The sick man of Europe? Don’t write Germany off

The sick man of Europe? Don’t write Germany off

All the major economies of Europe and North America have slowed in the last year, but none as fast as Germany. It saw a mild recession at the end of last year and in the first quarter of this year. Output is stagnating in the second quarter and seems at best likely to remain flat until spring of 2024.

• This doesn’t seem to be a temporary problem. In a cover story last month, the Economist argued that Germany needed to change direction to avoid becoming the growth laggard of the West. Last week the chief executive of Deutsche Bank, Christian Sewing, warned that without reform Germany would become “the sick man of Europe”.

• The challenges facing the world’s fourth-largest economy are partly a function of what, until now, have been strengths: its position as the world’s third-largest exporter, access to natural gas from Russia, and a large manufacturing and auto sector.

• Relative to GDP, Germany’s manufacturing sector is about twice the size of the UK’s. Manufacturing is energy intensive, and, although Germany uses energy efficiently, its outsized industrial base means it uses about one-third more energy per head of population than the UK.

• Having closed most of its coal-fired power stations and nuclear capacity, Germany became heavily reliant on natural gas. Before Russia’s invasion of Ukraine more than half of Germany’s gas came from Russia. It was also a significant user of Russian oil. Germany has successfully shifted away from Russian energy, but rising prices have hit manufacturing and led some energy-intensive businesses to move overseas.

• Slower global demand has weighed on exports which account for over half of German GDP. As global demand snapped back from the pandemic in 2021 Germany posted a trade surplus equivalent to 5.3% of GDP. Last year the surplus shrank to 2.1% of GDP and this year, it is likely to be lower still.

• German industry is more reliant on Chinese demand than other European countries, with exports to China accounting for 3.2% of GDP, more than twice France and Italy’s share. China’s lacklustre recovery this year has added to Germany’s export woes. So, too, has the threat posed by China’s own burgeoning auto sector.

• In 2006 China and Germany each produced 5m vehicles. Today Germany produces 4m vehicles a year and China produces 28m, more than the US, Japan and Germany combined. In just seven years Chinese auto sales have risen fivefold, to 2.7m cars, 40% of which are hybrid or electric. Sixt, a German car rental company, last year ordered 100,000 electric vehicles from the Chinese carmaker BYD to be delivered by 2028. With its lead in EVs and huge volumes of production, China poses an even greater challenge to German and US carmakers than Japan did in the 1970s.

• Germany’s consumer sector has fared no better than its industrial sector in the last year. Inflation, higher energy prices and rising interest rates have reduced spending power. Housing and construction activity has slumped, with house prices falling by almost 10% in the three months to June on a year earlier, the fastest decline since records began in 2000. This year consumption growth is likely to fall at an even faster rate than industrial output.

• These headwinds mean Germany is likely to be the only G7 nation that posts a decline in GDP this year. Not until next spring is the German economy likely to return to growth.

• Some of the problems Germany faces, such as high energy prices and weak export demand, are temporary. Others are longer term in nature: an ageing population, an energy-intensive economic model and growing competition, be it from Chinese automakers, the reshoring of supply chains or American firms benefitting from ‘green’ subsidies and tax breaks. It is these challenges that worry most policymakers and economists. They are not insurmountable, but to meet them Germany will need to reform and change.

• Germany's future matters hugely for the Europe and the West more generally. Germany accounts for almost a quarter of EU GDP in 2022, is the region’s leading political power and, after the US, the second largest donor of aid to Ukraine.

• While the risks are real, I think we have rather lost sight of Germany’s strengths.

• German public and consumer debt is far lower, relative to GDP, than in most other European countries and the US. That balance sheet strength is a source of resilience, especially, as now, when interest rates are high. Germany’s manufacturing sector remains a world leader in autos, machine tools, chemicals, medical equipment, consumer goods, electronics and green energy. Its small and medium-sized business sector, the Mittelstand, has demonstrated an enviable capacity to adapt and succeed in overseas markets. Germany’s system of employee training, scientific education and its use of robots are among the best in the world. 

• Perhaps most importantly, Germany has shown a capacity to adjust to major shocks and challenges, most recently in the rapid shift away from Russian gas and surge in energy efficiency. Industrial output per unit of gas used has risen by 16% since 2021.

• Germany has overcome other challenges that many thought to be intractable. In the late 1990s, when I covered Germany as an economist at an investment bank, it was widely seen as a sclerotic, slow-growth laggard. This was the first time that Germany attracted the title of the sick man of Europe. Germany’s then chancellor, Gerhard Schroder, responded with wide ranging and politically contentious reforms to liberalise the labour market. Despite considerable opposition the so-called Hertz reforms passed into law. The measures helped change Germany from a high to a low unemployment country and were instrumental in rebooting German growth. One study (Uhlig and Krause) estimates the reforms led to a 2.8 percentage points reduction in Germany’s unemployment rate (this in an economy where unemployment has averaged 6.3% in the last 15 years).

• Back to today. The good news is that German inflation is falling. This should help drive a recovery in growth next year. But to guarantee its long-term future Germany needs to reform. In doing so it needs to draw on the same determination and willingness to change that enabled it to bring down unemployment in the 2000s and to switch away from Russian energy over the last 18 months. Faced with the Europe’s migration crisis in 2015, Angela Merkel famously said, “we can do this”. It’s time to roll that phrase out again.

