The Economic Outlook for Germany May 8, 2010

Economic Growth "German economy had its biggest postwar decline with Real GDP shrinking 5% in 2009 on average annualized basis."1 In the time period leading up to the recession from Q1 2007 until Q3 2008, all components that comprise GDP including government spending, consumption and investment growth

1 with the exception of net exports, remained relatively unchanged. The component of GDP that initially led to the decline in economic growth in Germany was net exports with an annualized decline of 92% in net exports during the third quarter of 2008. Exports weigh heavily at 45% of overall GDP over the three year period studied. The recession caused investment growth to decline by 30% (annualized). The recession had little effect on consumption or government purchases compared to its effect on net exports. At the height of the recession, during Q1 of 2009, government purchases increased by 10% on an annualized basis. Since the US and France are Germany's leading importers, the US recession was a key factor in the decline of Germany's exports. By the Q2 of 2009 Germany's net exports dramatically increased by about 475% on annualized basis. The increase in exports was a result of improving economic conditions across the world. In 2009, the net exports still fluctuated but the percent change stayed above zero. The unexpected increase in inventory signaled the onset of the recession during the Q3 2008. Similarly, an unexpected decrease in inventory was observed in Q2 of 2009, which indicated improvement in economic conditions. Most recently, all other components of GDP including consumption, government growth and investments stayed relatively unchanged. The net exports, which had been the most volatile component in 2009 recovered and is trending positively. However during Q1 2010 consumption growth was adversely affected by the weather. The coldest winter in 14 years dampened the growth at the start of 2010. This depressed construction activity and slowed spending.2 Also, the expiration of government stimulus programs had a negative impact, Household spending has dipped since the end of Germany's car-scrapping incentives of 2009.3

10.00%

GDP (% Change Annualized)

5.00%

0.00% Q1 2007 -5.00% Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008 Q1 2009 Q2 2009 Q3 2009 Q4 2009

GDP

-10.00%

-15.00%

GDP & GDP Components (% Change Annualized)

600.00% 500.00% 400.00% 300.00% 200.00% 100.00% Export Growth 0.00% -100.00% -200.00% GDP Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2007 2007 2007 2007 2008 2008 2008 2008 2009 2009 2009 2009 Import Growth Consumption Growth Government Growth Investment Growth

GDP is represented by the bold dashed line

Net_Exports

GDP & GDP Components (% Change Annualized) Net Exports Removed

30.00% Consumptio n Growth

20.00% Government Growth

10.00%

0.00% Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2007 2007 2007 2007 2008 2008 2008 2008 2009 2009 2009 2009 -10.00%

Investment Growth

Export Growth -20.00% Import Growth

-30.00%

-40.00%

GDP

GDP is represented by the bold dashed line

-50.00%

5,000

Change in Inventory Investment (Millions of Euros)

0 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 2007 2007 2007 2007 2008 2008 2008 2008 2009 2009 2009 2009 -5,000 Inventory Investment

-10,000

-15,000

4 Labor Market The unemployment rate was moderately affected by the recession. It went from its low of 7.6% in Q3 2008 to a peak of 8.3% Q2 of 2009. Recently, unemployment is steady at around 8%. During the time period reviewed, Germany's unemployment never exceeded NAIRU with a 5 year average of 8.33%. There is an inverse relationship between unit labor costs and productivity, as productivity declined in 2009; unit labor costs increased putting upward pressure on prices. The minor improvement in

Germanys unemployment picture may not be indicative of a long-term trend. A government subsidy program, called Kurzarbeit (or "short work") is slated to expire later in 2010, and unemployment may increase once Kurzarbeit benefits end. Kurzarbeit subsidizes part-time workers wages, so an employee will receive up to 80 percent of her normal salary for working only half her normal hours, according to ING. The Financial Times estimated in January of 2010 that as many as 1.4 million workers participated in the Kurzarbeit program. The decline in productivity for the year 2009 can be due to subsidies like Kurzarbeit as it results in suboptimal workforce utilization even after the economy recovers.4 Typically a decrease in productively and the corresponding rise in unit labor costs, along with unemployment being below NAIRU lead to inflation. Surprisingly, this is not the case in Germany.

Unemployment Rate (%)

6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 2007 2007 2007 2008 2008 2008 2008 2009 2009 2009 2009 2010 Unemployment Rate (%)

Growth Rate of Unit Labor Costs and Productivity Growth

1.08 1.06 1.04 1.02 1.00 0.98 0.96 0.94 2007 2008 2009 2010 2011 Growth Rate of Unit Labor Cost Productivity Growth

8.6 8.4 8.2 8 7.8 7.6 7.4 7.2 2007

NAIRU % and Unemployment %

NAIRU (%)

Unemployment Rate (%)

2008

2009

2010

2011

Inflation As unit labor costs rose, inflation rose from 2.0% during the Q2 2007 to 3.4% in Q2 of 2008. As the recession started in Q3 of 2008, inflationary pressures decreased. In Q3 of 2009, Germany experienced negative inflation -deflation - of -0.5%. Currently, Q1 2010 inflation is 1.2%. Reduction in personal income and consumer confidence during 2009 reduced consumer spending, hence inflation declined.

