Although it is often depicted as the singular bulwark of economic strength and sensibility in Europe, in reality there are quite a few reasons to get worried about Germany's economic future.
While Germany pursued sensible economic policies under the previous (socialist!) government of Gerhard Schröder, most notably some labor market reforms, one should not forget that Germany's economic renaissance is to some degree the result of the euro itself. The creation of the euro removed the exchange rate risk in the periphery (Greece, Portugal, Spain, Italy, Ireland) and as a result, it propelled a huge amount of capital flows from the center to the periphery.
The mirror image of these were current account deficits, basically the periphery accumulated positive inflation differentials with the core countries and became uncompetitive. The result of this was a German export boom to the periphery. You can see the development of the respective trade balances in the figure below:
The effects of these capital flows were reinforced by the centralized, one-policy-fits-no-one monetary policy of the ECB. Rates were too low for the periphery, adding to the economic boom and inflation.
That good German trade fortune is about to end, in more than one way:
- The eurozone periphery is desperately trying to become more competitive, resorting to drastic measures (public sector wages have been cut by 20% or more in Ireland and Greece, for instance). While the effects of these are still quite small, they will increase over time
- The periphery is now experiencing capital outflows, which together with the tough austerity measures create a prolonged slump in economic activity, which hurt German exports to these countries.
- In a curious reversal of fortunes, Germany is now the country experiencing capital inflows and interest rates that are arguably too low.
The latter can actually help the necessary adjustment in the eurozone. If German labor cost and inflation would rise, less of the adjustment burden falls on the periphery, which is a very beneficial development. Here is Ernst & Young:
But if the economy is to continue growing, financial stability in the Eurozone must be secured and Germany must help to address the growth challenges facing the Eurozone. One way in which Germany could assist in this process would be by tolerating faster wage growth and hence higher inflation. If this were to happen, stronger consumption growth would boost domestic demand and, in turn, investment and the labor market. In addition, it would assist peripheral economies by boosting their exports to Germany and by making their labor relatively more competitive, without all the burden of adjustment having to come via falling nominal wages in these countries.
The IMF has made similar comments:
The IMF has long urged Germany to address its own role in the imbalances unsettling the euro zone, namely its reliance on exports for growth resulting in a large current account surplus and its wage restraint leading to meagre domestic demand. German authorities have conceded some ground this year on some key issues such as encouraging strong wage hikes and indicating that they would be ready to accept slightly higher inflation than in the rest of the currency bloc.[economic times]
Luckily, policy makers in Germany are acknowledging this:
In April 2012, German policy-makers signaled that they were willing to tolerate faster wage growth. For example, the Head of the Bundesbank's Economics Department told the finance committee of Parliament that Germany is likely to have inflation rates "somewhat above the average within the European monetary union" in the future and that the country might have to tolerate higher inflation for the sake of rebalancing within the Eurozone. [Ernst & Young]
Ernst and Young also warn of the consequences should this not happen:
Without robust wages and consumption, German growth could be derailed by weakness in other parts of the eurozone.
We already noted in March that wage demands were up notably, something we welcomed. One factor is that German unemployment has fallen to multi-decade lows:
As if there has been now global financial crisis at all. Part of it also the result of sensible labor market policies and institutions. Of course, in such an environment, it's much easier for German unions to ask for wage rises, which is exactly what they've been doing.
German house prices are also rising on the back of the ultra-low interest rates and low unemployment:
We started looking at German property back in 2007. We noted that you could buy an apartment in Berlin for a tenth of the price of one in London. We saw that only 40% of Germans owned their own homes, but that the mortgage market was about to be liberalised - making it easier for them to shift from renting to buying. [Moneyweek]
It's early days yet, but with the situation quite similar to, say Spain in the past decade in terms of capital inflows, too low interest rates and solid economic growth, this could potentially develop into a bubble.
Credit Suisse reports that the mini-boom is to continue in the residential sector for next 2-3 years, supported by 3 factors:
1 High levels of continued bank lending
2 Still historic low prices
3 Strong domestic labour market and EU immigration, in part driven by the eurocrisis.
Well, the combination of rising asset prices and high levels of continued bank lending has led to trouble before, although that's not to say this is inevitable, or will happen in Germany. For now, it is actually underpinning the economy.
So the downdraft from the crisis in the periphery, affecting exports and sentiment is counterweighted by rising asset prices and wages, and, arguably, monetary policy conditions that are too loose for Germany.
Germany's exports to China experienced a boom on the back of the latter's unprecedented investment and construction boom, especially after the financial crisis as a result of the Chinese stimulus program. Germany's exports are very favorably positioned as, together with Japan, they are very strong in capital goods, exactly what the likes of China needs.
But this boom is also slowing down considerably, although the impact is somewhat softened by the fall in the euro on the back of the euro crisis. But still:
German manufacturing shrinking at the fastest pace in three years. German retail sales unexpectedly fell for a second month in May. Unemployment climbed in June for the fourth month this year. [Businessweek]
While Germany could survive a necessary rebalancing of competitiveness within the eurozone at its expense and the effects of the recession in the periphery on exports and sentiment, any worsening of the crisis could become really problematic, even for Germany.
