahead which should lead to inflation being more in-line with the Eurozonea average. Additionally, intra-Eurozone sovereign spreads are very high and as a result, Germany is enjoying the lowest real yields within the Eurozone. Finally, as the outlook for the German economy is favorable, credit conditions are easing. As a result, for the first time since the start of EMU, Germany enjoys a very accommodative monetary environment.

What is more, all of these factors re-inforce each other. While at the beginning of the last decade this lead to a vicious circle whereby weakness in the corporate sector, the household sector, a restrictive fiscal and monetary environment all reinforced each other, we are now just at the beginning of a virtuous circle.
The strength in the corporate sector is leading to more employment and with that wage and consumption growth. The outlook for the domestic economy is thereby improving, leading corporates to invest more and banks to provide more funds (as the perceived credit risk is lowered). The fiscal deficit is reduced which reduces the need for fiscal tightening/opens the door for fiscal easing. Domestic inflation picks up which - given that Germany outperforms the rest of EMU - leads to lower real yields, further promoting more investments and a lower savings ratio. Within the monetary union if a country starts to outperform in economic terms, its monetary environment becomes even more accommodative not less, further reinforcing the upswing.
Given the favorable starting point for Germany in terms of corporate competitiveness and low private sector indebtedness such a virtuous circle can last for years without leading to cost disadvantages and/or over-indebtedness.

We are just at the start of this virtuous circle where the drop in unemployment - due to the export led growth rebound - starts to fuel wage gains and coupled with low real yields promotes a reduction in the savings ratio. This will create an increasingly favorable environment for domestic demand and lead to the next wave in growth. I remain convinced that Germany will show above trend growth for the next 3-5 years. While there will be ups and downs in quarterly growth numbers, I continue to look for growth to average around 2.5-3%.

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