6 Massive fiscal and monetary spending was helpful in stemming deflation and returning the economy back on a growth trend. Since the output gap is forecasted to be negative for year 2010 and 2011, inflation is likely to be well contained. As mentioned above, expiration of government subsidies to the labor market may negatively affect unemployment and can cause it to rise above NAIRU. This will likely keep inflation in check. Based on the core inflation data, it seems that core inflation is under the ECBs target rate of 2%.

Inflation
4.0 3.0 2.0 Inflation 1.0 (1.0) Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 2007 2007 2007 2007 2008 2008 2008 2008 2009 2009 2009 2009 2010

PCE and Core Inflation

1.16 1.14 1.12 1.1 1.08 1.06 1.04 1.02 1 2006 2007 2008 2009 2010 2011 PCE Inflation Core Inflation

PCE Inflation and Core Inflation - (% Change)

2.500% 2.000% 1.500% 1.000% 0.500% 0.000% 2007 -0.500% 2008 2009 2010 2011 PCE Inflation Core Inflation

Long-run economic growth The long term growth rate for Germany is about 1% and is expected to decline as a result of the great recession. The primary driver for long term growth is productivity and the factors that affect productivity. Productivity and number of hours worked both declined during the recession. Government stimulus programs like Kurzarbeit (short -work) that kept employees artificially employed, and reduction of investment in technology and physical capital were the primary factors for the decline in productivity. The output gap in 2009 turned sharply negative to -3.49% from the previous years output gap of 2.38%, it is expected to be -2.87% for 2010 and -1.78% for 2011. Output gap is a future indicator of inflation and thus future inflation is expected to be very moderate, probably around 1% to 1.5% range. As exports are the mainstay of the German economy, future economic growth will be highly dependent on the economic situation of its trading partners. The current debt crisis in Greece and other European countries pose a major threat to German economic growth. An escalation of sovereign debt crisis can push German and other European economies into a second recession with serious risks of deflation.

Potential GDP (% Change)

1.40% 1.20% 1.00% 0.80% 0.60% 0.40% 0.20% 0.00% 2007 2008 2009 2010 2011 Potential GDP (% Change)

Percentage

Output Gap
3 2 1 0 2006 -1 -2 -3 -4 2007 2008 2009 2010 Output Gap

Budget Deficits and the National Debt Prior to the great recession, Germanys annual budget deficit was actually a budget surplus. In 2007, Germany had a budget surplus of 0.2% of their GDP, its highest mark over the last 9 years. Once the downturn in the economy started in 2008, Germanys spending increased and its budget deficit increased as well. Budget deficits and national debt have a positive correlation; as budget deficits increase, national debt increases. Throughout the recession, the German government recognized that

9 spending was needed in order to stimulate the economy to prevent further economic downturn. In October 2008, the government approved a 480 billion rescue package to help stabilize the country's troubled banking system. After realizing that the global crisis would hit Germany, the government passed in January 2009 an additional 50 billion stimulus package. It also announced the provision of 100 billion to underwrite fresh credit to companies. 5 In January 2009, the government also introduced the German version of Cash for Clunkers (Abwrackpramie), which helped stimulate the economy by pumping in an estimated 2.5 billion to the economy. As mentioned previously, the government also introduced the Kurzarbeit (short -work) stimulus program that kept employees artificially employed to help stimulate the economy. With the government stimulus in the economy, the budget deficit increased to 3.3% of GDP in 2009 exceeding the 3% deficit limit set by the Maastricht Treaty, and national debt rose from 65.0% of GDP in 2007 to 73.2% of GDP in 2009. As history has proven, an increase in spending and a rise in budget deficits during a recession are common and expected in order to prevent the recession from getting worse. It is also important to note that the Germanys national deficit will continue to increase as the government has pressures from the International Monetary Fund and its European partners to help Greece out of the brink of bankruptcy and provide monetary help over a period of three years.

Budget Deficit as % of GDP

0.5 0 -0.5 -1 -1.5 -2 -2.5 -3 -3.5 Budget Deficit as % of GDP 2007 2008 2009

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National Debt as % of GDP

74.0 72.0 70.0 68.0 66.0 64.0 62.0 60.0 2007 2008 2009 National Debt as % of GDP

Interest Rates Interest rates have declined 127 basis points (from a high of 4.34 in Q3 2007 to a low in Q3 2009 of 3.07) which is more than a point over 3 year period. During the recession in the United States and the financial panic worldwide, investors rushed to buy 10-year German bonds resulting in higher bond prices. Currently, the 10 year bond rate is 3.18%. Lower long-term interest rates are an indicator of lower expected inflation. Investors perceived Germany as a safe place to invest. As the interest rates continue to remain low, businesses have the opportunity to invest in capital, land and equipment; this increases productivity and decreases unemployment thus potentially strengthening the economy.