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OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week down 0.4% at 7,684. 

Economics

• The price of a barrel of oil surpassed $95/barrel last week before falling back to $93.5/barrel at the time of writing following production cuts by Saudi Arabia and Russia
• Russia banned exports of petrol and diesel, causing diesel prices in Europe to jump
• Goldman Sachs raised its forecast for the Brent crude oil price to $100/barrel
• Chevron agreed on a deal to end strikes at two LNG facilities in Australia. The strikes had caused volatility in global LNG prices
• Early estimates of activity for September based on surveys of purchasing managers suggest a marked contraction in activity in the UK and euro area and nearly flat growth in the US
• Purchasing managers in the UK reported the steepest fall in private sector employment since October 2009 while in the euro area, new orders are falling at their fastest pace since November 2020. This data points to an increased risk of recession in the UK and the euro area
• UK inflation unexpectedly fell to 6.7% in the 12 months to August, down from 6.8% the previous month, in part due to a fall in restaurant prices
• UK core inflation, which strips out volatile prices of energy and food, fell from 6.9% to 6.2% over the same period pointing to an easing of underlying inflation pressures
• Following the news, the Bank of England’s Monetary Policy Committee, by five votes to four, elected to keep interest rates on hold at 5.25%, ending a run of 14 consecutive rate rises since December 2021
• Markets interpreted the decision to keep UK rates at 5.25% as signalling that this was likely to be the peak in rates for this cycle
• UK retail sales partially rebounded in August, growing by 0.4% from July, a month that saw a drop of 1.1% on poor weather
• UK consumer confidence unexpectedly rose to its highest level since January 2022 in September
• UK prime minister Rishi Sunak announced a delay to a range of climate regulations – the ban on the sale of new diesel and petrol cars will be delayed from 2030 to 2035, the phaseout of fossil fuel boilers has been relaxed and landlords will not be forced to upgrade the energy efficiency of their properties
• The US Federal Reserve kept its target for the Fed Funds rate at 5.25% - 5.5% but upgraded its forecasts for growth and said it was likely there would be another rate rise this year
• Germany’s Bundesbank warned German companies to cut their exposure to China, saying the reliance on trade with China put Germany’s “business model in danger”. The central bank said that almost three in ten companies were reliant on China for essential materials and components

 Business

• Atsushi Katsuki, chief executive of brewer Asahi, warned that rising global temperature could hit barley and hop production and lead to a shortage of beer
• HM Revenue and Customs increased its inquiries into overseas assets and requests to foreign tax authorities in the last tax year compared with the one before, seen as a sign that it is cracking down on underpayment of taxes
• The US’s fleet of advanced F-35 fighter jets, the most expensive defence procurement project on record, can only fly 55% of the time on average due to maintenance issues
• The UK government passed legislation to allow it to lower the age at which employees are required to be automatically enrolled into pensions from 22 to 18 and increase default contributions. The government will now consult on when to phase these rules in
• Media mogul Rupert Murdoch, 92, announced that he was stepping down as chairman of Fox and News Corp. His son Lachlan is to replace him
• Amazon announced that its Prime streaming service in Canada, Germany, the UK and the US will include adverts unless users pay more for an ad-free option. This follows similar announcements by competitors
• Shares in the Dutch banking sector were hit after the Dutch parliament approved a 70% increase in the country’s banking levy and an increase in the corporate tax rate. The development follows similar moves by Italy, Spain, Hungary, Czechia and Lithuania
• Shares in chip designer Arm and grocery delivery company Instacart have fallen following their initial public offering. The development may dampen enthusiasm for other stock market listings
• Japanese electronics company Toshiba is being taken private by a consortium led by a private equity firm following 74 years on the stock market
• H&M has become the latest UK retailer to charge customers for online returns. Shoppers must pay £1.99 to return items either in-store or online

Global and political developments

• US president Joe Biden promised an additional $325m in weapons to Ukraine following a meeting with Ukrainian leader Volodymyr Zelenskyy in Washington
• The FT reported that before the visit president Biden had made the decision, after months of deliberation, to provide long-range missiles to Ukraine
• Polish prime minister Mateusz Morawiecki said that Poland would no longer supply weapons to Ukraine as a row over Poland refusing to accept imports of Ukrainian grain escalated
• Russia plans to raise government spending by more than 25% next year, including on weapons, pensions and welfare, ahead of next March’s presidential election
• Canada and India are locked in a diplomatic row after Canadian prime minister Justin Trudeau said there were “credible allegations” that agents of the Indian state were responsible for the murder of a Sikh separatist in Vancouver. India has dismissed the allegations and stopped issuing visas to Canadian nationals in retaliation
• The UK’s Labour Party said that it would strengthen the Office for Budget Responsibility by requiring any significant tax or spending announcement to be accompanied by its independent forecasts *The UK government refused to confirm that HS2 would continue between Birmingham and Manchester
• UK chancellor Jeremy Hunt said it would be “virtually impossible” to deliver tax cuts until the UK economy improves

And finally… Wiltshire Times reported last week that builder Michael Thomas, who is locked in a bitter planning row with Trowbridge Town Council over his conversion of a former pizza takeaway into a house of multiple occupancy without planning permission, has added a stone gargoyle to the conversion that shares a likeness with the leader of the council - gutter humour