Germany
2008 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Germany
Author: International Monetary Fund
Publication Date:
21 Jan 2009
eISBN:
9781451810561
Language:
English
Keywords:
ISCR; CR; GDP; government; financial market stress; slowdown; Commerzbank; economic policy; current account; exchange rate; emerging market; return on equity; liquidity contingency plans; Global
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This 2008 Article IV Consultation highlights that the financial market turbulence has exposed vulnerabilities in the German financial system. The German consumer’s conservatism under the current uncertain conditions will amplify the export slowdown, and investment decisions are likely to be postponed. Executive Directors have welcomed the German authorities’ continuing priority to maintain financial stability and stabilize the real economy. Directors have also noted that the global financial crisis has highlighted important vulnerabilities of the German financial system, which could be intensified by the economic slowdown in Germany.

Abstract

This 2008 Article IV Consultation highlights that the financial market turbulence has exposed vulnerabilities in the German financial system. The German consumer’s conservatism under the current uncertain conditions will amplify the export slowdown, and investment decisions are likely to be postponed. Executive Directors have welcomed the German authorities’ continuing priority to maintain financial stability and stabilize the real economy. Directors have also noted that the global financial crisis has highlighted important vulnerabilities of the German financial system, which could be intensified by the economic slowdown in Germany.

I. The Context1

1. The authorities have stepped in to protect financial stability. Germany felt the force of the first shocks from the subprime mortgage markets in July 2007. Two banks—IKB and Sachsen LB—had to be rescued at significant cost to the German taxpayer. While the traditional strengths of the German financial system—its retail deposit base and low indebtedness of households and businesses—apparently put a cap on the exposure of the system, systemic concerns have remained live. Following the failure of Lehman Brothers, the liquidity rollover requirements at Hypo Real Estate in early October 2008 were another threat to financial stability. The public commitment to protect household deposits provided initial reassurance. This was followed by a comprehensive package in mid-October to support market liquidity and bank capitalization.

A01ufig01

CDS spreads of German financial institutions have been lower than in other hot spots.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

Source: Bloomberg, and IMF Staff calculations.1/ Four largest financial institutions for each country are as follows: Germany -Deutsche Bank, Commerzbank AG, Munich Reinsurance, and Bayerische Hypo & Vereinsbank AG. Switzerland - Credit Suisse, Swiss Reinsurance, UBS AG, and Zurich Allied AG. United Kingdom - HBOS, Barclays Bank, HSBC Bank, and Royal Bank of Scotland. United States - Citigroup, Bank of America, JP Morgan Chase, and Wells Fargo & Co.

2. Given strong spillovers, policy measures to contain the risk of a self-reinforcing and costly slump will achieve more if coordinated internationally. Global impulses, felt forcefully in Germany, are rapidly transmitted to other economies. A German economic slowdown lowers growth in the rest of Europe, which feeds back to Germany. Moreover, a likely reduction of German banks' exposure to emerging markets would generate cascading spillovers. Thus, giving due consideration to its domestic objectives, Germany stands to benefit from an internationally coordinated approach to managing global risks.

  • In this regard, actions to strengthen the financial safety net will buttress the recent initiatives. Germany's request for an FSAP update is timely.

  • A similar risk management philosophy should apply to economic, especially fiscal, policy

II. Near-Term Outlook

3. The German economy is experiencing a sharp turnaround. The ongoing fall in confidence—especially in business confidence, reflecting the sharp drop in foreign orders—accelerated with the elevated financial stress since September 2008. Following robust GDP growth at an annualized rate of about 3½ percent just before the crisis hit in mid-2007, the economy contracted in the second and third quarters of 2008, and a further four quarters of negative GDP growth now appear likely. The expected turnaround reflects German volatility to external impulses (as discussed below), and is larger than in all other G-7 countries except the United Kingdom.

A01ufig02

Sentiment has weakened.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

A01ufig03

The turnaround in German growth will be large.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

1/ Based on November World Economic Outlook Quarterly Forecast Update.

