The outlook for the German economy

Business Economics, July, 1995 by Klaus Wieners

During late 1994 and early 1995, most of the leading research institutions forecasted a stable economic upswing with low inflation. Since then, the drastic changes in exchange rates have prompted concerns in the financial markets, especially for Germany, with its huge external sector. A correction process is expected to start shortly, with real growth of 3 percent, inflation rates of 2-2.5 percent, and stable bond and stock prices. However, if the D-Mark stays around its current level, the outlook would be less favorable.

The Upswing in the German economy, which commenced surprisingly early last year, gained momentum and widened throughout 1994. Recovery in Western Germany was triggered by a vigorous increase in foreign demand. Domestic demand wa stimulated by a turn around in the inventory cycle an spending on residential construction. In tandem with improved sales and earnings expectations as well as renewed increase in capacity utilization, capital spending on machinery and equipment, which had dropped by a total of more than 25 percent in the previous two-and-a-half years, also increased noticeably as the year progressed. By contrast, private consumption remained weak due to a further drop in private household real incomes, with public and commercial construction also continuing to slide.

All in all, real GDP in Western Germany grew relatively steadily by 3.25 percent between the fourth quarter of 1993 and the fourth quarter of 1994, averaging 2.3 percent for the year as a whole. At that stage, the fundamental conditions for a continued upswing in Germany were distinctly favorable, even though a temporary slowdown was in the cards due to the sizeable hike in charges and levies.

With the strong appreciation of the D-Mark and the latest wage settlements, however, prospects have clouded appreciably. At the end of April, the weighted external value of the D-Mark against the currencies of the eighteen leading industrialized nations was up 6 percent on December 1994 and 7.5 percent higher than last year's average. As this appreciation does not reflect any improvement in costs and prices in Germany over other countries, the D-Mark's real external value rose to a similar extent, making German exports suddenly a good deal more expensive in foreign currencies.

However, some evidence suggests that the D-Mark's high flight is the result of speculative overshooting and will be corrected in part over the coming months. A turn around in exchange-rate expectations is likely as soon as the negative effects of the D-Mark's appreciation are reflected in the real economy. Recent information by Ifo, the Munich-based economic research institute, taken from regular polls within the industry, indicate that this will start to show up during the next couple of months.

EASTERN GERMAN ECONOMY: STILL NO

SELF-SUSTAINING GROWTH

In Eastern Germany, growth has accelerated substantially, with real GDP expanding by 9.2 percent last year, i.e., the highest rate since unification. Between the second half of 1990 and the same period of 1994, aggregate economic output in the new federal states climbed by a good 25 percent, meaning that roughly half of the previous slump has since been recouped.

With another strong increase in production (26.5 percent) last year, the construction industry is continuing to show dynamic expansion. The manufacturing sector is also registering high growth rates, albeit from a very depressed level. In the second half of 1994, output in this sector was still down about 10 percent from the levels prevailing four years earlier. During this period, the structure of industry has undergone considerable change, as may be seen from the differing from 240 percent in synthetics manufacturing and 135 percent in bricks and mortar to 15 percent in motor vehicle production, with iron and steel shrinking by 25 percent, electrical engineering by almost 35 percent and mining and clothing by 70 percent each. The overall increases in productivity in the manufacturing sector are considerable: although production is now the number of employed persons has fallen by 70 percent, meaning that, in purely mathematical terms, output per employee has climbed by 200 percent. However, the rise in hourly productivity was a good deal lower, as average working hours per employee have increased sharply with the reduction in short-time working.

The fact that the catching-up process has now gained considerable momentum after initially faltering is also proved by other indicators. Thus, building investment per capita is now almost 50 percent and capita spending on plant and equipment roughly I 0 percent higher in Eastern Germany than in the west.

Even so. there are still considerable economic imbalances in the new federal states:

1 . The situation in the labor market remains difficult. If

hidden unemployment taken into account, underemployment

stands at almost 30 percent. 2 . Domestic demand outstrips local production by more

than DM 220 billion at current prices. In real terms, this