Germany

Oxford Economic Country Briefings, Sep 16, 2008

Highlights and Key Issues

* GDP fell by 0.5% in Q2 after a surprisingly strong Q1. The weakness in Q2 was exaggerated by the abnormally mild winter, which boosted construction activity in Q1, and the less favourable depreciation rules as part of the reform of business taxation at the beginning of 2008, which encouraged investment to be brought forward. However, a decline in exports and private consumption indicates that the Q2 fall in GDP is down to more than statistical quirks.

* The Ifo index has dropped from 103.4 in May to 94.8 in August and is now below its long-run average, corresponding to the levels seen in 2004. Both the current situation and future expectations components have fallen sharply in recent months, with business expectations sinking to their lowest since 1993 despite an easing in the oil price and the euro. The near-term outlook is bleak and, with industry and exports falling in July, the economy is close to recession. We now expect GDP to expand by 1.6% this year and just 0.8% next, with risks skewed to the downside.

* Inflation now seems to have peaked, with preliminary data for August putting the rate at 3.1%, down from 3.3% in July. The main factor behind the decline is lower fuel costs. Inflation is set to fall through 2009 but still average 2.6% for the year as a whole. With wage inflation set to edge up, this will provide a welcome boost to households and help the economy strengthen in 2009H2.

Overview

The economy declined in Q2...

* GDP fell by 0.5% in Q2, after a surprisingly strong Q1. This was the first quarterly decline in GDP since 2004Q3, when Germany was still struggling to emerge from several years of stagnation. The strong growth in Q1 and the subsequent fall in Q2 are exaggerated as the abnormally mild winter boosted construction activity in Q1 and the introduction of less favourable depreciation rules as part of the reform of business taxation at the beginning of 2008 meant that investment was brought forward. However, a decline in exports and private consumption indicates that the fall in Q2 GDP is not just due to statistical quirks.

...and weakness continued into Q3...

* Indeed, although industrial output edged up in June, this was a very disappointing rebound from the already extremely weak May, suggesting weakness persisted through Q2. Manufacturing orders continue to plummet, falling 1.7% in July as orders for capital goods dried up. And the economy appears to have weakened further in August, as the PMI for manufacturing slipped below the 50-mark that separates expansion from contraction for the first time since 2005. According to the Ifo index, export expectations are at their lowest since 2003, prior to the period of wage moderation that boosted German competitiveness and another reminder that growth prospects have slipped back sharply.

...with economy close to recession

* The speed with which the economy is slowing is somewhat surprising: the lfo index dropped from 103.4 in May to 94.8 in August and is now barely above its long-run average and corresponds to the levels seen in 2004. Both the current situation and future expectations components of the index have dropped sharply in recent months, with business expectations plummeting to their lowest level since 1993 despite an easing in the oil price and the euro. The near-term outlook is bleak and, with industry and exports falling in July, the economy is close to recession. We now expect GDP to expand by 1.6% this year and just 0.8% next, with risks skewed to the downside.

Unemployment to rise...

* This sharp decline in the business environment will start to have repercussions in the labour market. Although unemployment continues to edge down, there have already there have been some high-profile announcements of job losses. Also, survey evidence from the PMIs and Ifo employment barometer show businesses' employment intentions have cooled, while the number of vacancies is trending down - we expect unemployment to rise to 8.5% by end-2009. However, this is fairly typical in a cyclical downturn and the labour market remains in much better shape than earlier in the decade.

...as unions demand wage hikes...

* But inflation seems to have peaked, down to 3.1% in August from 3.3% in July, with sharply lower wholesale price inflation in August indicating an easing of pipeline inflation pressures. The main factor behind the fall in inflation is lower fuel costs. Inflation is set to fall through 2009 but still average 2.6% in the year as a whole. With wage inflation set to edge up, this will provide a welcome boost to households and help the economy strengthen in 2009H2. The outlook for wages is a key risk to the outlook - for both inflation and growth. The IG Metall union is seeking a 7-8% wage increase in the upcoming wage round, its most aggressive demand in 16 years. However, against a likely backdrop of rising unemployment and weak growth, unions are unlikely to achieve their objectives.

...and political parties bicker

* The CDU is proposing a euro10bn fiscal injection next year through cutting social security contributions and additional child support payments. However, it is unlikely that a significant fiscal package will be agreed ahead of the general election next year. The CDU is trying to take advantage of the SPD - its partner in the Grand Coalition - being in disarray following the resignation of its leader Kurt Beck. In what seems likely to be a long election campaign, significant policy packages are unlikely. We therefore expect the fiscal position to deteriorate given the economic cycle and the likely rise in unemployment. The budget is forecast to slip back into a deficit of 0.9% of GDP in 2009 after being in balance in 2007.