Store window in Dresden, Germany, where financial crisis is likely to encourage consumers to continue saving, not spend (photo: Norbert Millauer/AFP)
GLOBAL FINANCIAL CRISIS
"Germany is going through a wrenching economic phase, and 2009 is now projected to be the most severe downturn that the German economy suffered in the last 60 years," Ashoka Mody, IMF mission chief for Germany, said January 22.
For a while, it looked as if Germany could escape the full force of the financial crisis. Even though two of its banks—IKB and Sachsen LB—were early victims of the subprime meltdown in the United States, Germany's industry remained confident that its competitive edge would see it through the worst of the downturn.
But since September 2008, the German economy has experienced a sharp drop in business confidence because of a steep decline in foreign orders (see Chart 1). "Exports are falling sharply, which is a particular setback to the German economy as it relies so heavily for its growth on exports," Mody said.
As a result, the economy went from robust growth—an annual average rate of 3½ percent—in mid-2007 to a contraction in the second and third quarters of 2008. The IMF now thinks that GDP will shrink by 2½ percent in 2009. A tentative recovery is expected in 2010.
Problems on several fronts
So what's behind the sudden loss of confidence in Germany?
Slowing demand for German exports. The primary shock has been slowing world demand. Since the mid-1990s, German growth has been powered by exports (see Chart 2). So it's not surprising that the principal source of the current slowdown has been a drop in foreign orders. As the U.S. economy has weakened, the knock-on effects through the world economy have led to a sharp deceleration of world trade, which is projected to continue at least through the early part of 2009. For Germany this implies a severe blow (see Chart 3).
Continued caution among German consumers. German consumers were careful with their money even during the upswing in 2007, when employment and earnings prospects finally improved after years of wage restraint and relatively high unemployment. And while there has been a temporary uptick in consumption due to lower oil prices and a stronger labor market, the financial crisis is likely to encourage consumers to continue saving for a rainy day rather than spend now.
Sharp drop in investment. The worsening business outlook, with rapidly shrinking foreign and domestic order books, will inevitably lead companies to postpone planned investment. Investment volatility has traditionally amplified export volatility and the current downturn is no exception. Despite the recently announced stimulus package, investment is projected to fall by ¼ percent in 2009, contributing 0.1 percentage point to the decline in output.
Strong case for fiscal stimulus
In a bid to restart the economy, the German government has rightly decided to provide significant stimulus to the economy. The space for such a stimulus was made possible by a long period of fiscal consolidation.
Following more modest stimulus packages announced in October and November 2008, the German government announced a more substantial set of measures amounting to about 50 billion euros to be spent over two years. "For now, the German fiscal package is comparable to or exceeds that of anyone else. This is a step in the right direction," Mody said.
By IMF staff's estimates, the stimulus will be just over 1¼ percent of GDP in 2009, and about ½ percent of GDP in 2010. In the annual Article IV consultation concluded in November last year, the IMF had recommended a stimulus in 2009 of 1½ to 2 percent of GDP. However, with the rapidly deteriorating economic conditions, a stimulus of at least 2 percent of GDP would have been desirable.
Also, while some of the measures should help increase demand and production activity, others are likely to have a more modest impact. IMF analysis of fiscal stimulus packages suggests that:
• Bringing forward the proposed reduction in social security contributions would reduce high labor tax rates and boost private consumption. Greater emphasis could have been placed on further reducing these contributions rather than on reducing personal income tax rates (since personal income taxes are paid only by the more well-to-do half of the population).
• Increased social benefits, mainly in the form of child benefits and short-term labor subsidies, are also an effective measure: the focus on poorer households directs funds to where they are most likely to be spent, while also mollifying those who feel that the dividend from the recent upswing has eluded them.
• Public investment in infrastructure projects is an important measure that should help: the key challenge is to accelerate projects in the pipeline—so-called "shovel-ready" projects—to boost output and, hence, confidence.
• Private investment incentives and increased lending to small and medium-sized firms are unlikely to raise investment while business confidence is low.
Finally, any fiscal stimulus package should be accompanied by a credible long-term commitment to fiscal sustainability. This remains a concern, especially with regard to trends in healthcare costs and debt accumulation by Germany's states.
So the German government's plan to introduce a disciplining rule as part of the recently announced package is an important step in the right direction. Such a rule would require returning to fiscal balance. Maintaining fiscal sustainability and credibility will generate confidence that the deficits needed for the stimulus will be temporary, which should help speed recovery.
Fixing the financial system
The global financial crisis has also highlighted important vulnerabilities of the German financial system. Though traditionally conservative, segments of the banking system were exposed to substantial risks, something which became apparent when the financial crisis hit.
As of end-September 2008, Germany accounted for about a quarter of European bank writedowns. Of these, about two-thirds have been in public or quasi-public sector banks. Two large private banks—Hypo Real Estate and Commerzbank—have sought assistance through the government's financial stabilization package.
Higher borrowing costs
Looking ahead, the economic slowdown will generate further pressures. The relatively low debt ratios of companies and households and the significant role that retail deposits play in the funding of banks will continue to cushion the impact of the current shocks. But borrowing costs in sectors ranging from construction and automobiles to engineering and chemicals have increased sharply as defaults are perceived as increasingly likely.
The Financial Market Stabilization Fund, which has been vital to shielding the financial sector from the storm in the global economy, should be used as a stepping stone for broader financial reform. The German approach has differed from that in other countries: it is voluntary and banks may choose from a range of stabilization measures.
However, because of the low absolute level of capital in several banks, a more proactive recapitalization may now be needed, particularly in view of the expected deterioration in asset quality. There is also a compelling case for tightening bank regulation and supervision, and the financial safety net needs to be strengthened through better deposit protection.
International repercussions
Because the German economy is so open, the longer the global shocks persist, the more severe and prolonged the downturn will be. This is bad news not just for Germany but for other economies in Europe as well. Lower growth in Germany is rapidly transmitted to other economies in the region because of close economic and financial links.
German economic ties to Central Europe through foreign direct investment, trade, and bank subsidiaries are particularly strong. From June 2007, just before the crisis started, to September 2008, German banks' exposure to emerging markets via loans and credit derivatives doubled to about $450 billion—4 percent of all German banking assets and 12 percent of all German banks' cross-border claims. This expansion occurred at a time when other lenders and investors were retrenching from emerging market assets.
German banks are now likely to seek to reduce that exposure, something which could generate cascading spillovers and add to the troubles of emerging markets in Europe, several of which have already requested financial assistance from the IMF in order to weather the storm in the global economy.
What happens in Germany also matters for Europe's other advanced economies. Sentiment in the eurozone becomes more closely aligned when economic prospects worsen. This means that a lack of confidence in Germany could hurt growth in the entire eurozone.
Stronger cooperation
All the more reason, then, for the European economies to strengthen their cooperation in key areas, such as fiscal policy and financial sector regulation. In a January 19 interview, IMF Managing Director Dominique Strauss-Kahn said the world is facing a deepening crisis, and that further policy action was needed, especially in terms of fiscal stimulus.
"In Europe especially, they are still behind the curve," Strauss-Kahn said. "There needs to be more done on the spending side, especially because the reaction of the economy to more spending is quicker than the reaction to a decrease in taxes."
But Mody is optimistic that Germany will eventually recover. "Over the next year, the German economy will undoubtedly experience a difficult situation exacerbated by an unfavorable environment. But the economy's fundamental strengths are deeply rooted and should facilitate a healthy turnaround. Lessons learned from this crisis can create the basis of a system more finely adapted to competing in the global economy while also buffering it from the inevitable shocks."
Comments on this article should be sent to imfsurvey@imf.org