4. Staff's and authorities' growth projections have largely converged, and the risks are viewed as tilted principally to the downside. Broadly in line with the authorities' projections, staff expects GDP to grow at 1.7 percent in 2008, followed by a contraction of 0.8 percent in 2009 (Table 1). The projection of a tentative recovery in 2010 reflects the assessment that the recent upswing was not associated with sustained productivity gains, and financial restructuring will also dampen growth. Corporate and financial sector stresses, thus far dissociated from each other in Germany, may become more intertwined. Moreover, the longer the global shocks persist, the more severe and prolonged would the weakness be.

Table 1.

Germany: Selected Economic Indicators

Total area357,041 square kilometers
Total population (2007)82.2 million
GDP per capita (2007)US$ 40,400

Sources: Deutsche Bundesbank; Federal Statistical Office; IMF, World Economic Outlook; IMF, International Financial Statistics; and staff estimates and projections.

IMF staff projections.

Growth contribution.

National accounts definition

Eurostat definition.

Deflated by the national accounts deflator for private consumption.

Data for federal government are on an administrative basis. Data for the general government are on a national accounts basis. Debt data are end-of-year data for the general government in accordance with Maastricht

Government expenditure in 2000 includes, as a negative entry, the proceeds from the sales of mobile phone licenses of euro 50.8 billion (2.5 percent of GDP). The proceeds also affect the financial (but not structural) balances and the government

Including supplementary trade items.

Data for 2008 refer to October.

Data for 2008 refer to the change to September.

Data reflect Germany's contribution to M3 of the euro area; data not shown for 2002 because of a series break.

Data for 2008 refer to October.

Data for 2008 refer to October.

Based on relative normalized unit labor cost in manufacturing. Data for 2008 refer to October.

A01ufig04

Growth is slowing sharply.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

A01ufig05

Risks to GDP growth are tilted to the downside.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

5. Whether—and the degree to which—downside risks materialize will depend on the evolution of expectations. The economy is being driven, in part, by current conditions but, increasingly, by expectations with regard to the next 6 to 12 months. The forward-looking sentiment is at historic lows. Moreover, the gap between the perception of the present and the future has grown sharply, to an unprecedented size. Pessimistic expectations may further worsen operating conditions and hence become self-fulfilling. As such, to the extent that the forward-looking indicators remain at low levels, they may create a further drag on the economy, and pull the economy into scenarios below the baseline projection.

A01ufig06

Expectations have increasingly diverged from current conditions.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

A. Shocks to Growth

6. The primary shock has been slowing world demand. Since the mid-1990s, German growth has been powered by exports. Not surprisingly, the principal source of the current slowdown has been the curtailment of foreign orders. The projected weakness of the world economy (and especially the U.S. economy) implies that this source of growth will remain heavily restricted. Movements in the euro exchange rate have some bearing on German exports, but staff analysis suggests that they mainly cause a shift in composition rather than a significant overall change.

A01ufig07

Germany has been reliant on export growth.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

A01ufig08

German exports will contract along with US growth.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

7. The German consumer's conservatism will continue to amplify the deceleration. The German consumer remained on the sidelines during the recent upswing. Even when employment and earnings began to finally increase towards the peak of the cycle, the threat of inflation apparently held consumption back. The authorities emphasize some temporary improvement in consumption from lower oil prices and the current labor market conditions. However, staff views low consumption growth to reflect a strong preference for precautionary savings in Germany. Increased exposure to volatility from global spillovers has recently held consumption back (Box 1 below). With financial and growth volatility expected to remain elevated in the coming quarters, and with unemployment expectations rising, consumption growth is projected to remain low. In contrast to staff, the authorities expect lower investment growth.

A01ufig09

Rising unemployment expectations predict higher unemployment.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

Source: European Commission. How do you expect the number of people unemployed in this country to change over the next 12 months? Answers range from “increase sharply” to “decrease sharply.”

