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Carsten Brzeski's blog

Germany – Quarterly Update Q1 2016

Calm at the surface but turbulent beneath

At first glance, the German economy looks set for another solid growth year. At second glance, however, 2016 could become the year in which policymakers start regretting that they did not fully exploit opportunities in the last years to increase structural growth.

Despite another very turbulent year with the Greek crisis, the Chinese slowdown, the refugee influx and increased geopolitical tensions, the German economy continued its solid growth performance. Domestic demand, and in particular private consumption, has become an important growth driver. Looking ahead, the economy should continue its current positive, though not breathtakingly strong, momentum next year.

Particularly the domestic part of the economy continues to be an island of happiness. The labour market continues moving along the line of its current natural rate of unemployment of around 5%. At the same time, the number of baby boomers leaving the labour market seems to be offset by immigrants and the non-active labour force, pushing employment from one record high to the next one. Extremely low energy prices and interest rates are another argument for solid consumption growth this year and beyond. In addition, the government’s decision to lower the so-called “cold progression” in the tax system should provide another small stimulus to the economy.

While consumption and construction are flourishing, industrial production is currently going through tougher times. In fact, industrial production has been treading water throughout the entire year, with a renewed weakness after the summer. There are several explanations for rather sluggish industrial production: inventories were relatively high at the start of the year, order books have become thinner due to weaker demand from emerging markets and still stagnant demand from the Eurozone and, last but not least, a broader trend across the globe of a transition from industrial production towards services. Particularly the latter is interesting as this shift is not only noticeable in Germany but also in the US and China.

In the same context, the investment weakness remains a conundrum. Normally, low interest rates combined with low energy prices should lead to some investment from SMEs. Up to now, however, uncertainties stemming from ongoing geopolitical conflicts and, at least until last summer, the Greek crisis seem to be a bigger hurdle to domestic investment than earlier expected. In addition, as indicators like capacity utilization are currently also only fluctuating around their historical averages, a sharp acceleration of private investment without new public incentives looks unlikely. The only exception to this pattern is be housing, where still low home-ownership ratios, record-low mortgage rates and now the inflow of refugees should continue boosting residential housing.

Despite the negative contribution of net exports to German GDP growth in the third quarter, the export sector remains an important growth driver. Since 2009, net exports have contributed 0.1 pp to quarterly GDP growth; or one third of GDP growth every single quarter. The year 2015, however, could have marked a structural change for the export sector. While during the first nine months of the year 2015, exports to China were down by 2.5% compared with last year’s period and exports to Russia dropped another 28% on the back of sanctions, exports to the US surged by more than 20%, reflecting the direct impact of the euro weakening. Moreover, exports to the UK (+14%) and Eastern European countries (+9%) compensated for weaker demand from China. Turning to Eurozone export partners, exports benefitted from the recoveries in both Spain (+14%) and the Netherlands (+9%), while exports to France remained sluggish (+3%). As a consequence, the US has become Germany’s biggest trading partner and for the first time in years should end the year on the number one spot, ahead of France. To some extent, the ECB’s QE programme and more specifically the weak euro have been an extremely welltargeted stimulus package for German exports. It nicely amplified export growth in the US and the UK, thereby offsetting the negative impact from slowing China.

Besides traditional macro-economic and political risks, the current influx of refugees poses both opportunity and risk for the German economy. In the short term, the positive impact should prevail as the refugees will bring more government spending and consequently a small fiscal stimulus to the economy (some 0.2 percentage points of growth). The inflow of refugees should also keep wages in the low-wage sector in check. In the longer term, however, the picture is more mixed. While the German economy indeed needs “fresh” labour to better cushion the negative impact from ageing, it is not clear whether the society can actually absorb so many refugees within a very short time span. Political and societal integration of the refugees will require unprecedented, lasting flexibility of the German public, to say the least.

All in all, the German economy is still surfing on the last waves of a positive reform-and-growth cycle. Backed by the ECB’s QE, and consequently low energy prices, low inflation and low interest rates, this wave can still last for a while and should not quickly end in a big splash. Without new structural reforms, new investment and a structural solution for the refugee crisis, Germany could easily end up waiting quite some time before it can catch the next splendid wave.