5.0 4.0 3.0 2.0 1.0 -

Ten-Year Government Bond Rate

Ten-Year Government Bond Rate

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 2007 2007 2007 2007 2008 2008 2008 2008 2009 2009 2009 2009 2010

11 Monetary policy, Interest Rates, and the Euro At the beginning of the recession in 2008, the ECB reduced the interest rates on reserves, the federal funds rate, and the discount rate in order to increase liquidity into the economy and stimulate spending. "On October 8, 2008 the ECB announced that starting from the operation to be settled, on October 15th, the weekly main refinancing operations would be carried out through a fixed rate tender procedure with full allotment of the main refinancing operations." This was an attempt to ensure liquidity in the market.

Based on the above answers, it seems that the ECB did the right thing by reducing the interest rates significantly and providing additional liquidity. Some analysts have however criticized the ECB for not reacting fast enough. They say the ECB was focused on inflation for too long and that they needed to cut interest rates sooner; the ECB lagged the US Federal Reserve by about a year.

6 5 4 3 2 1 0 2006 2007

Monetary Policy
Deposit Facility Interest Rate on Reserves Main Refinancing Operations Rate Federal funds rate Marginal Lending Facility - Discount Rate 2008 2009

Below is an updated chart of the Euro vs. Dollar since the start of the recession in Q3 of 2008. After the collapse of the Lehman Brothers in September 2008, investors started moving back into extremely safe investments like US Government Treasuries and bonds. This caused the decline in the Euro against the dollar. The Euro went from $1.55 on August 1, 2008 to the low

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of $1.25 in March 2009 a 24% decline. After March 2009, economic conditions started to improve due to massive government fiscal and monetary intervention across the world and reduction of panic among investors. Thus money flowed out of US Dollars and the Euro appreciated by 20% to $1.50 by December 2009. Another factor behind the decline of the US Dollar during this period was a reduction of the Federal funds rate to almost zero and a drastic increase in US debt as a result of bailouts and stimulus. Since December 2009, the debt crisis in Greece and other European countries like Spain, Portugal, Ireland and Italy has worsened and been the focus of investor attention. This has negatively affected the Euro which has fallen to a fourteen month low of $1.27 as of May 6, 2010. Euro/USD

A somewhat similar trend has been observed in the Euro vs. Japanese Yen. The Euro declined by 29% from the start of the recession until March 2009, then rallied back 13% until December 2009 and again declined to a low of 113.74 as of May 6, 2010.

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Euro/JYP

Conclusion The German GDP came out of the recession in Q3 of 2009, however, growth stagnated in Q4 of 2009. Moving forward, the German economic growth will depend on how exports perform which in turn will depend on the economic conditions of its trading partners. A decline in the Euro may positively affect the overall German economy. Inflation in Germany is likely to be contained as its output gap is forecasted to be negative for 2010 and 2011. The increase in national debt is an issue and will need to be addressed in the coming years by increasing taxes and/or decreasing government spending. Germany will contribute 8.4 billion ($11.1 billion) for the first year of the Greece bailout this year, followed by 14 billion ($18.5 billion) over 2011 and 2012. As far as Germany is concerned, it would prefer for the ECB to keep interest rates steady at 1% to promote steady growth and to control inflation.

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The ECB has an extremely difficult task to set interest rates that will suit all countries that use the Euro each with distinct monetary needs. Some analysts are recommending that the ECB should follow the Fed and buy bad fixed income assets what many refer to as quantitative easing. Based on our limited knowledge, it seems this may not be favorable to Germany as it will have to foot the bill. Credit Suisse estimates that the cost to bailout Spain, Portugal and Greece could be as high as $600 billion. The bailouts have very strict austerity measures which can potentially push the recipient country into depression. So this Euro system is causing a lot of pain for all the member countries and one would question if the countries should work for the Euro (stability) or should the Euro work for them!

15 References

1 http://online.wsj.com/article/SB10001424052748704362004575000264093920970.html 2 http://www.bloomberg.com/apps/news?pid=20601100&sid=aYhQe.NDNByM 3 http://www.bloomberg.com/apps/news?pid=20601100&sid=aYhQe.NDNByM 4 http://job-news.odesk.com/unemployment-news/employment-situation-improves-in-germany-butlong-term-job-growth-may-be-a-ways-off-568 5 http://www.globalpropertyguide.com/Europe/Germany/Price-History 6http://blackboard.rollins.edu/webapps/portal/frameset.jsp?tab_id=_2_1&url=%2fwebapps%2fblackbo ard%2fexecute%2flauncher%3ftype%3dCourse%26id%3d_2170_1%26url%3d