Schroders: Germany faces more difficult road ahead

Keith Wade, chief economist & strategist at Schroders traveled to Frankfurt and Berlin in mid-September to meet senior officials at the ECB, Bundesbank, Finance, Economics and Labour
Ministries of the German government plus a think tank. Here, he reports back on the main themes of his discussions.

An optimistic assessment of the German economy and a sense of relief that the Greek crisis is back under control provided a positive backdrop to this visit, which took place just before the Volkswagen scandal broke. However, although no one wanted to say it, the longer term prognosis for Germany looks poor.

The slowdown in China and the emerging markets presents a major challenge when the growth model is based on a significant manufacturing sector which has benefited enormously from the emergence of China and growth in the emerging markets.

Germany is increasing its long-run fiscal commitments through:

(a) support for migrants, which may prove to be a short-term boost but long run drag
(b) the eurozone, through guarantees and the mutualisation of risk in the banking sector, not to mention Greece.

These challenges come on top of a demographic deficit which will see the working population shrink in coming years. It could well be the case that today proves to be the peak for Germany and it thereafter struggles as it seeks to meet its new obligations and keep a balanced budget.

Economy: near term optimism on growth and inflation
There was near universal agreement in my conversations that the German economy was performing fine and was set to grow by 1.8% this year and the same next year. Not surprisingly, the cloud on the horizon was the downturn in China which was expected to lead to some moderation in export growth. Generally, though, this was not seen as a major problem with just 6.5% of German exports (2.5% GDP) going to China, the same as to The Netherlands.

Most saw the problems in China as temporary and expected a government stimulus to lift the economy in 2016. There were offsets for Germany in the form of better demand from peripheral Europe where economies are strengthening, and from increased public expenditure on refugees (more below).

Nonetheless, it was recognised that the impact of recent events in China was not in the data yet, and many companies had significant sales in China (for example, it accounts for one in three cars sold by VW) and that the broad impact could be exacerbated by financial markets, particularly through the euro.

The higher trade-weighted euro combined with the recent tightening of financial conditions was expected to take about 0.2% off eurozone core CPI inflation next year and delay the closure of the eurozone output gap until later in the decade (2019).

Downside risks had risen and these developments would seem to have increased the European Central Bank’s (ECB) willingness to increase or extend quantitative easing (QE) beyond September 2016. Monetary policy remains the primary source of stimulus given the limits on the fiscal side.

Coming back to Germany, there was some surprise at the lack of inflation this year as a result of the fall in the euro over the past year. Most believed the output gap had closed and, as the economy continued to grow above trend, inflation would normally pick-up.

Most welcomed this and none saw inflation as getting out of hand as there was a belief that the ECB had succeeded in stabilising inflation expectations at 2%.

Immigration
The influx of immigrants is seen as positive by all from an economic perspective, by helping to boost demand and address the demographic deficit. It is expected that at least 800k migrants will arrive this year and some 2 million in total over the next four years.

Germany already has net migration of 400k p.a. but this would be a considerable step-up. It is estimated that it will take five months to process and settle each refugee. Each will then be offered a six-month German language course to be followed, if necessary, by a technical training course to equip them for the labour market.

Initial estimates suggest that such training will be necessary, with unofficial surveys finding that 80-90% of refugees are not currently qualified for the German labour market. Whilst it is difficult to criticise Germany’s approach, there is also a cost which has been put at €10k minimum per refugee.

German finances are strong and all we spoke to said “the money is not a problem”. However, it may not take long to absorb the €10bn which can be spent before the balanced budget policy is put at risk.

Since my visit, Finance Minister Schäuble has asked government departments to prepare savings of up to €2.5bn to finance additional federal expenditure of €9bn for refugees. However, as some of this will be through lower-than-expected interest payments, the expenditure cuts will be correspondingly smaller. Consequently, the net increase in migrant spending so far is about €8bn on current plans. This amounts to about 0.3% of GDP, which – whilst not insignificant – will amount to the maximum effect unless Schäuble relaxes his budget policy.

As for the supply side, adding 2 million people will help address the demographic deficit, whereby the German workforce is set to shrink from 45 million to 36 million over the next 15 years. The impact on potential output though will depend on whether the new arrivals can be profitably employed.

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