One of the most intriguing growth stories over the past year is the sudden stop in the German economy. At the end of 2017, GDP-growth hit 2.8 percent with contributions from both domestic demand and the ever-efficient export sector. Then a series of events occurred in 2018: a flu epidemic, strikes, and a dry period lasting months and making the rivers – a main transportation artery – unpassable from summer until end-year.
However, the problems in the auto sector have eclipsed all other issues. Firstly, the diesel emissions scandal continued to cast a shadow over the production of diesel vehicles. Secondly, German producers were slow to adapt to the new emissions test (World Harmonized Light Vehicle Test Procedure – WLTP) that became mandatory for all new cars from 1 September 2018. Adding to that, uncertainty about potential tariffs on European auto exports to the US, and a cyclical slowdown in global auto demand, particularly in China, have created a perfect storm.
Auto producers a major factor
The headwinds have brought Germany to the brink of a technical recession with declining activity in the second half of 2018. The lack of autos for sale also hit the domestic turnover, thus adding further to the economic pain. Manufacturing production is significantly lower than a year ago with new orders a full 7 percent lower. However, much of the annual decline in new orders occurred earlier in 2018, and the latest 3m/3m-trend shows some stabilization.
Confidence indicators are also nothing to cheer about. The latest Markit PMI puts the manufacturing sector in recession (47.6) – and much lower than in France, where manufacturing activity expanded more quickly in February.
The same message comes from the comprehensive Ifo-survey. Manufacturing confidence has declined sharply led by a collapse in expectations for business development over the next six months. The assessment of orders on hand shows some improvement in January and February, but the assessment of finished goods on hand (something you do not want) has increased further, matching the euro crisis in both speed of deterioration and actual level. Involuntary inventories are brought down by reducing production – unless final demand jumps.
Will uncertainty hit investments?
Pessimism does not necessarily translate into lower activity, but given the substantial global political risks, there is an increased likelihood that lower confidence will lead to postponement of planned investments. That would also hamper longer-term growth as production costs have risen continuously in German during the past seven years. Since 2012, unit labor cost has risen by 14 percent in Germany, 6 percent in France and declined by one percent in Spain. Indeed, recent developments in costs and inflation (and trade balance) show a convergence within the euro area with Germany near the top of the cost/inflation table and the reform countries near the bottom. Construction costs are also increasing rapidly, which could explain the lower optimism among entrepreneurs.
Since mid-2018, there has been a decline in the share of businesses citing lack of labor as the most important factor limiting production. It is still high by historical standards, and the rapid economic growth in Eastern Europe has eliminated the hitherto labor reserve for the German labor market.
Not all is bleak
In the US, such a significant economic slowdown would have caused major political concern and spilled over to consumer confidence. That is not the case in Germany. Probably because the labor market displays amazing strength. Unemployment continues to drop, even though the unemployment rate (at 3.2 percent) long ago broke previous all-time lows. Employment is growing around one percent annually and wage growth remains around 3 percent. Hence, household wage income is growing at 4 percent and with lower inflation, real income growth is 2.5-3.0 percent. This year, pensions have been lifted for some groups and lower social contributions are also benefitting lower income households. Overall, German households are in a uniquely favorable position.
However, so far consumption growth has been weak, and the household savings rate has increased sharply rather than declined as would be expected in a situation with strong wage gains and full employment. Part of the explanation could be ECB monetary policy and the suppression of yields on government bonds. For ageing households, the lack of safe investment opportunities serves as an incentive to put even more aside to achieve pre-set saving goals. Except for mid-2008, the German savings rate is now at the highest level since 1995.
Modest growth outlook
Some rebound in manufacturing activity should be expected if, for example, the trade war between the US and China is ended – and President Trump does not set his sights on the European auto sector. However, auto demand is unlikely to grow by the speed seen in recent years as many markets have reached a temporary saturation. Moreover, Germany is also hit by symptoms of late-cycle fatigue: increasing cost pressures and a political landscape more focused on handing out “free” welfare benefits than undertaking new, unpopular reforms.
The International Monetary Fund has reduced the growth outlook for Germany to 1.3 percent this year with the München-based Ifo down to 1.1 percent this year and 1.6 percent in 2020. International organizations count on higher private consumption growth this year, not only in Germany, but broadly in Europe. While economists easily could be disappointed, German households have the ability to deliver.
Prudent fiscal framework
Germany also remains in a very strong fiscal situation. The high economic growth and associated tax windfalls have been saved, and Germany has been running a fiscal surplus since 2014. The public debt has been reduced to 60 percent of GDP. The fiscal restraint has also dampened the demand for additional labor in the public sector, thus reducing the risk of overheating. If Berlin decides to support the economy later this year, incentives to corporate investments and public investments in physical and digital infrastructure should be at the top of the list. But there is little available labor in Germany, so artificially adding demand for labor risks triggering a cost/inflation spiral. That would be of little use to anyone.
Most likely, the German economy will stay in the slow lane in the coming months and then pick up some speed. But for Germany to enter a new phase of high growth, more reforms are needed. According to the Global Competitiveness Report from the World Economic Forum, Germany ranks behind Russia and Bulgaria in digital preparedness. The infrastructure is in need of an upgrade. The two largest banks are barely floating. It is not just Southern European countries that needs a competitive overhaul.