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back to index backEUROtalk May,  2005

German economic recovery in jeopardy?

By mid-February 2005, there was ample evidence that German economic growth seemed on the verge of accelerating sharply from its slump in the second half of 2004. In December 2004, manufacturing orders had posted their biggest jump since German unification, 7.6% month-on-month (m/m), driven by domestic investment goods. Moreover, the Ifo and GfK leading indicators had posted dramatic gains in the preceding months. And income tax cuts at the beginning of 2005 offered the potential for stronger private consumption, while consumers had apparently come to terms with the hardships involved with the Hartz IV labor market reform.

Just over two months later, the picture is vastly different. Leading indicators have turned sharply lower again, with business confidence indexes falling below their 2004 nadir seen in November. Manufacturing orders and production have given back most of the gains observed around the turn of the year. Accordingly, GDP growth forecasts have been revised down sharply. The leading economic research institutes have halved their joint forecast for 2005 growth to 0.7%, down from the 1.5% projected in autumn 2004. Global Insight's growth forecast, which had been for (an unadjusted) 1.7% in September 2004 and still 1.1% in early February 2005, has now also been lowered to 0.7%. Even the German government in late April cut its official forecast from 1.6% to 1.0% growth.

So what has gone wrong since February? Modifying a well-known catch-phrase: it's the oil price, stupid.” While not the full explanation, it is the single-most important factor depressing the outlook in recent months. It is not so much that we have seen another surprising price surge to record heights in March–April. The salient point is that widespread expectations (nurtured by softening oil prices in November–December 2004) of weakening prices throughout 2005 (towards US$40/barrel or even US$35/barrel) have been shattered. This has been reinforced by the fact that back months of the futures contracts have often been more expensive than the spot price. Indeed, the general view—Global Insight included—is now that oil prices will average around US$50/barrel in both 2005 and 2006, before a modest softening possibly occurs in 2007.

Why is this so damaging? The main factor restraining companies' investment plans in 2004 (apart maybe from political uncertainty related to structural reforms) was the squeeze on profit margins due to relentlessly rising commodity prices while output prices could not be raised due to weak domestic demand. Many firms had hoped they could proceed with new investment early this year, when input prices would be falling and domestic demand would increasing, helped by income tax cuts. This dream has largely vanished.

Other domestic factors have added to the gloom, particularly the impact of the Hartz IV labor market reform on officially reported unemployment, which at around 400,000 has been larger than assumed. The psychological impact was magnified by the fact that this occurred in January–February, when seasonal factors drive unadjusted numbers higher anyhow. Political issues such as the so-called visa affair (concerning overly lax granting of visas, inviting illegal immigration) have further damaged the credibility of the government and are rightly seen to distract the government from dealing with economic issues.

But all is not lost for the German economy this year. First, the 12 May release of first-quarter GDP should reveal a strong start to 2005, based on the production spike in January and robust consumer spending relative to late 2004. The quarter-over-quarter (q/q) growth figure, which should be at least 0.5% (or 2.0% annualized), will also be bloated by a technical correction to the calendar effect that overly depressed fourth-quarter GDP (worth at least 0.2 percentage point). Indeed, this might even be reinforced by an adjustment to the opposite side for two less working days in the first quarter.

Second, although activity will be much weaker in the second quarter—possibly showing stagnation—consumer confidence and retail sales have been conspicuously resilient so far this year to the bad unemployment and oil price news. While no miracles should be expected, the consumer should still support economic growth during 2005.

Third, export expectations in recent Ifo reports and export orders in the PMI surveys have slipped only modestly. This may have been helped by the euro's slight correction from its all-time high at the tail end of 2004, but is mostly due to the ongoing robustness of global growth, especially in China and the United States. In addition, Germany's price competitiveness aside from currency developments has improved sharply in the last four years, notably against such competitors as France and Italy. As such, Germany is profiting internationally from its virtual stagnation in real wages (or even reduction since mid-2003) and sub-Eurozone inflation in recent years. Given that imports will stay subdued in the first half of 2005 due to soft domestic demand, net exports may boost GDP growth considerably during this period.

Finally, the destocking of inventories in fourth-quarter 2004 (a 0.8-percentage-point drag on quarterly GDP growth) offers upside potential for production in early 2005 because of depleted stocks. This effect may even be enhanced by precautionary stockpiling of raw materials—like in the summer of 2004—as German firms seek to safeguard against surging commodity prices and supply bottlenecks.

In sum, there is no denying that higher oil prices relative to January projections have again delayed the economic recovery. But improved export competitiveness and a positive impact on consumer spending from the unwinding effects of labor market reform (leading to greater reductions in unemployment than warranted cyclically) will increasingly support Germany's economic growth during 2005. The income tax reductions and looming midyear cuts in contributions to the health system will also bolster private consumption. These factors will limit any further downside risks for 2005 and raise the potential for 2006 growth, which Global Insight currently forecasts at 1.6%, calendar adjusted (or 1.4% without adjustment).

Source: Global Insight

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