The simple fact is that the liabilities of the periphery to Germany are rapidly accumulating:
According to the IFO institute, German losses via all European bail-out funds if the GIIPS countries were to default amount to €704bn. Whilst this would not bankrupt the country, this would apply a very worrying increaqse in Germany's debt to GDP ratio. [The Telegraph]
A summary of these [FT Alphaville]:
- First Greek bailout 22B
- Guarantee EFSF 211B
- Capital subscription ESM 190B
- EFSM 12B
- SMP share 40B
Adding to that, the Bundesbank claims on Target to just keep getting bigger:
Since late 2007, the European Central Bank has helped with an international shift of refinancing credit, also known as Target credit, from the core euro states to the periphery, to which the German Bundesbank has contributed $874 billion. Greece's and Portugal's entire current account deficits were financed that way.[NYT]
And German banks are highly leveraged and exposed to the periphery:
Pension funds have invested in bonds issued by southern European states, while banks and insurance companies have underwritten a sizable fraction of the credit-default swaps protecting investors against default. [NYT]
The sums on the line here for Germany should the eurocrisis escalate are truly staggering. It gives the periphery a considerable degree of leverage over Germany, we saw some of it in the latest eurozone summit, where Mario Monti in particular got considerable concessions from the Germans (the ESM, the permanent rescue fund is supposed to provide capital to banks directly and can buy sovereign debt on the secondary market), even though there is some fog on the exact status of these.
The funny thing about this is that these concessions (if they stick, the jury is still out) are actually helpful in defusing the eurocrisis.
Germany also stands to lose in another way should the eurozone crisis escalate. If the eurozone breaks up, Germany's currency (whether a remaining euro romp or a re-introduced dmark) will appreciate significantly against almost any currency, wiping out much of Germany's competitive advantage overnight.
It's often overlooked, but Germany's public debt/GDP at 81% is, well, pretty high for a country with a rapidly aging population. The public deficit is under control still, but if the economy continues to worsen this isn't written in stone.
So whether Germany provides the balance sheet that can stabilize the whole eurozone remains very much to be seen. We think that only the ECB can perform that function.
Germany's economy is at a crossroads. In the past, a combination of booming trade to the eurozone periphery and the rest of the world, combined with the fruits of sensible labor market reforms kept the economy growing nicely. After the financial crisis, the economy got a further jolt from Chinese demand for capital goods, capital inflows, rising domestic wages and too loose monetary policy.
But that favorable picture can't remain, and it isn't. Germany is losing competitiveness to the eurozone periphery and its exports are affected by the slump there, as well as a slowdown in the rest of the world. The depreciation of the euro is of some help, but the eurocrisis is also affecting confidence.
This is all the more so now that the truly staggering sums that are on the line should the eurozone crisis escalate are hitting the public consciousness.
One can make a pretty strong case for German equities, even now when the economy is slowing down. There is a German ETF, the iShares MSCI Germany Index (NYSEARCA:EWG).
German shares trade at a huge "eurozone discount," that is, a good chunk of value is not materializing because of the precarious state of the eurozone and the possible consequences for Germany. Below you can see how, when the crisis took a turn for the worse mid last year, this impacted the Dax, quickly tumbling from well above 7000 to just over 5000 in a matter of weeks.
Should the eurozone break-up, this would be bad for the stockmarket but international investors would be compensated by a large revaluation of the German currency.
We would say that while the crisis in the periphery and the re-balancing of competitiveness are continuing, moving out of exporters like BASF (OTCQX:BASFY), BMW, Siemens (SI), Infineon (OTCQX:IFNNY), and Bayer (OTCPK:BAYRY), and move into more domestically orientated stocks, but the eurocrisis has depreciated the euro and this is likely to continue. So what German exporters are losing in the rest of the eurozone, they gain elsewhere.
The "re-balancing trade" seems to favor exporters in Spain and Italy, if you can stomach the obvious risks. These benefit from both the lower euro and intra-eurozone re-balancing of competitiveness. Or maybe not:
While Spanish wages rose much faster than the euro zone average during the pre-crisis years, large exporters kept costs under control, allowing them to stay relatively competitive. Meanwhile Spanish employers with more than 250 workers stayed just as productive as their German, Italian, and French counterparts, according to BBVA, Spain's No. 2 bank. [Dailybeast]
If you're as disappointed as we are not to have found any obvious intra-eurozone re-balancing of competitiveness trade, then also consider this. The more this process goes on uninterrupted by really existentialist crisis periods, the more the eurozone crisis will defuse itself. And the nice upside about that is that the reforms and wage cuts in the periphery, together with the lower euro will make the whole of the eurozone a more dynamic place. But before that happens, there are many a banana peel to be avoided on the way.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.