8. The worsening business outlook—with rapidly shrinking foreign and domestic order books—will trigger postponement of investment. Investment volatility has traditionally amplified export volatility and the current downturn is no exception. The slowing global manufacturing cycle has sharply curtailed incentives to invest. Investment is projected to fall by 2¾ percent in 2009, contributing ⅔ percentage point to the decline in output. The fiscal measures approved in fall 2008 (see ¶37) to provide investment incentives will not be able to stem these macroeconomic headwinds. Investment is expected to remain weak in 2010.

A01ufig10

Investment volatility has amplified export volatility.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

Volatility from Global Spillovers Add to German Angst

After a sustained decline, GDP growth volatility has increased since the mid-nineties, in Germany and some other industrial countries. This rise in volatility1/ reflects spillovers of other countries' own idiosyncratic shocks, as the world has become more integrated (with trade in goods and financial assets).

A01ufig11

GDP growth volatility is rising in several industrialized countries.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

A01ufig12

Germany's rising volatility reflects increased spillovers.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

A01ufig13

Germany: Trade Openness

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

A01ufig14

Germany: Financial Openness

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

This, in turn, contributed to the slow consumption growth in recent years. Increased GDP volatility and Germany's above-average stock market volatility added to the concerns about tail risks (extreme losses with low probabilities). For precautionary reasons, consumers have preferred to restrain consumption and build buffer-stock savings. During 2002-2007, this effect lowered consumption growth by ½ percentage point.

A01ufig15

Stock market and GDP volatility have dampened consumption.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

1/ Measured as time-varying variances of growth innovations.

B. Macro-Financial Linkages

9. These developments in the real economy do not, as yet, reflect a credit crunch, although that may be changing. Lending standards have tightened somewhat, but more so for large firms than for the small- and medium-sized sector. Yet, overall, bank credit to enterprises has remained relatively robust, declining only slightly in the third quarter of 2008 as demand weakened (Figure 1). Moreover, credit growth has been broad based by type of lending institution. As such, limits on bank credit availability have apparently not constrained growth. That may be changing. Staff analysis suggests that banks have been competing on tightening margins, substituting in some cases for the drying up of the corporate bond market. The authorities agree that with higher funding costs and worsening asset quality, a sharper contraction of credit is likely, contributing to a financial accelerator-like process.

Figure 1.
Figure 1.

Germany: Credit Market Developments

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

Source: Bundesbank, and IMF staff calculations.
A01ufig16

Credit standard have tightened, but especially for large enterprises.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

1/ +/- one standard deviation around average. On a scale of 1 (significant easing) to 5 (significant tightening).Sources: Bundesbank; IMF staff calculations.

10. The corporate bond market is pricing in significant economic weakening. A financial accelerator is evident in corporate bond spreads, which have proved a keen predictor of German GDP growth (Figure 2). The sharp rise in spreads in late-September and early October suggests that the market expects a sizeable growth slowdown along with increased corporate defaults that will keep spreads up. The recent level of spreads predicts a slowing economy through much of 2009. Although this ongoing down cycle started from a point of strength, including in corporate sector balance growth sheets (Figure 3), the projected GDP rates are lower than in the previous recession. This reflects levels of financial stress (and sentiment) that are significantly worse than during the corresponding phase of the previous downturn.2

Figure 2.
Figure 2.

Germany: Probabilities of Default by Sector

(in percent)

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

Source: Bloomberg, Fund staff estimates.
Figure 3.
Figure 3.

Germany: Balance Sheets of Nonfinancial Corporates

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

Source: Bundesbank.
A01ufig17

Corporate bond spreads are consistent with prolonged weakness.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

A01ufig18

The current recession is likely to be deeper and longer …

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

1/ Recession in 2002 started in Q4, while recession in 2008 started in Q2.

… because of greater stress than in the 2002 recession.

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For eight quarters, from the first quarter of the recession.

At the beginning of the third quarter of the recession (October 2008, and April 2003 respectively).

C. Spillovers

11. With its strong international linkages, spillovers into and from Germany are substantial. The Staff Report for the 2007 Article IV consultation concluded that U.S. and European growth impulses have a significant bearing on German growth, manifest at present in Germany's sharp response to the deceleration in world trade. Growth impulses from Germany were contained in the past but are more prominent now. The authorities agree that an economic slowdown in Germany lowers growth in the rest of Europe, which feeds back to Germany.

12. Over time, Germany has become more exposed to emerging market shocks, with implications for ongoing developments. German economic ties to Central Europe are particularly significant: through FDI, trade, and bank subsidiaries (Figure 4). 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 (Table 2), 4 percent of all German banking assets and 12 percent of all German banks' foreign claims. This expansion occurred at a time when other lenders and investors were retrenching from emerging market assets. A likely scaling back of German banks' exposure to emerging markets would generate cascading spillovers.

Figure 4.
Figure 4.

Central and Eastern Europe: Spillovers from Germany

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

Source: Bundesbank, BIS, Direction of Trade Statistics.
Table 2.

Germany: foreign claims of banks on individual countries, November 2008 1/

(In billions of US dollars; unless otherwise specified)

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Sources: BIS, Deutsche Bundesbank, ECB, IMF staff estimates.* projected based on historical trend.

Foreign claims include all international claims plus local claims of foreign affiliates in local currency. The difference between the claims to all countries and the sum of mature and emerging market exposures is due to offshore center exposures.

BIS data is based on the consolidated lending statistic compiled by the Bundesbank (end-Sept. 2008).

The data are derived from the “Groß- und Millionenkreditmeldung” stipulated in §§ 13 and 14 KWG (Credit Services Act). Under the Credit Services Act, debtors are obliged to register all loans (and other credit-like obligations) of EUR 1.5 million or higher with the Bundesbank on a quarterly basis. In this context, the definition of credit also included equity and counterparty risk exposure from credit default swaps (CDS). Specific details on the obligation to register are stipulated in the Groß- und Millionenkreditverordnung (GroMikV). Credit derivative exposures are recorded as off-shore transactions at their nominal value if available, otherwise the book value applies. The presented data reflect gross amounts without recognition of collateral.

A01ufig19
Source: BIS, Bundesbank, ECB, IMF staff calculations.1/ Consolidated lending statistics, ultimate risk basis, in accordance with BIS reporting standards.2/ German emerging market claims (in percent of all emerging market claims).3/ Equity market composite of all emerging market debtor countries. Equity market composite is weighted by GDP at current prices.

13. Spillovers are also manifest in a heightened concordance of sentiment, particularly in an economic downturn. Sentiment in the eurozone becomes more closely aligned when economic prospects worsen. Today, sentiment is more tightly aligned than in the recent past, suggesting that a strong negative reinforcement could continue to hurt growth. German loss of confidence contributes to the contagion of pessimism in the eurozone.

A01ufig20

Euro Area sentiments are more closely aligned in economic downturns.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

Source: WEO and GlobalInsight.

D. Inflation Trends

14. Inflation has remained contained and is expected to decline fast. Through the period of rising food and fuel prices, German inflation expectations have been solidly anchored. Inflation rose mainly in the headlines, with core inflation remaining low. There is no evidence that second-round effects threatened at any point. Food and energy prices did not feed into the core categories (Box 2), nor did wages experience an unusual spike. Indeed, real wages dropped sharply when inflation rose. With the moderation of food and fuel prices, inflation is projected to decline from 2.8 percent in 2008 to below 1.0 percent in 2009. Downside risks to growth imply downside risks to inflation.

A01ufig21

Well-anchored inflation expectations have contained core inflation.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

A01ufig22

Wage pressures have remained moderate while productivity growth has slowed.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

Source: Federal Statistical Office, Federal Labor Office, and Bundesbank.1/ Wage drift is the difference between actual and negotiated wage increases (monthly basis).

Pass Through from Global Fuel and Food Prices

The influence of global fuel and food prices felt in Germany is broadly in line with the impact observed in other advanced economies. International fuel prices are passed through to domestic commodity prices to a significantly greater extent than are food prices. However, once passed through, food prices have a larger impact on core inflation. The size of these transmission coefficients—the extent of prices transmitted over a year—is consistent with the relatively modest effects that were felt in Germany during the recent run up in food and fuel prices.

Pass-Through from International Commodities Prices to Core Inflation, 1995-2008

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Source: IMF (World Economic Outlook, Fall 2008, Helbling and others)

III. Risks to Financial stability

15. The global financial crisis has highlighted important vulnerabilities of the German financial system. Though traditionally conservative, segments of the banking system were exposed to substantial risks. The exposures interacted vigorously with global financial turbulence. As of end-September 2008, Germany accounted for about a quarter of European bank write downs. 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, as discussed below. Looking ahead, the system faces two key vulnerabilities:

  • The rollover of wholesale funding: funding conditions remain tight, and bunching of maturing debt obligations creates rollover risk.

  • The availability of adequate capital buffers: the low absolute level of capital will be further stressed as profits fall and asset quality worsens with the economic slowdown.

Balance Sheet Magnitude of Financial Crisis

(In billions of U.S. dollars unless noted otherwise)

article image
Source: Annual Reports, Bloomberg, Bankscope, Moody's KMV, The Banker, IFS statistics, IMF staff estimates.

Bank regulatory capital to risk-weighted assets (CAR) according to revised Basel Capital Accord.

At end-2007, in percent of total assets.

Since start of the crisis in June 2007 until September 2008.

Includes only commercial banks.

Median CAR values in the respective region.

A. Funding Pressures

16. Traditionally reliant on a strong retail depositor base, German banks had increased their demand for wholesale funding. This was so especially over the years 2004–2007. Starting in mid-2007, but especially since early 2008, these funding sources have contracted sharply. The continued risk that market liquidity will not be rolled over presents an important short-term source of vulnerability. These concerns were especially manifest in the case of Hypo Real Estate.

A01ufig23

After rising rapidly, banks' wholesale funding sources have contracted sharply.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

17. Funding pressures are manifest even in the highly-secure covered bond (Pfandbrief) market. Backed by high-grade mortgages retained on their books (with loan-to-value ratios in the 60–80 percent range) or by loans to the public sector, German covered bonds have been considered almost as safe as Bunds. However, since the spring of 2008, spreads on these bonds have tended to increase, and, following the sharp rise in September, have stabilized at historically-high levels. Trading in the secondary Pfandbrief market has nearly halted since early September, as bondholders are apparently using their Pfandbrief positions as collateral for receiving liquidity from the central bank. Planned issues of covered bonds have been cancelled or cut in volume as the primary market demand has shrunk. Wholesale investors apparently prefer the large ongoing and expected issues of directly government-guaranteed debt.

A01ufig24

Even in the covered bond market, liquidity has dried up.

Citation: IMF Staff Country Reports 2009, 015; 10.5089/9781451810561.002.A001

Source: Datastream; and IMF staff estimates and calculations.1/ Data for non-Jumbo bonds for the second half of 2008 not available.

B. Capital Adequacy

18. Though banks are in compliance with their regulatory capital requirements, their high leverage ratios and falling profits will add to stress. At about 4½ percent, the equity-to-consolidated assets ratio of the German banking system is low even by European standards (Tables 3 and 4). The gap between the risk-weighted capital ratio and the leverage ratio is particularly large for the big commercial banks, the Landesbanken, and the mortgage banks. This reflects the favorable risk weighting of their assets (including portfolios of derivatives instruments) under current regulatory guidelines. Moreover, bank profits had fallen sharply by mid-2008 and, with the economic downturn, are likely to remain low in 2009. As asset quality worsens, and the need for additional provisioning increases, so will the need for additional capital.

Table 3.

Germany: The Core Set of Financial Soundness Indicators for Banks, 1999-2007

(In percent)

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Source: Deutsche Bundesbank. The authorities provide annual data only and disseminate them once a* A methodological break in the supervisory time series on the capital adequacy of German banks has taken place in 2007 due to substantial changes in the regulatory reporting framework, following Basel II.

1998-2006 according to Capital Adequacy Regulation, Principle I. Since 2007 according to Solvency Regulation.

Revised data.

2000-2007 data compiled in accordance with IMF's FSI Compilation Guide. Data not available before July 1, 2000.

Due to one off data availability, comparability of 2006 data with other years limited.